Will analysts stick with Apple this time?

Apple Computer’s stock price continues to set post-Power Macintosh G4 Cube records, most recently last week with a closing price of $68.44 per share on Monday, November 29. That’s the company’s sixth-highest closing price of all time; the watermark remains $72.10 per share on March 22, 2000.

What sent Apple’s stock price up 6 percent in one day this time? Even more analyst excitement over the iPod, and the belief that everything it touches turns to gold, including the Macintosh. Merrill Lynch had a $61 per share (in U.S. dollars) price target on Apple stock, but as the shares are already more than 10 percent beyond that price, the firm raised its price target to $78 per share, as well as boosting its quarterly and yearly earnings estimates for Apple. The new target “represents a 2.2 multiple applied to enterprise value over sales and is a 20 percent premium to hardware makers like Dell and Lexmark.”

That’s right—Merrill Lynch now thinks Apple stock is worth 20 percent more than Dell stock given the same sales. Why? Because Apple’s installed base is so small. Market share changes that would seem trivial to Dell could make a big difference to Apple. Not that Merrill Lynch expects such changes: “We have not changed our Mac estimate,” the report said, “so if iPod success spills over to Mac sales there could be additional upside to our estimates.”

All this money is coming from the iPod. Merrill Lynch raised its estimate of December quarter iPod sales to 4,000,000 units, up from the previous projection of 3,500,000 units, and “noted the device is meeting with faster consumer acceptance than Sony’s Walkman in the 1980s.” Banc of America is even more bullish, setting a $73 price target for Apple’s shares, up from a long-outdated $47 per share, on a belief that Apple will sell 4.1 million iPods by the end of calendar year 2004.

UBS raised its target price from $66 per share to $77, raised its fiscal year 2005 revenue forecast to $11.1 billion from $10.9 billion, and raised Apple’s estimated earnings per share for fiscal year 2005 by 10 cents to $1.40. UBS analyst Ben Reitzes now expects Apple to earn about $180 million in profit in the December quarter, largely because of great iPod sales. A UBS survey of US retailers “showed strong demand” for what UBS called the “higher-margin” iPod photo and iPod mini devices, though that’s a bit confused: Apple executives have hinted on multiple occasions that iPod mini margins are slightly smaller than those for full-size iPods.

Fantasy devices

That’s not the only miscue in what Alan Greenspan might have called the “irrational exuberance” these analysts now display for Apple. Merrill Lynch continues to insist that Apple will release an iPod with flash RAM storage in the next four months (a notion that’s been debunked before, and that John Gruber picks up again), and might well release other exciting products like an “entertainment server.”

If you’ve never heard of an entertainment server before, don’t worry—Merrill Lynch just made it up. It’s the latest in a long line of Wall Street predictions about the future of television that have, in their entirety, been almost completely wrong. Wall Street continues to believe that some magic box will control and expand your TV in an Internet world, despite that after ten years of attempts from WebTV to Pippin, nothing has succeeded as well as the Mac-friendly TiVo digital video recorder, but Wall Street continues to pronounce TiVo “doomed.”

Therefore, analysts keep imagining new set-top boxes that will become the center of your TV life. A few years ago, it was going to be based on Microsoft’s Media Center PC combination, until they figured out no one really wants a Media Center PC. Now, calling such boxes “too complex and unstable,” Merrill Lynch told its customers, “It strikes us as more likely that either (1) the game console will move up market to become the leading device or (2) a new system we dub the entertainment server will be created.” The firm went on to imagine Apple creating this device with technologies from iTunes, iPhoto, iDVD, AirPort Express, and (of course) the iPod: “A 200GB Apple server at a reasonable price and possibly with PVR technology could be Apple's next category killer.”

Some things never change. Analysts who insist that a product category should be taking off, but find that it is not, regularly pressure Apple Computer to enter the field and show everyone how to do it so the analysts can be proven right. Just in the Steve Jobs era, analysts have insisted that Apple’s best chance for Microsoft-like growth is in making cell phones, PDAs, set-top boxes, digital video recorders (including more than one suggestion to purchase TiVo, Inc.), PC clones, and most recently, handheld video players. The analysts can’t figure out why the perfectly sensible idea of convergence entertainment hasn’t caught on, and since they didn’t understand why digital music hadn’t caught on before the iPod, they’re looking to Apple to “fix it.”

No matter how carefully Apple sets expectations, this kind of stuff continues to filter into the business discourse. And it’s not like Apple doesn’t explore ideas—Steve Jobs revealed this year that Apple did produce a PDA prototype but killed it before introduction. Jobs also quashed persistent rumors of an Apple tablet computer or cell phone, but you can bet those rumors will be back as well—oh, wait, the cell phone rumor was back just last week ! (Those who remember Apple’s announcement in July about working with Motorola to build an iTunes music player into Motorola’s new phones may not be as surprised about indications the two companies are—shockingly—working together on cell phone technology.)

Seasoned Apple observers are therefore cautioned about believing earnings estimates based on such wild and unsupportable speculation. Merrill Lynch’s ratings are based on solid iPod and Macintosh sales estimates, says the firm, but it’s clear that the analysts behind the report are enthusiastic about Apple saving their rhetorical bacon without much evidence it will happen.

Imagining Apple

The iPod has powerful mojo over Apple’s stock price right now, just as the iMac and iBook did back in 2000 before the tech bubble burst on the rounded corners of all those unsold Power Macintosh G4 Cube machines. Any significant report of an iPod stumble could send the stock price plummeting, just as the Cube stumble did in 2000. Every month there’s another story that says, in essence, “Apple’s music-player dominance with the iPod is about to end because now other companies are making digital players, and they’ll take the market away from Apple just like Windows did.” But as yet, no one’s come up with a player that outshines the iPod, even though the pundits keep believing someone will do so just any day now.

A number of companies clearly want to take the iPod’s market share from Apple, and they’ll continue trying to do so, so Apple can’t rest on its laurels. The point is not that the iPod is perfect, but that analysts are extremely imperfect, believing in fantasy devices and likely to change from “the iPod is the success story of the decade” to “Apple’s going to lose it all again” faster than you want to imagine.

Apple’s stock price is flirting with its record high because the analysts keep saying the sky’s the limit. If anything, no matter how flimsy, makes them change that tune, you can expect uninformed investors to drop the stock like a flaming Dell laptop battery. Look at what happened last Friday. Charles Wolf of Needham & Co. downgraded Apple Computer shares to “hold” for a simple reason—he’d set a target price of about $70 per share, and the stock was trading at about $70 per share, so he doesn’t think it’s a bargain any longer. Or, in analyst speak, “most of the upside is now captured in Apple’s current share price.”

Wolf’s assessment of Apple’s fundamental profitability did not change. How did investors react? They sent the stock price down $2.53 per share, and a total of $5.76 for the week, closing at $62.68 per share. That’s 8 percent off of Monday’s sixth-highest closing price ever, but still Apple’s 30th-highest close of all time (at least, as of this writing). That’s what mild “bad” news can do. In September 2000, when Apple announced one afternoon that Power Macintosh G4 Cube sales were far below expectations, the company’s stock lost more than 50 percent of its value in a single trading day. The price didn’t recover for nearly four years.

Just a few months past that recovery, we’re back near the record high again, even though Apple’s business fundamentals haven’t changed since a year ago. The only difference is that now, when Apple says the iTunes Music Store is a success and that people really love the iPod, analysts believe it—for now.

Two weeks ago, the Los Angeles Times suggested that the iPod might be a fad, “the Rubik’s Cube of the 21st century.” To its credit, the paper let Steve Jobs refute that, and he said the iPod (in the article’s words) “is capitalizing on a fundamental shift in the way people buy and enjoy entertainment in the digital age.” Jobs himself said, “We didn’t sell two million of them last quarter because it’s trendy, we sold two million last quarter because it’s a phenomenal product that’s reinventing the way people enjoy music.”

Right now, analysts believe the digital music player is here to stay, and that the iPod will define the category for years to come. Should they stop believing that for any reason at all, you won’t want to see the investment carnage. Apple’s Great Troubles of 1996 started when the company posted a loss—not due to low demand for Macintosh computers, but due to an out-of-control infrastructure that was eating up profits. The press immediately started questioning Apple’s future, and demand plummeted, requiring two CEOs and nearly $2 billion in losses to correct.

The experts refused to let go of the faltering Apple Computer that they imagined, and examine the real company with popular products. That’s remained true over the past decade, as analysts continue to believe that Apple’s Macintosh business can’t be all that profitable or grow much as long as other operating systems exist. There are signs of hope, though: analyst Rebecca Runkle of Morgan Stanley said last week that Apple Computer has the best chance of any PC maker of gaining market share in 2005. That’s good—but news that IBM, a company with more than twice Apple’s global market share, may be exiting the PC business could be seen as bad.

We’re approaching the same spot on iPod road that January 1996 saw on the Macintosh road, and there’s precious little indication that any of the analysts loitering by the side of the road are going to behave any differently. As long as iPod sales shine, they’ll cheer like crazy. If they don’t, no matter how profitable the iPod and Macintosh businesses remain for Apple Computer, investors should brace themselves for a bumpy stretch of road.

Excerpted with permission from the December 4 issue of MWJ, published by MacJournals.com. Copyright 2004, GCSF Incorporated. For a free trial to MWJ, visit www.macjournals.com.

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