Gasp! A Less Than Bullish Apple Analyst?

Citigroup's Richard Gardner is pulling back from Apple. Here's why, and why he might just be right

To characterize Apple's first-quarter earnings as excellent is the epitome of understatement.

In the first three months of the year, profit ballooned by 88%, to $770 million. The per-share earnings of 87 cents made Wall Street forecasts of 64 cents to 67 cents look downright conservative (see, 4/26/07, "Apple's Sweet Profits and Sour Legal Woes").

In response, many analysts were quick to issue upgrades. Shaw Wu of American Technology Research led the pack, boosting his target price to $145 a share, while the average target price among analysts is sitting at $123 and change. Either scenario is pretty bright, considering Apple (AAPL) shares closed on May 2 at $100.39.

There's reason to expect the good times to last. Demand for Macintoshes and iPods is robust, and the forthcoming iPhone music-playing wireless device is expected to be a huge sales catalyst.

One Bad Apple?

Indeed, it would appear that everyone loves Apple these days, if not for the likes of Citigroup (C) analyst Richard Gardner. He's covered Apple for about 10 years, and even as his counterparts at other firms gushed, Gardner urged caution: Hold the Apple stock you have, but don't buy any more, for now.

The call ranks Gardner as easily the most prominent Apple analyst who's not advocating buying more. On Apr. 26 he reduced his rating on Apple from "buy" to "hold." At the same time he raised his 12-month price target to $110 from $105, adding that he'd be "more aggressive" if the stock were to retreat to about $90. Translation: The time for accumulating Apple stock is over. Wait for the price to go lower before you start buying again.

It's probably not right to describe Gardner as "bearish" on Apple. "To be clear, we have no issue with medium- to long-term fundamentals on Apple," he says in his note. "Our modeling simply suggests that forthcoming products like the iPhone are fairly reflected," in earnings estimates. He didn't return calls requesting an interview, but his views are pretty clearly outlined in the note.

Forget Those High Profit Margins?

His argument is simple: Much of the good news that investors can expect from Apple, whether it's related to the iPhone, AppleTV, Macs, or iPods, is already accounted for in the stock price. Consider the favorable pricing environment on many of the components used in Apple's machines. Low component prices buoyed results in the most recent period, but they won't last. Apple executives didn't say which components had the favorable pricing, but it's not hard to guess.

Chips from Intel (INTC) are probably cheaper than they would otherwise be at the moment, given the company's price war with Advanced Micro Devices (AMD). Meanwhile, prices on the memory chips that go into the iPod nano and iPod shuffle are starting to firm up. Market research firm iSuppli last month said it expects a shortage on flash chips to hit the market in the second half, as suppliers like Samsung and Hynix slow flash production and shift attention to DRAM memory chips that go into PCs. That will put an end to the market glut of flash and tighten supplies, boosting prices.

Seeing this trend, Gardner says that Apple probably can't sustain gross profit margins at the crazy-high 35% level seen in the last quarter. "We expect a less favorable component pricing environment beginning in the second calendar quarter, and some components could even rise in price," he said. Those 35% gross margins were too good to last.

No Major Sales Catalyst

To make matters worse, the second calendar quarter is a slow period for consumer-electronics sales. There's no buzz of the back-to-school season or major holiday gift-giving periods on the calendar. A revision to the iPod lineup in time for the holiday season probably won't happen before July at the earliest, and probably not until August or September. And though some new Macs are expected at about the same time, Gardner reckons there's no major sales catalyst for Apple in the near term, at least none that aren't already known.

But what about the iPhone and AppleTV? Here's an interesting detail only an accountant could love: Apple is going to treat the sale of the iPhone and AppleTV devices in terms of 24-month subscriptions. So money that would normally go to the revenue line of the earnings report in a lump sum will instead be broken into 24 smaller chunks.

For example, if $1 million worth of iPhones are sold in the quarter, Apple will record only $125,000 on that period's earnings report. The remaining $875,000 will be reported in increments of $125,000 in each of the succeeding seven quarters. No matter how big a hit the iPhone and AppleTV prove to be, their impact to sales and earnings will be spread out over the longer term.

For Apple, this accounting convention makes a good deal of sense. The company intends to offer regular upgrades over the lifetime of both the iPhone and AppleTV, all the while incurring costs. "Apple logically intends to leverage its decades of software expertise to enhance its products in ways that incumbent equipment vendors, which have historically treated products as closed systems, cannot," Gardner wrote.

But this also means you have to cut how much revenue Apple will report on its books in the coming three years. For the 2007 fiscal year, Gardner figures Apple will clock $23.3 billion in sales, which is a billion and change less than he had forecast previously. And he did the same thing for fiscal years 2008 and 2009, figuring Apple will report sales of $27.8 billion and $33.2 billion, respectively, in those years. Oh and by the way: He's made similar cuts to his profit forecasts for '07 and '08, but boosted his profit forecast for 2009.

Right On the Money, So Far

Gardner has a good track record figuring out which way the wind is blowing with Apple. In the past two years, he's been pretty close to the mark. He rated it "buy" with a target of $18.50 in July, 2004, and it reached that price by September. That same month, when it was trading at $19.38, he upped the target to $23.25. Apple stock hit that target within 12 trading sessions. Then he boosted it to $30, a goal met before the end of November.

He switched his rating to "hold" in December, 2004, and left it there until March, 2006, continually revising targets along the way.

And get this: On March 13, 2006, with Apple stock again in a bit of a slide, Gardner moved it back into his "buy" column when it was trading at $65.68. He left it there until October before moving it back to "hold." By that time it had gained another $9.18. Had you followed his advice, you'd be pretty happy right about now.

I am not qualified to dispense investment advice, but I certainly find it interesting that when so many in the market are saying "buy, buy, buy," someone can say something else and make it sound pretty clear. That to me sounds like, well, thinking different.

Before it's here, it's on the Bloomberg Terminal.