iTunes and Apple Hardware As Content Conduits

For the three-month period ended in September, Apple recognized $1.018 billion in revenue that, according to the financial statement "Consists of iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories." For the quarter this category represented 10.3% of GAAP revenue and a 22% gain in revenue over the prior-year period. Apple consolidates iPhone accessories revenue in a different category.

The increasing importance of iTunes Store revenue to Apple's revenue and earnings matrix is often overlooked. For example, while many of the media reports concerning the iPhone focus on AT&T's cell service issues, new competition from Android-based smartphones and the battle between Apple and Research In Motion for smartphone market share, the importance of the iPhone OS app economy is infrequently mentioned outside the context of more than 100,000 apps available as a competitive advantage in consumer hardware sales.

The iPod line (including the popular iPod touch) has reached a mature market position with the iPod touch materially responsible for the scant gains in unit sales, if any, and growth in sales revenue for the product line. 

Due to the success of the Apple iPhone, it's expected some iPod sales would be cannibalized by iPhone sales. The iPhone, in addition to being a handheld computing and communications device is also an iPod and at subsidy pricing is priced attractively compared to iPod models such as the iPod touch and iPod nano.

But look at the unit sales numbers another way. One Wall Street analysts predicts cumulative unit sales of the iPhone and iPod touch to reach 78 million units by the end of the December quarter. Both the iPhone and the iPod touch use the iPhone OS and thus have access to the apps available through the iTunes app store. App sales alone will provide for yet another year-over-year surge in iTunes store sales.

The much-rumored Apple tablet, which most of us expect to be announced in late January, will presumably have access to the iTunes app store as well, adding another app-enabled device to Apple's hardware product matrix.

The iPhone, iPod touch (and the pending Apple tablet device) function even more effectively as content conduits  and iTunes store revenue generation devices than the iPod line. Apple, in my view, is purposely designing hardware devices that generate as much constituent revenue as possible through iTunes Store sales.

Apple's revenue matrix, though highly dependent on hardware sales, is slowly migrating to a mixed revenue formula for recurring revenue from each device sold via of the iTunes Store. 

The importance of iTunes Store sales to Apple's future revenue and earnings growth can be hardly overstated. Content availability drivers hardware sales whether it be over 100,000 iPhone apps available as a competitive differentiator in choosing a handset or the resulting direct sales of apps, music, movies, etc. to owners of Apple's hardware devices. For the three-month period ending in December, I expect the revenue category referenced at the top of this post to rise at least 25% both sequentially and in year-over-year comparisons, reaching at least $1.25 billion in the December period alone.I expect similar or greater year-over-year percentage gains in revenue for this category for the next several quarters.

This recurring revenue source provides Apple with the opportunity to continue to moderate hardware device prices in favor of greater recurring revenue from iTunes Store sales as more hardware devices are sold.  

iPod Unit Shipments Revisited

I'm raising my estimate of iPod unit shipments in Apple's 1st fiscal quarter to 23 million units. The rationale for the estimate increase is strong sales of both the iPod touch and the iPod nano. The iPod nano's video capabilities and its attractive price starting at $149  are winners this holiday season. The iPod touch continues to be a popular product and sales this quarter should be robust.

The estimate of 23 million units sold is just slightly ahead of last year's results. But it's in an environment in which most analysts see a doubling (or more) of global iPhone sales versus the prior year period. 

Apple will report record revenue and earnings this quarter from strong Mac sales including the recently refreshed iMac, seasonal iPod sales and the continuing global rollout of the Apple iPhone. 

Apple and the iTunes Gift Card Economy

I'm amazed at the number of iTunes gift cards purchased and distributed as gifts during the holiday season. No matter the small commission paid to retailers for sales of the gift cards, they represent an interest-free loan to Apple for iTunes product purchases at a later date. The cards purchased at retail may also reduce Apple's distribution costs because merchant fees are not paid on purchases made from gift card redemptions.

I've searched Apple's financial statements for some inkling of the amounts carried in the company's cash balances and the offsetting liabilities for unused gift card balances and the financial value of the cards still to be redeemed. I can't find a conspicuous mention of the amounts anywhere. I'm surprised these amounts are not detailed because of the volume of and dollar value of gift cards purchased and redeemed each year.

iTunes gift cards can only be redeemed at one place - Apple's iTunes store. But these gift cards provide recipients with an array of product purchase options ranging from music and movies to iPhone apps. The cards have become their own form of currency for use at the iTunes store.

While debates rage about the iPhone versus Android 2.0-enabled smartphones on the merits of the hardware, there's no disputing the added value to a product franchise from iTunes store integration. There's no real competition currently for the iTunes app store and Apple has become the world's largest commercial distributor of recorded music via of this online store. 

Today content and accessibility of content (software, music, movies, iPhone apps, etc.) drives hardware device sales. iTunes gift cards lock-in the card recipient to the store similar to the way many other gift cards can only be redeemed at particular retail outlets. The popularity of iTunes gift cards and the value of the unused card balances can only be a draw for app developers and owners of commercial content seeking to expand sales and expand those sales through a relatively easy to use digital store front on attractive distribution fee terms.

Providing access to the growing iTunes economy is one way Apple will continue to entice interested parties to provide content for its products. Access to the iTunes store is a decided advantage for Apple and an advantage that can not be mitigated quickly nor inexpensively by competitors. It's also a reason the iPod touch is important to the iPhone's continuing success. The iPod touch provides a large pool of consumers (now measured in the tens of millions) that can use iPhone OS apps, building the market for developers and accessory makers much more rapidly than the iPhone could provide on its own during its nascent phase of sales growth. 

iTunes integration is providing an underpinning for Apple hardware device sales and a captive market of iTunes account owners with unused gift card balances can only sweeten the proverbial pot for app developers and commercial content owners seeking to increase product sales. 

AT&T's U-verse

Last week I migrated from Time Warner Cable's residential services to AT&T's U-verse service. This was a change long in coming but transitioning the home's Internet, phone and TV services from one company to another is not a decision I made quickly considering week day installation logistics and the hassles involved in returning equipment and canceling the prior service bundle. 

Over the past couple of months I had received several mailers from AT&T promoting the U-verse service. There were at least a half-dozen mailed pieces extolling the features of   the service on my desk.  These were just enough reminders from AT&T that my discontent with Time Warner Cable merited a change in services.

On Monday last week I made the call and a Friday U-verse installation was scheduled. I received an order confirmation via of email and voice mail and text message reminders of the scheduled installation. On Friday morning the installer himself called to provide his ETA within the time range initially provided. I was impressed by the level of communication even before the installation began. 

In all the installation took about five hours. The AT&T representative not only installed the services bundle, he offered to rewire the phone lines from the box on the side of the house with cabling to provide better voice call quality. Beyond the installation, he remained on site and worked through turning off U-verse's wireless networking as I reset my Time Capsule to work in bridge mode with the U-verse modem. I was pleasantly surprised by the responsiveness of the representative and the quality of the work provided. In all I'm glad I made the switch.

Despite my increasing frustration with Time Warner Cable, it was my existing relationship with AT&T through my iPhone service contract that was a catalyst in making the switch. I figure if the company was smart enough to make the iPhone deal with Apple, it was smart enough to provide satisfactory home services as well. I consider my switch to U-verse AT&T's own iPhone halo effect.

Both Verizon and AT&T are losing traditional home phone customers by the minute. U-verse is one way AT&T is working aggressively to gain new revenue and establish new relationships with residential customers. In the September quarter AT&T had a net gain of 240,000 U-verse customers, bringing the installed base to 1.8 million customers. Obviously it's a relatively small segment of overall operations but it should grow at an impressive pace.

I'm long AT&T and see the company emerging as a much more aggressive provider of home, business and wireless services. Combining what I pay to AT&T for family plan wireless services and now for a multi-service bundle of residential services, I see AT&T as a company with strong growth potential and a 5.9% dividend at Friday's closing price as an investment incentive.

AAPL: Buy Now

Ordinarily on the Apple Finance Board I would post the above statement as a question. Tonight I'm posting it on Eventide as an emphatic point. The recent pullback in Apple's share price provides an excellent entry point for investors looking for long-term gains. 

Nothing about the company's fundamentals has changed and there's been no indications of a softening of demand for Apple's popular products. This quarter (Apple's 1st fiscal quarter) the company will report record revenue and earnings using both GAAP and non-GAAP measures. 

The recently refreshed iMac line should push Mac unit sales for the quarter to 3 million units and the iPod touch will buttress Apple's line of digital music players through this economically challenged holiday shopping season. The iPhone is continuing its global roll out and that product is still in an early stage of sales growth.

There may be a variety of reasons for the recent drop in the share price but none of those reasons reflect a change in the company's short-term or long-term prospects for revenue and earnings growth. At today's closing price of $189.27 I consider AAPL at a bargain price relative to this quarter's anticipated performance and ahead of positive changes in share price targets from analysts as we move closer to the end of the quarter and the release of revised revenue and earnings estimates. 

Acer: Apple's Unintended Ally

Acer Inc., the Taiwanese maker of popular netbooks and other computing products, recently surpassed Dell Inc. as the world's #2 maker of PCs. While Dell has seen continuing weakness in its consumer product sales, Acer has become the world's fastest-growing PC maker in part due to success in the PC market in which Dell is most challenged.

Acer sells PC products under four brand names: Acer, Gateway, Packard Bell and eMachines. The Gateway and eMachines brands up were picked-up when Acer purchased what remained of Gateway in 2007 and the company acquired Packard Bell in early 2008. Through these acquisitions Acer picked-up the remnants of failing PC makers and took possession of brand names with perceived value in various global markets.

Acer operates on razor-thin margins. Gross margins on products sold are around 10%, less than 1/3 the margin Apple commands on its products. To maintain success the company must grow unit volume. Acer may soon become the world's leader in laptop sales and eventually challenge HP for the global top spot in total PC shipments. At low margins unit shipments become all the more important.

How does Acer's success benefit Apple?

Acer has become the successor to three defunct computer makers: Gateway, eMachines and Packard Bell. These brands have become nameplates for Acer's inexpensive PC products. The different nameplates are used in the regions in which the respective brands maintain the greatest strength. By creating one central enterprise (including Acer's own branded product) the company continues to push PC prices lower and is essentially clearing the field of competitors in the PC market.  

In 2008 Acer recorded revenue of $16.65 billion and net income of $358 million. The company is targeting $30 billion in annual revenue as the company's goal. To achieve this ambitious goal the company is moving into smartphones in a more substantial way and is moving away from Windows Mobile in favor of Android-based phones. In the PC market the company will continue to drive down costs to protect its 10% margin while gaining as much unit volume as possible.

Acer's aggressive growth plans will make it challenging at best for Dell to remain in the consumer market. The company's successful focus on netbooks is also redefining the way people choose and use laptop PCs and is unwittingly eroding the market for more expensive portable Windows PCs. 

Acer has become Apple's unintended ally in furthering Apple's effort to undermine the PC-centric model. This is not good news for Microsoft but it is good news for Apple. Acer is clearing the way for the much-rumored Apple tablet which is expected to arrive in a small form factor with constant connectivity. It will also feature access to over 100,000 low-cost/no-cost iPhone OS apps. 

Acer will continue to devour competitors in the PC market with low-cost, low-margin netbooks and laptops leaving a gaping hole for an Apple-designed tablet with unique functionality to fill the middle ground between the limits of a netbook and Apple's higher priced laptop line.