January 22, 2014 – Apple: Is Apple the New Microsoft?

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The raft of new products launched at year-end have analysts bullish for AAPL’s FY14, and optimism may be well placed for 1H. Still, with high-end smartphones easing toward saturation, raging competition in tablets and dying PC demand, meeting expectations for accelerating 2H and longer term sales will depend on a) taking market share in devices; b) adding new device categories; and/or c) expanding post-sale monetization. AAPL’s market share initiatives center on adding new carriers and expanding its product range. For FY14, the additions of China Mobile and NTT DoCoMo are an obvious boon, although one that can’t be repeated for FY15, while the rumored spring launch of larger screen iPhones and iPads could be detrimental to margins while only modestly spurring sales. As for new categories, we are skeptical that rumored products like an iWatch or iTV can be big enough or profitable enough to move the needle for a company with $170B+ in sales and $36B+ in net income. For the longer term, we see monetizing cloud-based applications as the key, but Apple’s track record is poor despite the massive opportunity. We are concerned that AAPL could disappoint in 2H14, and that longer term growth will be tepid at best, potentially leaving the stock in a MSFT-like purgatory despite its superior cash flow.

New products and carriers driving strong 1HFY14. In the last 14 weeks, AAPL has launched 2 new iPhone models, 2 new iPads, and signed 2 of the world’s largest carriers for the iPhone. Understandably, analysts have been enthusiastic, as reports of strong sales continue to filter in. In particular, having China Mobile (763M subs) and NTT DoCoMo (62M) distribute iPhones for the first time is a lucrative coup. Acceleration from the tepid 2% growth of 2HFY13 is almost given.

Questions abound for 2HFY14 and beyond. Over the past several years, AAPL’s 2H results have been increasingly weak, as holiday season products lose luster and competitive devices hit the market. Moreover, having committed itself to a high-end smartphone strategy, AAPL faces a looming saturation of its only market segment as global demand shifts to lower price points. Despite the apparent success of the iPhone 5S, iOS share in the US and top 5 European countries fell sharply in the September-November period, likely due to the shift to the low-end and mid-range. Competition continues to intensify in tablets, where AAPL’s 2HFY13 growth was just 3% – iPad pricing is 20-60% above comparable products, with more competitive launches due by spring. Macs, still 12.5% of sales, face a depressing PC market coming off of a 7% decline in FY13.

Competition for smartphone share will be fierce. China Mobile and NTT DoCoMo could account for an additional 30-35M iPhone units for FY2014, although the sales will be concentrated in the 1H launch period and higher projections of 50M+ from the 2 carriers are likely optimistic given the demographics of the Chinese market. Strong products from new Asian rivals, like Huawei, ZTE, and Xiaomi, are pushing high-end specs at mid-range prices and looking to enter developed markets – a serious threat to AAPL and other incumbent brands. Rumors suggest that AAPL may launch new large screen iPhones, perhaps in the spring to combat the increasingly painful 2H sales drop-off. Such a move could sustain market share, but perhaps not as much as many will hope given customer service contracts and would likely have a negative effect on margins by spreading demand over more products, each with fixed costs and diminished scale.

Competition for tablet share will be fiercer. The global tablet market settled to less than 40% growth in 2013, and as of 3Q13, iPad’s share had dipped below 30% in a market that it invented less than 4 years ago. With 2 new models for Xmas and price cuts on the older versions, AAPL will surely pick up lost ground in 4Q13, but rivalry will heat up again in early 2014 with new models due from a long roster of competitors. Without carrier subsidies to mask its 20-60% price premium vs. comparable models, AAPL likely faces the unwelcome choice to either cut prices (and margins) or cede more market share. Here too are rumors of a larger 12” iPad Pro, a product that could extend the market to even higher price points, but with the same risk of dilution as larger iPhones.

Rumored new product categories too small to matter. The buzz around iWatches and iTVs has been deafening, but the addressable markets are small and the issues around market entry are problematic. AAPL is late to the game for wearables and the market response has been, thus far, unenthusiastic. In a world where the trend has been decidedly anti-wristwatch, an iWatch would have to a complete game-changer to be more than an accessory sold to a small minority of iPhone customers. TVs are a bigger problem. AAPL has little basis to differentiate itself on the quality of the display, the key buying factor for consumers and by FAR the biggest cost element in a product category with 7 year replacement cycles and razor thin margins. An updated adjunct AppleTV box is likely, but the potential sales are de minimus for a company AAPL’s size.

Cloud apps attractive, but not AAPL’s strong suit. AAPL’s media, software and services business grew 25% to $16B+ in FY13. However, more than half was paid back out to publishers, ~30% of sales were derived from the now declining music download business, and another 23% or so came from AAPL software, where a recent shift to free upgrades will sap 2014 revenue. AAPL does not generate meaningful sales from advertising, non-media e-commerce, or cloud-delivered consumer services, areas that have been very lucrative for rivals GOOG, AMZN, and even MSFT, all of whom have shown willingness to subsidize device sales to gain advantage for these revenue streams. We believe these platform-related cloud opportunities are more than large enough to generate future growth for AAPL. However, the company’s historic reticence to play in these areas, its poor track record in cloud-based services (iAd, Siri, iCloud, Apple Maps, etc.), and its lack of necessary skills/infrastructure put the likelihood of significant future upside seriously in doubt.

AAPL may be stuck in a low/no growth zone. Absent an unexpected “hero” product launch, it is difficult to see how AAPL can reaccelerate sales growth or expand margins to satisfy TMT investors. While viewing the stock as a cash flow annuity suggests value-driven upside, MSFT’s lost decade under similar circumstances suggests pain for investors if management cannot credibly demonstrate a path to delivering a reacceleration to double-digit earnings growth in the future. We have seen nothing from this AAPL management team to give them the benefit of the doubt.

For our full research notes, please visit our published research site.

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