Speed dial: Apple shares headed to $200

By Jon Markman

As everyone on the planet knows by now, Apple (AAPL, news, msgs) will release a drug on Friday that cures cancer, fixes broken bones and freshens your breath. No, sorry, I mean the company will release a definitive solution to world peace. No, that's not right either. It has solved the mystery of death, and on Friday it will simultaneously resurrect Albert Einstein, Jimi Hendrix and Princess Diana.

Well, actually, I guess that's not true either. Apple's got something bigger than that in mind. It's going to release a brand-new cell phone, called the iPhone! Which has a built-in camera! And accesses the Web! And has a touch screen!

I know you can just barely contain your excitement. I pretty much feel the same way.

What is all the hype about? I mean, most people who want a cell phone already have a cell phone, and they're locked into multiyear contracts. And having music, the Web and your contacts list in the same device isn't exactly a big whoop either.

I've had them on my Treo for years. There are some pretty cool map, traffic and voice mail features in the iPhone, but there are some problems, too, like the fact that it only works on one wireless carrier's network, is slow on the Web and will end up costing you at least $2,000 over two years once you add the least expensive data service fees to the device.

Getting better all the time

But I guess there's no point in being cynical about the new iPhone. Apple will probably sell at least 1 million of them through the end of this fiscal year in August, and up to 8 million of them in the 2008 fiscal year. After that it really gets interesting, because the 2.0 version of the device is bound to be a lot stronger than what's released on Friday. Already, Apple has promised that the second version will work on faster networks, provide more storage and have a longer battery life. No promises about curing cancer, but perhaps that's in version 3.0.

So, what does the iPhone release on Friday mean to us as investors in Apple? Most of the time, I would advise you to sell a stock into a hype storm like this because the oldest rule in the trading book is to "buy the rumor and sell the news." I recommended the stock back on March 15 in a column, "Apple rolls out a bright iFuture," and it's up a tidy 36% since. You might easily wonder what the point of holding on for more is, especially since the shares have already crested past my original target of $120.

Well, here's the deal. I really hope that you don't think I've just drunk the Kool-Aid over at Cupertino, because I think that not only will the iPhone enjoy one of the most successful launches in consumer product history -- right up there with the original Xbox and PlayStation 2 -- but it will also help take Apple a lot farther down the path toward the Total Convergence Zone in which all of its various product lines combine in powerful ways to create an absolute vortex of cash flow.

What most people probably don't understand is that for all the hoopla about the iPhone, the real ticket to riches over at Apple will continue to be the Macintosh desktop and notebook franchise. According to one analysis, every quarter of a point in market share that the Mac claws away from Hewlett Packard (HPQ, news, msgs), Dell Inc. (DELL, news, msgs) and Lenovo provides another 11 cents in earnings per share to Apple. And the excitement over the iPhone, and the coming new iPod video devices, will almost certainly continue to drive new customers into the Mac ecosystem. After all this time, Apple's share of the PC market is still small, so there is lots of ground that it can make up -- there really is.

The amazing thing with Apple is that it not only has figured out how to generate a mind-blowing amount of free publicity for its new products but it has also blown away analysts' expectations for earnings growth performance for the past two years. In the past five quarters, Apple has beaten expectations by 6.8%, 22.7%, 24%, 46% and 38%. That is a lot considering how well analysts cover this company. Consider that with other large companies, like General Electric (GE, news, msgs), earnings rarely miss consensus by more than a penny or two.

$500 phone, $200 stock

Right now, analysts on average expect Apple to earn $4 in fiscal 2008. Now let's figure that the analysts have blown it again by the average amount that they have been mistaken over the past four quarters, which is 27.5%. So you add 27% to the $4 consensus number to get an estimate that we'll just call $5 to keep it simple. If that's the right number for 2008, then the stock is currently trading for just 23 times our new estimate. That's pretty darned cheap for a company that has been growing at better than 30% for the past few years and is actually on the verge of a whole new product cycle.

If you apply the company's current 37 price-earnings multiple to $5 you get a target of $185. Which is not bad, but then if you are looking out two years, you need to speculate that Apple will grow by another 30% over the next 12 months. So add 30% to $5 to get a 2009 estimate of $6.50. Multiple that by 35 and you get an 18-month target of $240, or double the current price. Shares have doubled in the past year, so that's unlikely but not totally outrageous.

Although that sounds like a lot, and it is a lot, it's a target that only assumes the company's current pace will continue and does not include any possible new devices or product cycles -- or, to be fair, any risks like the potential for a total meltdown in consumer spending. So I'll ratchet down my target, and add more time, to account for any mischief and overheated assumptions out there. Nibble on Apple now for my 18-month target of $200, but add materially if and when it trades down into its 10-month moving average to around $110-$115 over the summer.

At the time of publication, Jon Markman owned shares of Apple, GE, Hewlett-Packard and Dell.