Why earnings contractions are coming for Apple in 2013

This is another of my ten surprises for 2013. Apple is down 50 points today, well below its shoulder line on a topping head and shoulders pattern. The stock is breaking down. But there is a lot more pain to come. I have been increasingly negative on Apple since March of last year. While I warned you in March about margin compression, I made no mention then of stock price impact because Apple had enough momentum to ride out a miss or two. Now that Apple has begun to miss and the stock has cratered, earnings declines and larger share price declines are what we should expect in 2013.

Usually I don’t get into specific stocks, but Apple is such a bellwether and so widely owned, I have made an exception here. Let me walk you through the timetable since March because it gives you a history of how we have come here.

First, the thesis in March 2012 was margin compression generally in 2012, with Apple a prominent example:

What is clear to me is that we have high margins combined with still historically normal or above normal price/earnings ratios. These margins are mean reverting and I believe the next recession will see a doubly difficult compression as both P/E and margins come in.

Apple fits into this perfectly. It is not a bubble stock in the way Cisco or Microsoft were in 1999 or 2000. However, it is the market leader in the S&P500 the way those stocks were. And the technology sector is also experiencing the buoyancy and IPOs that we saw during that time. Again, the froth is much less pronounced but the trend is the same.

Apple’s market share have been pressured by Android and the company has turned to patent wars to deter its competitors. This won’t nearly be enough. Android will continue to gain share, not just in mobile phones but increasingly in tablets. And so I expect Apple’s margins to compress as well. I should note that while everyone has told us that the Amazon Kindle Fire would not pressure Apple because it was an inferior mid-level piece of technology, it is clear that the aggressive pricing of the Kindle Fire and it’s huge sales volume has had the pricing pressure effect I anticipated. The Wall Street Journal points out that Apple’s new iPad costs at least $316 to build.

It is only a matter of time here and I believe now is when we will see earnings growth slow at Apple.

I have to note here that I believed then that a more defensive posture was necessary. However, high beta, high risk and cyclical sectors still did ok. So despite the increasing risk, 2012 was good for US shares, one reason I believe complacency – and risk – is even higher now.

By April, I was questioning valuation at Apple ahead of earnings:

my earlier love of Apple as a stock has waned over the past eight years, particularly in the past few months, mostly because of valuation. As I wrote here earlier, Apple’s ascendancy in the S&P500 is more indicative of narrowing market leadership than anything else from a technical perspective. That has me worried. Moreover, I expect margins at Apple to compress as it competes for growth in an increasingly competitive market for mobile phones and tablets. Android has continued to make huge inroads and at some point either Apple’s market share erodes or eventually they are forced to compete at a lower price point. In fact, I expect compression to begin sometime this year, pressuring shares.

And note, Apple did well early in 2012, in April two days after questioning valuation, after the earnings I wrote:

While I think Apple’s valuation has reached uncomfortable levels, the company continues to execute. I am not bullish because of this. But again, Apple’s performance should power shares forward in an aggressive way over the near term because of Apple’s importance as a market leader.

This is important because it demonstrates that Apple, as a great company, superb on execution, was doing well right up until my thesis started to play out. Margins for that April quarter actually increased, causing me a bit of worry. Read that post again because you will see why Apple has fallen so hard. Unless you took a macro view on mobile that saw margin compression due to increasing competition there was zero warning that Apple would start to miss. I don’t fault anyone for missing this because Apple is a great company. But, this is also a good example of why I believe macro analysis is important.

Fast-forward to the next earnings in July and Apple misses:

Quick post here on Apple for the daily summary. The results for the most recent quarter are in and they were under market expectations across the board: on the top line, on margins, on profit, and on handset sales. In my view, this most recent report for Apple was abysmal.

It will get worse in my view. Samsung is taking share and Android has become a threat to Apple’s revenue growth. This is precisely the reason Apple is suing Samsung for patent infringement. Apple is afraid. For me, the bottom line is that Apple’s earnings growth has slowed and will continue to slow. When growth turns to contraction as it eventually will, the sell off will begin in earnest.

For me, that was it. Apple’s momentum was busted. All we needed was a catalyst. And the key here that I will circle back to is my belief that “when growth turns to contraction as it eventually will, the sell off will begin in earnest.” I now believe Apple’s earnings will contract in 2013 and this will mean a big sell off even from today’s levels.

Now Apple won a big patent case just after that and this turned sentiment somewhat. On a macro level, however, the verdict was meaningless. Here’s why:

First, let’s remember that similar cases elsewhere, from South Korea, to Germany, the UK, Australia, and even the US have had mixed results. So while the case in Apple’s home turf was a clear victory, I don’t believe that Apple will have similar success elsewhere. When a similar Apple case against Motorola Mobility came before Richard Posner threw the whole thing out

Second, the macro picture is one of a single mobile competitor with a closed platform trying to operate effectively against a bevy of others, almost all of whom are using another operating platform. This picture is one that is unfavorable for Apple over the long-term… Android manufacturers increasingly dominate the mobile market and this will not change anytime soon.

Third, the look and feel of Samsung phones is changing drastically. Samsung phones no longer look like Apple phones. The flagship Samsung mobile, the Galaxy S3, is very different from an iPhone. It is Samsung who is leading the industry right now by moving the mobile phone form factor to much bigger phones like the 5.3inch Galaxy Note, while the iPhone lags behind…

…there will probably be a cost of future litigation, licensing deals or efforts to circumvent the patents that gets passed onto customers in the form of higher prices. This will diminish Android’s price advantage somewhat. But I don’t think it will be a significant hurdle over the long term.

Bottom line: this is a significant victory for Apple in its patent war. In the short-term there will be some pain for Android. But the pain will not be a big problem. Over the long-term, Android manufacturers will adapt and continue to take share pressuring Apple’s rate of growth and margins. 

Now, the stock actually started breaking down in mid-September, with 19 Sep being the highest close just above $700 a share. I happened to write a piece on Apple’s upgrade cycle that very day that was positive on Apple’s ability to execute another upgrade cycle well but negative on the longer-term. I said that I felt this would make “2013 the year when Apple’s shares feel the impact of the new competitive landscape.” Little did I know the high was already in.

By the time, I ‘officially’ said sell in October in making the case against Apple, the stock was already at $604, or about 12% below its high.

While I first started warning  about Android taking share from Apple in 2009, I was not worried about earnings at Apple. It wasn’t until this year that margin compression became an issue for me. But even then, it wasn’t clear the issue would knock Apple’s share price back. After the latest earnings release, I must change my tune. Estimates got ahead of reality and Apple missed this quarter. But the earnings report issued by Apple yesterday was just fine on top line and unit volume as it handily beat guidance due to the massive upgrade cycle now ongoing. Nonetheless, the report was very alarming on precisely the issues I have been warning about since the beginning of the year, margins, market share and earnings growth. In my view, Apple’s ability to leverage existing markets to propel growth in new markets in order to maintain earnings growth is now compromised. Therefore, I would rather see dividend increases at Apple to return cash to shareholders than a push into marginal markets where Apple has no competitive advantage. I still believe that Apple’s previous momentum will protect its share price somewhat over the short-term. However, given this is now the second consecutive earnings disappointment and it comes on the heels of a 12% stock price correction, it is now clear that Apple’s stock has peaked.

And it’s been downhill from there to $460 last I checked. I think it will get worse. Here’s why.

Yesterday, I mentioned the fact that Apple moved to an earnings range that did not sit well with market watchers. The problem is that Apple said on its earnings call that the range was a target Apple fully expected to fall within rather than a conservative floor base case as previous guidance had been. This means that the whole lowball and beat charade is over. Apple is now giving us real numbers – and they are not good. If you do the math, earnings growth is now becoming earnings contraction at Apple.

Here are the numbers again (this time with the math) (UPDATE: I reversed the signs on the other income originally. There is slightly more net income now):

  • Revenue between $41 billion and $43 billion
  • Gross margin between 37.5 percent and 38.5 percent (Gross profit between $15.4bn and $16.6bn)
  • Operating expenses between $3.8 billion and $3.9 billion (Operating earnings between $11.475bn and $12.755bn)
  • Other income/(expense) of $350 million (taking us up to $11.825bn to $13.105bn)
  • Tax rate of 26% (net income between $8.7505bn and $9.6977bn)
  • Shares outstanding of 938,973,000 get you to EPS of between $9.32 and $10.33
Last March quarter saw net income of $11.622bn. So the math on Apple’s guidance yields a significant decline in net income year-over-year in this quarter. That’s extremely bearish unless this is a one-off.

Bottom line: Apple is breaking down both in the stock market and in terms of earnings. While this quarter has net income matching last year’s for zero earnings growth, next quarter will see a significant decline in earnings. This will put the stock under heavy selling pressure.

One final note on trading: I would rather be late than early on rotating out of an individual stock. You may see a trend early and think the stock is a sell but the reality is momentum can carry a stock higher for a long time after that; and you would have missed a huge rally. When a high-flier moves up, the peak is often a parabolic move where most of the price gains come. Apple is no different in that respect. So despite seeing the macro case turning against Apple, I didn’t make a full-throated case to sell until October for just this reason. The right approach is to trade with a stop-loss because you can stop accumulating shares on the way up and wait for the stop-loss to kick in when the stock breaks down. Otherwise, it might just be a pause before another rally that you miss.

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