"While a successful iPhone launch is now better incorporated into the share price (though we still believe Street expectations understate potential iPhone penetration), operating leverage remains an underappreciated source of earnings-per-share upside longer-term," lead analyst Katy Huberty wrote in a detailed report to clients.
Huberty said Apple's operating margin should continue to benefit from two primary factors, mainly that the company's operating expenses grow at only half the rate of revenues, and that products sold through its fixed cost brick-and-mortar retail stores earn as much as 14 points in incremental profit.
Should Apple's operating expenses to revenue ratio hold tight going forward, every $1 billion of incremental revenue in 2008 should drives 30 basis points of operating margin, according the analyst. Similarly, she said, a 5 point increase in the mix of revenues through the company's retail stores will add another 50 basis points.
Given that iPhone will only sell through Apple and Cingular/AT&T stores (roughly 2,300 points of distribution compared to 8,000 for Mac and 20,000+ for iPod), Huberty believes it could drive a higher percent of revenues through direct distribution.
At the same time, the analyst said conviction in her iPhone forecast of 8 million units in 2007 and 12 million in 2008 is increasing. "Our checks point to a strong build rate into the back half of the year and potential for new product ahead of the 2007 holiday season," she wrote. "We also believe iPhone operating margins are accretive, not dilutive."
The Morgan Stanley analyst also believes Mac market share is due to accelerate as a result of the platform's growing customer base, integrated virtualization technology in Mac OS X 10.5 Leopard, and new products.
"The biggest opportunity, in our opinion, is to leverage Apples differentiated compute (Mac) + communication (iPhone) platform into a truly mobile compute and communication device," she told clients. "We believe this is a market that will emerge with or without Apple and will ultimately replace a large portion of laptop computers."
Should Apple lead innovation in the new mobile segment, Huberty believes the company could achieve 10-15+ percent global market share in the longer-term. In taking a first stab at modeling the market opportunity, she assumed a 5 percent penetration rate within the firm's customer base, which in a bull case scenario would drive shipments of 3 million Mac ultraportable devices in 2008 (should the product launch in January).
Huberty maintained an Overweight rating on Apple stock, but raised her price target to $150 per share from $110. The analyst also increased her 2008 operating margin to 19.8 percent from 16.7 percent, and her 2008 per-share earnings estimate to $5.00 from $4.29.
"The perpetual mistake investors make is to compare Apple to other PC companies with operating margins in the single digits," she told clients. "While Apple earned PC-like operating margins historically (pre-2004), we believe the company is successfully evolving into a software-focused consumer electronics company."