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Thursday, April 26, 2007, 07:00 am PT (10:00 am ET)

Evolving Apple seen entering rental space for video games, movies

Apple on Wednesday again showed its unparalleled ability to think and execute the unconventional, says American Technology Analyst Shaw Wu, who in a note to clients argued that earnings per share (EPS) may no longer be the best way to value the consumer electronics maker.

Wu, who maintains a $145 price target on shares of the Cupertino-based company, says there were "three notable surprises" in the firm's March quarter report. Specifically, its ability to capitalize in a favorable component pricing environment, its strong Mac shipments despite evidence of a pause ahead of Leopard, and its grander plans with iPhone and Apple TV.

"Apple reported surprisingly strong March quarter results of $5.26 billion in revenue and $0.87 in EPS, well above consensus of $5.17 billion and $0.64 and its guidance of $4.8 - 4.9 billion and $0.54 - $0.56," he wrote. "The gross margin came in at 35.1 percent, well beyond expectations of around 30 percent due to [the company's] surprising ability to capitalize on the favorable component pricing environment in NAND flash, memory, panels, and processors."

On the Mac front, Wu was surprised to see Mac shipments rise 36 percent year-over-year despite perceived evidence of a slowdown ahead of the Leopard operating system roll-out. "We believe if not for a Leopard pause, Mac shipments would have been even stronger," he wrote.

Meanwhile, the analyst said there may be some near-term confusion and concern over Apple's special and conservative accounting treatment of both Apple TV and the upcoming iPhone. "Apple plans to amortize revenue over two years or eight quarters, meaning total hardware revenue is recognized in increments of 1/8 and the rest recorded in deferred revenue," he explained. "We would like to note that the cash flow impact is unchanged as Apple collects cash upon the point of sale of the hardware."

While the new accounting allows Apple to state only 1/8 of a hardware sale each quarter, over the longer-term, Wu believes it will improve the company's linearity and his ability to predict future revenue streams. It may also be a sign of future initiatives on the subscription front.

"We believe Apple is in the midst of building a more serious effort in the subscription business where it could enter the 'rental' space with video games and music, TV, and movie content," he told clients. "We would not be surprised to see Apple compete with the likes of Netflix and Blockbuster in a bigger way."

For fiscal 2007, Wu now estimates Apple to earn $3.45 per share on sales of approximately $23.3 billion, up from $3.12 and from $23.3 billion. He's modeling for earnings of $4.00 on sales of $30 billion the following year, down from $4.15 and $31.1 billion, due to the company's new accounting procedures.

In his note to clients, the AmTech analyst concluded that EPS may no longer be the right way to value the multi-directional electronics firm. "In our view, Apple's move to subscription accounting in its new, high-growth business areas iPhone and Apple TV may signal that EPS is not the best way to value Apple shares," he wrote. "This is because EPS is amortized and understated on a quarterly basis while cash flow remains the same. Because of this, cash flow from operations may be a more appropriate way to value Apple shares."