Apple's first $1.5 billion iPod Christmas?

Knowing that MP3 players (of which Apple commands about 85% of the market) are the number one choice of consumers for holiday gifts, I began wondering what that might mean for Apple's business and stock price next year. So I pulled Apple's SEC annual report and quarterly filings, and I built a simple model relating unit sales, revenue, and earnings over the last four quarters. And when I looked back over the past year, I found some interesting bits that I hadn't realized:

• Apple has four strong businesses now. Apple sold 22 million iPods over the past year, compared with about 4 million desktop and portable Macs. iPod and music revenue contributed about $5.4 billion, compared with Macintosh revenues of $6.3 billion. Apple peripherals are now a $1 billion business as is Apple's software and services business.
  



• Apple's gross margin continues to rise. Apple has figured out how to keep costs in check even as it continues to build hipper products. Gross margins are now 29% of revenue compared with 27.3% last year.
  



• SG&A is falling. Apple's sales, general, and administrative costs have fallen as a percentage of revenue from 20% in 2003 to 13% in 2005. While booming revenue -- up 50% year over year -- helps that, it also shows good cost control.
  



• Cash continues to build. Selling Mac OS X upgrades, developing hot software products like iLife and Aperture, and making money on every iPod and song sold has built up Apple's cash hoard to $8.3 billion. For those of you playing at home, that's about $10 of the company's stock price right there.
  

So it's a good business. No question. But what about Christmas? Well, that's all tied to a simple question: how many iPods can Apple make and sell? Last quarter, Apple sold 6.5 million iPods for $1.212 billion. But it was also transitioning its product line from minis to nanos, and iPod Photos to iPod videos. So assuming that Apple built up its production for the Christmas season, how many do you think they forecast making?

So here are a few different scenarios I ran through the model to understand what Apple's earnings might be, based upon calendar Q4 iPod sales.

Scenario #	iPods sold	iPod revenue	Total Q4 revenue	Q4 earnings per share	Implied stock price
1	7.5 million	$1.48 billion	$4.11 billion	$0.49	$90/share
2	8 million	$1.58 billion	$4.22 billion	$0.50	$93/share
3	9 million	$1.77 billion	$4.45 billion	$0.53	$98/share
4	10 million	$1.97 billion	$4.68 billion	$0.55	$103/share
5	12 million	$2.36 billion	$5.13 billion	$0.61	$113/share

Personally, I don't think Apple has the manufacturing capacity at this point to make 12 million iPods this quarter, despite some analysts predicting that. No, my bet is between 7.5 and 8 million (i.e., scenario 2), and earnings around $0.50 per share, which is the middle range of estimates. If we accept a trailing P/E of 46 for a company growing revenue at 56% year over year (not a crazy number for that growth rate), we could expect the stock to trade somewhere in the vicinity of $90 to $100 a share in February or March next year. So despite the fact that the stock is currently trading at an all-time-high, it seems like a Christmas selling season where they sell 8 million iPods could drive the stock higher, even if it's only a $1.5 billion in iPod sales. And should we see exciting announcements of new products and media services at January MacWorld, we could see new growth on the Macintosh side of the house as well.

One other observation. Piper Jaffrey has been noting that many retailers are starting to see some iPod models run out of stock while Apple stores don't seem to have that problem. While conspiracy theories may abound about that, I think the answers there are very straightforward and business-like. First, Apple stores have been in business long enough that they have good data about product demand and stocks required, so they forecast better; other retailers don't necessarily share that information with Apple, nor do they think about forecasting Apple iPods much (that's an assumption, but a likely one). Secondly, Apple probably does prioritize its stores, because it makes more profit on sales from them and can assure more add-on sales of accessories and computers. Apple is simply capitalizing on four years of retail investments, which, incidentally, most analysts claimed were a complete waste of money at the time.

All this said, I'm not a financial analyst, but Apple's business is not rocket science. Given that the company makes the hottest selling product this Christmas season, it's a pretty safe bet they are going to have a good quarter. The only question is, how good? My prediction is that Apple investors will find their stockings very full indeed when they unwrap Apple's earnings for the fourth quarter.

Full disclosure: I do own some Apple stock if that makes any difference in how you interpret the numbers. No one should be making financial decisions on my recommendations; instead analyze the numbers yourself and consult your own financial advisors. Your mileage may vary.

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