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Thursday, July 20, 2006, 10:45 am PT (01:45 pm ET)

ML upgrades Apple, says iPhone could be near

Merrill Lynch today updated its rating on shares of Apple Computer from Neutral to Buy with a price target of $72, saying the risk-to-reward ratio of the company's stock has recently improved.

In supporting the upgrade, analyst Richard Farmer offered clients eight examples of why he believes shares of the Mac maker are once again attractive.

In addition to increased confidence in the potential for Mac market share gains and waning iPod deceleration, Farmer believes the overhang from the company's stock options investigation is starting to diminish.

"Our sense has been that potential Apple shareholders were understandably hesitant to buy stock with the stock option timing investigation seemingly open ended," he told clients. "Although there is not yet definitive conclusion to the investigation and we offer no legal opinion on the substance of irregularities, we think the statement [...] by Apple management (that financial restatement is not anticipated) suggests risk is lower."

Farmer also said that while the potential for an iPod phone is not news, its financial impact is not part of consensus estimates. "The fact that management publicly alluded to it (albeit indirectly) on the conference call reinforces the possibility that its introduction could be near enough to influence consensus estimates within the next 12 months," he said.

With the mobile phone market set to possibly approach 1 billion units in 2008, the analyst believes every 1 percent share potentially captured by Apple could produce as much as $3B in incremental revenue, assuming Apple sells the phones for around $300.

"Cracking the phone business won’t be simple given the complexity of the business model and ecosystem but we see iTunes as a key asset that can create differentiation for consumers as phones and other mobile media devices (like iPods) converge over time," Farmer told clients.

Among the analyst's other top reasons to own shares of Apple are the imminent arrival of the company's strong back-to-school and holiday quarters, a nearly completed Intel transition, upcoming margin expansion and a shift in focus by the Street towards Apple's fiscal year 2008 (supporting valuation).