Saturday, July 31, 2010

Apple and The Law of Large Numbers

Apple and The Law of Large Numbers
There's been much talk about the perceived limits to Apple's continuing growth due to what's called the Law of Large Numbers. This axiom or financial rule suggests as Apple's revenue grows the chance of sustaining current rates of growth diminishes as more growth is required to maintain the same percentage of growth.
In my view applying the Law of Large Numbers to Apple at this time is a fallacious argument. It might appear valid to casual observers of the company or to those fixed on applying commonly accepted axioms in their investment strategies without regard to the  unique circumstances of a particular enterprise, but for now this axiom or financial rule does not apply to Apple. 
Here's why:
In the June quarter close to 50% of Apple's revenue was derived from products that did not exist in the market just over three years ago. In the September and December quarters, well over 50% of Apple's reported revenue will be derived from iPhone and iPad sales. At the moment there's no practical limit to the size of the market for these two products. 
The Macintosh
Apple's oldest hardware product line, the Macintosh, has sustained a roughly 33% unit sales growth rate over the past three fiscal quarters. In the June quarter operating segments exclusive of the Americas and Apple's international chain of retail stores accounted for just over 41% of unit sales. In Europe alone unit sales increased 46% over the prior year period. While Mac sales continue to grow at a pace greater than industry averages, the Mac still accounts for less than 10% of domestic PC sales and garner a much lower percentage of global market share. Although Apple's offerings in the sub-$1,000 PC market are limited to the Mac mini and nominally the MacBook, the company recorded in the June quarter the largest shipment into the educational channel  in the company's history. This occurred during a period in which public education spending remains severely constricted. 
Apple Retail Stores
At the end of the June quarter Apple had 293 retail stores open for business. During the September quarter Apple will open 24 new stores and store sales and foot traffic continue to accelerate. In the June quarter store revenue increased 73% to $2.578 billion and produced average store sales of $9 million. Foot traffic into the stores reached a record 60.5 million visitors, an increase of 57% over the prior-year period. With an increase of over 8% in the number of stores in the September quarter alone, store sales and foot traffic will continue to rise at record levels for the foreseeable future.
Management reports roughly 50% of the 677,000 Macs sold at Apple retail stores in the quarter were to customer who had never owned a Mac before.
The Apple iPad
In the June quarter and in limited release, The Apple iPad and constituent products accounted for $2.166 billion of reported revenue, representing almost 14% of Apple's reported revenue activity. The Apple iPad remains in constrained supply and even Apple's management does not have a reliable metric to gauge global demand for this currently unique device. 
In the September and December quarters the Apple iPad and constituent products should deliver between 15% and 20% of Apple's reported revenue. This is revenue from a product that was not present in the market as recently as five months ago and will deliver significant year-over-year revenue gains for the next several quarters. 

The Apple iPhone
According to Apple's management, iPhone unit sales in the June quarter were running 90% above the year-ago period prior to the company aggressively draining the global channel ahead of the iPhone 4's release. In the December and March quarters, unit sales were 100% or more above prior-year results. Supplies of the iPhone 4 remain constrained and each successive iPhone model has surpassed the sales records set by its predecessor. With at least an annual model update, the iPhone franchise will continue to grow unit sales as the global market for smart phones continues to expand.
The Apple iPod
No matter the 8% decline in unit sales in the June quarter, the iPod line delivered a 4% gain in revenue due to the popularity of the iOS-based iPod touch and its 48% unit sales  gain. Although the iPod's percentage contribution to Apple's revenue and earnings have diminished following the successful Intel transition of the Mac and the release of the Apple iPhone and now the Apple iPad, the company will continue to innovate its line of ubiquitous digital content players with additional iOS-based devices.
Mac OS X's Versatility
Apple's UNIX-based operating system is at the core of the company's iOS for mobile devices. With more than 100 million iOS-based devices sold, Mac OS X's versatility has been brought into global view. At the center of Apple's hardware devices is a highly scalable operating system that was designed to serve as the foundation and springboard for new generations of digital devices. Apple has yet to reach the limits of Mac OS X's versatility and the operating system can be scaled up or down to meet the particular needs of each hardware device. 
With a common operating system running a multitude of digital devices, interoperability and complementary features and functions are elements of new product development that Apple can exploit for the next several years.
To a casual observer unfamiliar with Apple's products and product markets and for investors who dare not tread far from conventional ways of looking at investments, the law of large numbers as it applies to Apple would on the surface appear to be a reasonable concern considering the company's recent pace of revenue and earnings growth.
With more than 50% of revenue and resulting earnings for the next several quarters sourced from products that did not exist in the marketplace as recently as three years and three months ago, the law of large numbers does not apply to Apple at this point in time. 
To suggest that Apple's current or near-term growth is limited due to its recent historical rates of growth is a fallacious argument. It suggests Apple's pace of new product development will cease or slow and Apple in the future will be unable to find new markets or products for new markets in the way the company, for example, discovered revenue and earnings opportunities in smartphones and now digital tablet devices. 
Apple's robust earnings potential is evidenced by 27% of revenue flowing to the operating income line and no less than 20% of revenue flowing to the net earnings line. With nearly $46 billion in cash and marketable securities on the books at the end of the June quarter, there's no shortage of resources to develop new products, expand the company's global retail store presence or acquire technologies desired for product innovation.
Foe Apple, for now, the law of large numbers should not be applied. I reiterate my early fourth fiscal quarter estimate of revenue of $20 billion and earnings per share of $4.30 or more. I also reiterate my price forecast of over $400 per share by early May 2011. 

Robert Paul Leitao