iPods Could Transform Apple Computer

Apple Computer's ( AAPL) iPod has revolutionized the digital music business. Now, some observers wonder if the hip consumer gadget could do the same for Apple itself.

Most investors still treat iPods and Apple's related online music venture as a sidelight to the flagship computer business, which accounted for 63% of Apple's sales in the latest quarter.

But Merrill Lynch analyst Steve Milunovich argues the iPod could help put Apple back on the consumer tech map and "become relevant again thanks to its tech know-how and strong brand." (Apple sold 2% of worldwide computer units in 2003, according to Gartner Dataquest and Merrill Lynch.)

In a recent note Milunovich predicted iPod sales could approach $1 billion in the current fiscal year, or about 13% of Apple's projected annual sales of $7.5 billion. iPods have mostly drawn rave reviews, although some consumers have complained about the device's sticker prices and short battery life.

As for the financial takeaway, Milunovich believes iPods will contribute 15 cents of Apple's projected total EPS of 50 cents for fiscal year 2004. His firm, Merrill Lynch, has done recent investment banking for Apple.

No other analyst has published such a detailed analysis of how iPods could affect Apple's bottom line. But several say Milunovich's revenue forecast is not unreasonable, given iPod hardware revenues totaled $256 million in Apple's December quarter.

Fortuitously, sales of the portable music players have taken off amid the expansion of Apple's retail store base. The company has opened 76 retail stores since May 2001, and there's reason to believe iPods are attracting more foot traffic to the outlets, where customers will be exposed to Apple's sleekly displayed, consumer-friendly computers.

Milunovich believes the music players could even create a "halo effect" that prompts Windows users to switch to Macs, though not all investors would agree.

"I've always thought of iPod as icing on the cake, not enough to buy the stock by itself," said Robert Rhodes, manager of the ( STCIX) STI Classic Capital Appreciation fund, which has a stake in Apple. "But it does illustrate the fact that here's a company that's been able to do very creative things and create products that people want to buy."

To be sure, it shouldn't come as a shock that a company famed for its design prowess should roll out an eye-catching consumer device. More notable is that Apple has lately shown surprising deftness on the strategic front, too.

Marketing the Engineering

In October, Apple made its online music store accessible to Windows PCs, dramatically expanding the iTunes market. Soon after, it struck a surprise deal to let Hewlett-Packard ( HPQ) resell its iPod players under the H-P brand, starting this summer. H-P will also load all of its consumer PCs and notebooks with Apple's iTunes jukebox software.

Taken together, the decisions suggest Apple may be rethinking its traditional disdain for the consumer mass market.

"The deal with H-P is in my mind crucial to Apple's success," said Charlie Wolf, an analyst at Needham & Co. "You've nabbed the biggest consumer PC company into selling the iPod, which currently sells at around 8,000 outlets. H-P has 110,000 retail outlets around the world." (Needham hasn't done banking for Apple, but Wolf owns shares in the company.)

On the downside, as more competitors crowd into the digital music player market and Apple inevitably reduces prices, most believe iPod margins are bound to drop from the current 26% level, probably to around 20%. And plenty of analysts question whether the iPod really will spur Apple computer sales.

As Apple's December quarter results made clear, Wall Street still cares far more about the PC business than iPod momentum. Despite surging iPod purchases, which helped propel revenue above expectations, investors honed in on disappointing unit sales of PowerMac and iMac computers.

Apple shares peaked at $24.20 just before the company reported earnings on Jan. 14. But the stock shed 6% the next day and shares haven't yet recovered to their pre-earnings level, closing Wednesday up 11 cents, or 0.5%, to $23.92.

"The real earnings driver in the near term is really the creative professional cycle. That's got to bounce back," said Vinnie Muscolino, managing director at money manager David L. Babson, which holds Apple stock in its value portfolios.

Muscolino believes the latest edition of the PowerMac, which was introduced last year based on the G5 processor, should spur new purchases as the economy picks up. He finds the stock appealing on a price-to-cash ratio, noting "you can't find many tech companies trading at 2 times cash, and that generate cash."

Apple's quarterly net profit has steadily accelerated over the past year, from a $14 million net profit in the March 2003 quarter to December's $63 million profit.

But some investors want even more from Steve Jobs & Co. "The issue for us is, they need to start making more money," said Rhodes, who bought shares in Apple about eight months ago as a turnaround play. Now, he'd like to see that turnaround accelerate.

But for a change, longtime Apple watchers say the company isn't merely resting on its technological laurels with the iPod. This time it seems to be making savvy strategic moves to capitalize on the gadget's success.

"I've followed Apple for 20 years and usually they make boneheaded decisions," said Wolf, who has owned the stock in his personal portfolio since 1997. "But in the last two years they've grown up, starting with iPod and with iTunes for Windows."

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