Apple's iPod Works Magic on Mac Sales

The music player's 'halo effect' has helped drive computer sales up 51% in the last quarter, though investors wonder how much near-term upside is left in the stock.
By Priya Ganapati ,

SAN FRANCISCO --

Apple's

(AAPL) - Get Report

iPod juggernaut is cooling off, but it has helped to drive scorching growth at the company's Mac computer business.

In a PC market that grew only 12% last quarter, Mac unit sales were up 51%, outpacing the market by three-and-a-half times and offering the strongest quarterly growth in almost two decades.

Ironically, it has been the so-called iPod halo effect, where iPod owners look favorably to other Apple products, as well as the strong retail push using Apple stores, and the Mac's ability to run Windows applications, that helped drive sales for Apple and offset weakness in gross margins during the second quarter, say analysts.

The upcoming back-to school-sales season and increasing reports of consumer dissatisfaction with

Microsoft's

(MSFT) - Get Report

Vista operating system should drive consumers further into the arms of Apple. That trend will go a long way to dismiss concerns that Apple's sales could be hurt by weakening consumer spending.

Cramer: A Bull Case for Apple

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Despite the strong results, Apple investors seemed to hold back on Wednesday, likely as a result of the quarter's decline in gross margins (32.9% from 35.1% in the year-ago quarter) and what has been perceived as weak third-quarter guidance. Shares of Apple were recently up 2.9% to $167.59.

Investors also may be wondering how much higher shares can go, following a bounce of more than one-third in the past three months -- and without future near-term product catalysts.

For the third quarter, Apple

said it expects

revenue of $7.2 billion and earnings of $1 a share. Analysts are expecting revenue of $7.15 billion and earnings of $1.10 a share.

The outlook from Apple, considered one of the four horsemen of technology, along with

Google

(GOOG) - Get Report

,

Research In Motion

(RIMM)

, and

Amazon.com

(AMZN) - Get Report

, follows the company's historically modest pattern when it comes to guidance. Apple's guidance in six of the last eight quarters for the company has been below Street estimates, points out Mike Abramsky, an analyst with RBC Capital Markets, and each time Apple has beat consensus by a healthy margin.

But investors' focus on weak gross margins takes away from the real Apple story of the quarter, the blistering sales of Macs, say analysts.

Last month, Apple overtook

Dell

(DELL) - Get Report

as the

No. 1 PC supplier

in the educational institutions market. Apple's U.S. education business during the second quarter generated Mac unit growth of 35% from a year ago -- the highest growth rate in any quarter in the last eight years, the company told analysts on a conference call.

Strong Mac sales are clearly the highlight of the earnings report, says Romeo Dator, co-manager of the

All American Equity Fund

(GBTFX) - Get Report

at U.S. Global Investors, which has Apple in its top 10 holdings.

"They were better than expected again," he says, "and shows the iPod halo effect is working."

Apple's own stores and the company's push through big box retail channels are paying off, too. Apple's stores sold 458,000 Macs during the quarter, an increase of 67% from a year ago.

Apple's move to expand its reseller locations should help the company stay strong, say analysts. Earlier this year,

Best Buy

(BBY) - Get Report

executives said they will have Macs in 500 Best Buy stores, up from about 270 at the beginning of the year.

In addition, the Mac's ability to run Windows applications following the October launch of Mac OS 10.5 has brought in a number of Windows users that have in the past been skeptical about the Mac platform, says Charlie Wolf, an analyst with Needham in a research note. Needham has an investment banking relationship with Apple and Wolf has a long position in Apple shares.

More than 50% of all Mac sales were to first-time Mac customers in both the U.S. and a few countries in Europe.

Mac products and services represented 59% of Apple's total quarterly revenue and the company shipped 2.29 million Macs in the quarter. Sales of desktops grew 37%, driven by strong demand for the iMac and Mac Pro, two products that Apple had updated in January, while sales of laptops grew 61% driven by demand for MacBook, MacBook Pro, and the lightweight ultra-portable MacBook Air.

Apple also proved the skeptics wrong when it comes to MacBook Air, which has been criticized because it lacks enough features and is expensive. Apple said it has seen stronger-than-expected demand for the ultra-thin laptop and has struggled to bring more units into the market to meet demand.

There's more coming from Apple later this year that should keep existing Mac users interested, say analysts. Apple is expected to deliver upgrades including a redesign of the MacBook and MacBook Pro.

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