TMO Reports - Analyst Upgrades Apple to Buy on Strength of Notebook, iPod Demand

by , 2:35 PM EDT, July 31st, 2006

Bank of America analyst Keith Bachman on Monday upgraded his rating on Apple's stock from Neutral to Buy, citing higher demand for notebooks, in particular the MacBook, as well as healthier demand for the iPod. He has raised by 300,000 units his forecast for MacBook sales for the rest of 2006 and tacked on 270,000 units for 2007.

"Importantly, we note that Apple's new MacBook is in the sweet spot of the notebook market in terms of pricing," the analyst wrote.

"We are encouraged that Street expectations have moved lower for iPods, which was part of the reason for our downgrade in Dec 2005," he wrote. "Further, we are also making estimate revisions to our iPod forecast for FY07 - raising estimates by 4%. We project 8.3 million units in the Sept Q and 15.8 million units in the Dec Q."

Mr. Bachman added: "We see the same product introduction schedule as we have mentioned previously - a new Nano late in the Sept Q and modestly upgraded Video in Q4, in time for a holiday demand."

He sees iPod sales adding 8 to 12 cents to Apple's EPS (earnings per share) in the second half of this year, "depending on whether Apple can generate enough additional unit sales." However, he is not factoring in any impact from the introduction of Apple's fabled "iPhone," which he expects to see the light of day in the second quarter of 2007. When it does ship, he only expects it to add three to five cents to Apple's EPS.

As for the potential threat posed by Microsoft's upcoming Zune MP3 player and music download service, the analyst said that Apple's rival "could pose a longer-term threat to Apple's iTunes business, given Microsoft's size, scale and past business practices. While nobody has been successful at dislodging Apple from its place atop the portable player market, we note that none of the companies competing in the space have much experience in software development. We believe that software (iTunes) is the key to Apple's success in this area."

The analyst noted that Microsoft has a history of being willing to lose money if it can eventually take over a new business segment, citing the development of Internet Explorer as well as the Xbox. "We believe that Microsoft is planning on following a similar strategy in Zune," he wrote. "While the company gave few details, they have indicated that: (1) it will take millions of dollars of investment, (2) it will not have any immediate payoffs and (3) that the company expects the time horizon of the investment to take 3-5 years."

Mr. Bachman also used his report to outline what he sees as the three stages of Apple's current growth cycle. The first, lasting from 2004 to the middle of 2006, has been characterized by "hyper revenue, unit and EPS growth" as well as leadership in the MP3 player category. The second stage, which he sees lasting until next year, will be CPU-driven and focus on Apple's market share gains with the Mac. The third, which will last from 2007 to 2008, will see "normalizing revenue growth" as well as new content- and network-driven products, such as wireless portables and set-top boxes, where software is key.

Finally, the analyst increased his target price for Apple's stock from US$68 to $79. Despite broader Nasdaq weakness, as of 2:32 PM EST on Monday, Apple's shares were selling for $67.93, up 3.57% for the day. The stock has yet to lose ground, except for a small dip last Thursday, since the company reported its financial earnings nearly two weeks ago. On July 19, the day of that earnings call with analysts, the stock closed up for the day at $54.10.

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