Late in January, I predicted why earnings contractions were coming for Apple in 2013. And since that time, Apple has indeed shown back-to-back quarters of earnings decline, with the announced earnings yesterday much lower than in the comparable quarter in 2012. This will be the new reality for Apple for quite a while, one reason the company must continue returning money to shareholders.
The course of events for Apple were market share loss to margin compression to reduced earnings. We saw the margin compression already last year. But now this margin compression has morphed into earnings compression due to the slowdown in sales growth at Apple. And I believe, this trend will continue.
Yesterday, Apple released its third quarter earnings results for 2013. Here are the highlights:
- $35.3 billion in revenue versus Q3 2012 revenue of $35 billion
- $6.9 billion in net profit versus Q3 2012 net profit of $8.8 billion
- Gross margins of 36.9% versus Q3 2012 gross margins of 42.8%
- 31.2 million iPhones sold versus Q3 2012 iPhone sales of 26 million
- 14.6 million iPads sold versus Q3 2012 iPad sales of 17 million
- 3.8 million Macs sold versus Q3 2012 Mac sales of 4 million
Forward guidance is as follows:
- revenue between $34 billion and $37 billion versus $36 billion in Q4 2012
- gross margin between 36 percent and 37 percent versus 40.0% in Q4 2012
- operating expenses between $3.9 billion and $3.95 billion versus $3.45 billion in Q4 2012
- other income/(expense) of $200 million versus an expense of $51 million in Q4 2012
- tax rate of 26.5% versus a tax rate of 24.5% in Q4 2012
As you can see, all of the main business variables at Apple show weakness versus the year ago periods. Growth and earnings are now in decline. Here’s why.
Handset sales growth is slowing. Samsung warned us of this already in January. Samsung believes most of the growth in handset sales will come from lower cost and lower margin handsets sold in emerging markets where market penetration is lower. In developed markets, any growth will come not from the growth of mobile as a platform since these markets are mature, but rather from the handset upgrade cycle and the move from feature phones to smartphones. Overall, this mix of drivers puts downward pressure on handset average sales price (ASP) even while volume growth is declining.
Apple produced very good handset sales volume numbers in Q2, well above estimates. And it has developed strategies for both the low-cost arena as well as for emerging markets like China. And while execution here is key, Apple has always done well in the past in terms of execution. So the volume metrics are a problem, but less the problem for Apple. ASPs are falling for Apple. The last quarter saw the ASP at $581, down from $613 the previous quarter. And this trend is set to continue for multiple reasons. The mix of handsets is already moving down market as the iPhone 4 has taken a larger share of the market than previous older product. And Apple is due to add to this by producing its low cost handsets. Morgan Stanley pegged the right price point for an iPhone mini (that could be sold in emerging markets) at about $330. That tells you, prices can go down a lot. Ostensibly, were Apple to go to market at a higher price point, sales volume would suffer. So take your poison, lower average sales price or lower volume. That’s where Apple is.
The large decline in iPad sales volume in Q2 was surprising though. Apple still has a stranglehold on the tablet market and since PC sales are also declining, I had anticipated some of those sales would show up in tablets. Apple’s results show this is not the case. It bears watching how Apple does here because the tablet market was the last great growth market for the company; if Apple loses traction here, one must believe that dependence on the iPhone is even greater. And with the margin and price pressure in the handset market, weakness in the tablet market is bad news for Apple’s top and bottom lines.
My sense is that Apple knows all of this. That is why it has moved toward increasing dividends and buying back shares. The company has $146.6 billion in cash and securities on its balance sheet, enough to buy every single professional sports team in the four largest American sports of baseball, football, basketball and hockey. So, there is a ton of money to distribute to shareholders. Excess cash on the balance sheet is wealth destruction. That’s my view. And we want to see Apple doing exactly what it is doing with its cash because it means it is focused on not destroying shareholder value through expensive mergers or by chasing growth. I expect dividends to continue to increase and for Apple to continue to buy back shares. As of the end of June, Apple had nearly 23 million fewer shares outstanding than it had one year ago. If anything, I expect Apple to step up its share purchases.
But the story here is of a company whose core product is experiencing a decline in both sales growth and in sales price. That will put Apple under tremendous pressure to find growth somehow. I would not be surprised if we do see a major merger in the future, even though I think this would be a bad move for Apple. The heyday for mobile handset growth is over and we need to accept this. Apple still earns a lot of money but it is a not a growth stock. Those days are over.