Merrill Lynch Financial Analysis - May 2004

Apple could eventually open more than 100 stores, including a store in China, according to Sr. vice-president for Retail Ron Johnson.

Johnson revealed that fact during a talk with financial analysts from stock broker Merrill Lynch, which then issued an enthusiastic and positive analysis of Apple's retail operation on May 26th, and forecast that Apple's stock price could increase to $32 over the next 12 months. "The company made the difficult decision to invest for the future even as earnings fell apart; now Apple is benefiting," the stock report said.

In the 8-page financial analysis of Apple, M-L first vice president Steven Milunovich wrote that he met with Apple's incoming CFO Peter Oppenheimer, VP of iApps Eddy Cue, and Sr.V-P of Retail Ron Johnson, and "came away impressed with the marriage of creativity and discipline at the new Apple." He added, "Expansion overseas is expected with London and Osaka in process, Canada likely, and China being considered."

He said that, "Previously we had heard another Apple exec suggest that the limit might be 100 U.S. stores, but Ron seemed to think the figure could go higher. Ron pointed out that Target now has more than double the number of stores it once thought was the limit. Apple does want any new store to be profitable in its first year and not to cannibalize an existing store."

As for Johnson, Milunovich said, "We're much impressed with his approach to retailing, an area that has caused investors some consternation. He said most of the risk is past. In addition, Ron's approach is to 'grow smart' and gradually in opening about 25 stores each year."

Milunovich said the "lessons learned" so far with the retail operation include: the best locations for high traffic, the effectiveness of a smaller store, and the need for greater staffing given more traffic than expected. Johnson told him that there are 20,000 people on the waiting lists to work at Apple's stores.

Apple has 300 employees in third party locations such as CompUSA, the report said, and the completed pilot program with Best Buy is still under review by both companies. "Distribution of Macs through Best Buys would be a plus," Milunovich wrote.

The report noted that, "The Apple stores are quite efficient." One-half of the U.S. population lives within 15 minutes of an Apple store, and about 80% of the stores are located in malls. "The philosophy is to go into high traffic areas with one of three store sizes (4,000/6,000 sq. feet or high profile)," the report noted.

The average Apple store does $2,500 sales per square foot per year (Ed.--Johnson has earlier said $3,000, and as of June 2005 it's approaching $10,000) compared to $500 for the average retail store, the Merrill Lynch report said.

The report broke out per-store sales figures for various chains: the average Apple store does $15 million in sales each year, while Best Buy does $36 million, Circuit City does $16-17 million, and the electronics department of a wMart store does $4 million per year.

"The contrasts with Gateway are stark," Milunovich wrote. "Gateway opened too many stores too quickly. Gateway chose low-rent, low-traffic areas and invested in advertising. Apple's choice to pursue higher rent but high-traffic areas looks superior. Gateway was getting 250 visits per store per week while Apple is averaging 6,000."

Sony and Palm are opening retail stores that look much like Apple stores, Milunovich wrote. He noted that Apple retail operation is profitable even without accounting for manufacturing profit. "Apple spends about $100 million per year on its stores, not a lot given the company's $4.6 billion cash balance. In total, Apple will have sunk about $400 million into retail by year end."

Apple's retail model is "highly leveraged" with fixed costs, including rent, depreciation, and some payroll, representing 90% of the total. "Consequently, growing same store sales is critical in addition to opening new stores." Milunovich said Apple didn't provide figures, "but we believe same store sales growth is running 35% to 40%." He said Apple retail currently has an operating margin of about 2%, "which Apple thinks could rise to 5-6% over time." He said M-L estimates that retail stores could do more than $2 billion in sales in during fiscal year 2005, generating operating income (profit) of $80 million or almost $0.15 per share. [Ed.-That would put Apple's retail operation down around Smart & Final, Lencrafters and Pep Boys in terms of annual revenues, and well below specialty retailers Best Buy ($20b), Circuit City ($10b) and CompUSA ($5b).]

Milunovich said, "The retail stores provide some evidence for increased switching to Macs." Interest in iPods is boosting store traffic, he wrote. "Apple believes that at least 50% of its store sales are incremental. In addition, about half of Mac buyers are new to Apple. This provides some proof of the ‘halo effect' of iPod."

Milunovich said, "Apple is keenly focused on getting Windows to Mac switchers," and that a small increase in Apple's 1.8% PC unit share "goes a long way." He mentioned the "Switch at Six" campaign, and that Apple is "innovating through services." About 20% of store traffic is generated by the Genius Bars he said, and one-third of PC repairs now take place in the stores.

"Overall, we're impressed with the creativity and discipline of Apple's retail model," Milunovich concluded.

[Thanks to Tom for tipping me to this information.]