The Case Against Apple

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.

Earnings at Apple

First, let’s look at the numbers for Q4. Here are the main points:

1. Revenue: $35.97 billion versus guidance of $34 billion and expected range of $34.28 billion to $38.04 billion), up from $28.3 billion last year
2. Profit: $8.2 billion or $8.67 per share versus guidance of $7.65 and $8.75 expected, up from $6.6 billion and $7.05 EPS last year
3. iPhones: 26.9 million, up 58% from Q4 2011
4. iPads: 14 million (including my own family), up 26% from Q4 2011 but down 17% sequentially from Q3
5. iPods: 5.3 million, down 19% from Q4 2011
6. Macs: 4.9 million, of which 4 million were notebooks (including my own), up 1% from last year
7. Apple TV: 1.3 million for 5 million in FY 2012
8. Gross margin: 40.0% compared to 40.3% last year
9. Cash: Added $4 billion to bring total to $121.25 billion after a $2.5 billion/$2.65 per share dividend

Apple’s Strategy in Context

Apple is a premium product integrated consumer products and technology company. That means Apple is focused on supplying premium-priced consumer products in the Technology space by controlling end-to-end product profiles: hardware, operating system and software. Apple’s unique position means first and foremost that it can maintain high gross margins on its product due to its premium positioning. But it further distinguishes itself by selling a completely integrated package which gives it control over design and software, operating system and hardware integration as well as customer support and branding. No other technology consumer products company has this kind of strategy. The result for Apple has been high positive brand awareness and high marks for customer service, ease of use and styling. Moreover, because Apple has come to dominate the iPod, iPhone and iPad categories despite its premium branding, it has generated massive profits and cash flow.

The Achilles heel for Apple, therefore has always been the margin/market share trade-off. Thinking about other premium-priced consumer products like BMW, one understands that the inherent trade-off for higher priced premium product and branding is lower aggregate volume versus competitors like Volkswagen. Sony is a good precursor model for Apple, where Sony was able to maintain margins for a long time despite competition from competitors like Hitachi with less powerful brands. Eventually, however, Sony’s approach – which is much like Apple’s in terms of making proprietary technology and selling it at a premium price – became a liability as non-proprietary standards began to take form in Sony’s markets. See Gizmodo from 2010 on this.

The longer one maintains the proprietary technology at a premium price, the greater the likelihood that competitors will enter the market under your price umbrella and undercut you, taking share. At some point, this presents the company with a dilemma on whether to cut margins or lose share. The right approach is stick to one’s knitting, maintain brand integrity and focus on core competencies. For a premium-priced seller, that means sacrificing share for margin. However, in the spaces that Apple now occupies, making the share trade-off to maintain margin can be a killer because of the benefits of network effects in the operating system space that Apple is in with iOS.

The Critical State

Early in the year, I predicted that US companies had reached an inflection point on margins. US companies had weathered the financial crisis well without adding significant headcount and had on aggregate record profit margins as a result. Unless we were in a new era, this trend could not continue and I expected reversion to the mean. Because of an incipient global growth slowdown that began late last year I believed – correctly as it later turned out – that 2012 would be the year in which margin mean reversion would occur. Apple fits right into this macro view. Here’s what I wrote in March:

“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. But Apple could already be indicative of narrowing market leadership as the negative earnings surprises have mounted. I believe this cyclical bull market looks tired. My recommendation: rotate out of high beta, high risk and cyclical sectors into a more defensive investing posture.”

Apple’s Defensive Move

With the release of the new iPad mini, we see that Apple was indeed pressured by the likes of Amazon. Amazon, with its Kindle and Kindle HD and Google with its Nexus 7, have undercut Apple in the tablet space. Without a defensive move by Apple to a 7-inch tablet, it was clear that Apple would lose share and probably volume growth in the tablet market. So they were forced to release the iPad mini. There are numerous reasons to believe that the iPad mini was a purely defensive move. But two stand out.

First, it is well documented that Steve Jobs did not believe a 7-inch tablet was a good product. Speaking in October 2010 at the Q4 2010 earnings call (audio here), Jobs said the following:

I’d like to comment on the avalanche of tablets poised to enter the market in the coming months.

First, it appears to be just a handful of credible entries. Not exactly an avalanche. Second, almost all of them use seven-inch screens, as compared to the iPad’s near 10-inch screen.
Let’s start there. One naturally thinks that a seven-inch screen would offer 70% of the benefits of a 10-inch screen. Unfortunately this is far from the truth. Screen measurements are diagonal. So that a seven-inch screen is only 45% as large as iPad’s 10-inch screen. You heard me right: Just 45% as large.

If you take an iPad and hold it up in portrait view, and draw a horizontal line halfway down the screen, the screens on seven-inch tablets are a bit smaller than the bottom half of the iPad display. This size isn’t efficient to create great tablet apps in our opinion.

While one could increase the resolution to make up some of the difference, it is meaningless unless your tablet also includes sandpaper, so that the user can sand down their fingers to around one-quarter of their present size. Apple has done expensive user testing on touch interfaces over many years, and we really understand this stuff.

There are clear limits of how close you can place physical elements on a touch screen, before users cannot reliably tap, flick or pinch them. This is one of the key reasons we think the 10-inch screen size is the minimum size required to create great tablet apps.

Third, every tablet user is also a smartphone user. No tablet can compete with the mobility of a smartphone-its ease of fitting into a pocket or purse, its unobtusiveness when used in a crowd. Given that tablet users will already have a smartphone in their pockets, giving up precious display area to fit a tablet in their pocket is clearly the wrong tradeoff.

The seven-inch tablets are tweeners. Too big to compete with a smartphone; too small to compete with an iPad.

Clearly, Jobs was just trying to explain why Apple’s product was superior to competitive products. But, nonetheless, his point stands. Here’s the key about 7-inch tablets. Jobs wrote the following in an e-mail to present Apple CEO Tim Cook according to documents discovered during the Samsung-Apple trial in Silicon Valley:

Having used a Samsung Galaxy, I tend to agree with many of the comments below (except moving off the iPad). I believe there will be a 7″ market and we should do one. I expressed this to Steve several times since Thanksgiving and he seemed very receptive the last time. I found email, books, facebook and video very compelling on a 7″. Web browsing is definitely the weakest point, but still usable.

So Jobs is basically saying that the 7-inch tablet is inferior to the 10-inch from a usability perspective but that this is a market segment Apple’s competitors are in. As the competitors could beat Apple up using this market segment, Apple should be in that market, if only for defensive purposes. 

Margins and Cannibalization

But, this is not a new category killer. The iPad mini is not a new disruptive market at all. It’s the equivalent of releasing an iPod and then releasing the iPod nano to supplement it to address the different needs of different consumers. So, there is certain to be cannibalization. Now, this doesn’t have to be a problem if the margins were the same on the iPad mini as on the iPad. Pre-release calculations suggested this could be the case. So, despite the lower price point, there would be a higher margin to partially compensate. Unfortunately, the margin on the iPad mini is lower than on the iPad, which is lower than the margin on the iPhone. An analyst at Piper Jaffray estimated 20% cannibalization. Meaning that 20% of the iPad mini buyers would be buyers of the higher priced and higher margin iPad. Apple is expecting margins of 36% for the next quarter, down from 40% this quarter. That’s a huge erosion in margin.

How does Apple expect to make its numbers then? The only answer can be volume. I do believe the upgrade cycle will be massive. But therein lies the problem. Apple is now sacrificing margin for volume – solely because it is feeling the competitive threat of Android. Can it deliver the volume. It’s hard to say at this point, especially since we are still in the midst of a global growth slowdown. But what is clear is that the iPhone and iPad markets will be saturated soon. And so adoption rates will slow. Apple has to anticipate a large part of growth coming from the upgrade cycle. This explains, perhaps, why it has made its most aggressive product turnover in history, with 80% of its products released in the last two quarters. I am uneasy about this volume strategy because it clearly violates Apple’s competitive strategy and moves it beyond its core strengths. But, what choice does Apple have? It must compete on price or see significant erosion of share.

In my view, Amazon is the real game changer in the competitive landscape here.  Amazon CEO Jeff Bezos has said it sells hardware at cost in order to recoup profits on services and Internet sales. I wrote last week that “my sense is that it will have the same impact on Apple’s margins that it has had in other markets, namely putting significant downward pressure on margins. For Amazon, it’s all about services and volume. That’s a low-margin business model. And now that Amazon is a mobile competitor, that’s trouble for Apple. I anticipate an Amazon phone, perhaps as soon as September 2013. By the time this happens, it will be clear that Amazon has been a threat to Apple’s profitability and share price will be down.” That is how I still see it, more so after the earnings announcement.