Apple: Is Apple the New Microsoft?

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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January 22, 2013

Apple: Is Apple the New Microsoft?

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.

Saturation, or, the Law of Large Numbers

AAPL’s fall product announcements were doozies. Coming off of the 2nd half of FY13, where the company had posted anemic 2% YoY top line growth, the product barrage was a balm to investors who had seen the stock drop precipitously from its September 2012 peak of more than $700. 2 new iPhones reaffirmed AAPL’s commitment to a high-end only smartphone strategy, and came out of the gate fast – important since iPhones account for over half of sales and, likely, more than 2/3s of profits. Adding the last two major carrier hold outs – China Mobile and NTT DoCoMo – to the fold was a coup that could add more than 30M units to FY14 sales. The two new iPads injected life into a product line that had grown sales just 3% in FY13 in the face of aggressive competition. So far, so good.

The problem is the hangover after the binge. Last year, the iPhone 5 and the iPad Mini launched to similar acclaim, only to see sales drop off dramatically in the June and September quarters as the products aged and new alternatives hit the market. Across the product cycles in both smartphones and tablets, AAPL’s market share fell, as the saturation of the high-end segment and the rapidly improving quality of lower priced products took their toll. Recent data suggests that iPhone share loss in developed markets occurred even during the September to November roll out of the new models. The current sales trajectory is a saw-tooth deceleration that bodes poorly for 2H14, and for FY15, when there are no more China Mobiles or DoCoMos to bring into the fold.

With repeated denials of interest in the rapidly growing low-end device market, arresting the share loss is no small task. Rumor has it that AAPL may expand its iPhone and iPad lines into larger screen form factors, possibly accelerating its product introduction schedule in the process. This is a good idea and LONG overdue, but balancing 3-4 form factors raises product costs, particularly if it means shorter product life cycles. Moreover, it’s not clear that AAPL’s loyal users can accelerate their buying cycles in the face of carrier contracts or, that incremental high-end gains would be sufficient to accelerate sales for a $170B company, particularly since these segments appear to be peaking.

New product categories won’t do the trick either. While the vigil for the mystical iTV and iWatch continues, an AAPL product in either market would now be quite late to the party. Furthermore, the global TV market features glacial consumer upgrade cycles, differentiation centered on display technologies (where AAPL is a buyer, not an innovator), and rapacious competition, while wearables are a speck of a market without clear proof that consumers are even interested. We are skeptical that either has the potential to be a $20B+ business that could move the needle for AAPL.

Cloud-based apps and services – monetized via ads, e-commerce, and subscriptions – have the potential to move the needle, but AAPL has delivered a long string of failures (iAd, Siri, iCloud, and Apple Maps amongst many others). iTunes is a $16B business but hardly a state-of-the-art application, and more than half of the revenue must be paid back out to publishers. Add in that music downloads have slipped into decline and that AAPL has committed to offering free software upgrades, and growth here is threatened, too. In the AAPL culture, device and OS designers are the rock stars, not cloud app and infrastructure engineers, and as a result the company has neither the skills nor the infrastructure to compete with the likes of GOOG, AMZN, FB or even MSFT. Add it all up, and we are concerned that AAPL will settle into low single digit growth, wildly profitable, but unexciting to investors despite apparent value in the shares.

Exh 1: Apple Quarterly Sales by Segment

It’s Apple Season

In the last few years, Apple’s sales have become increasingly seasonal. New product introductions in the fall drive strong holiday sales during the first half of its fiscal year, while the second half dies on the vine as fan boy demand dries up and new products from competitors leapfrog the increasingly long in the tooth iPhones and iPads (Exhibit 1). This pattern is playing out in spades during the first fiscal quarter of 2014. Apple introduced an unusually rich palette of products for Christmas – two new iPhone models, two new iPads, a major new iOS software release, and a handful of new Macs. Along with the product line refresh, Apple also managed to negotiate new iPhone distribution deals with the only two major carriers that had previously rebuffed its overtures. NTT DoCoMo, with its 63M well-heeled subscribers, was on board for the September 25th launch weekend, while China Mobile (762M much less well-heeled subs) began selling all three models of iPhone just this past week – just in time for the Chinese New Year’s rush. This is all good news.

Apple is also sticking to the script on pricing. Prior to the big product reveals in September, analysts had been abuzz with conjecture about a new low-priced iPhone that would compete for market share in the red hot low-end, or at least mid-range smartphone market segment. The demand for “good enough” smartphones at sub-$200 price points had pushed several Chinese and Indian brands to the top of the sales charts in their home markets, with the most successful amongst them plotting competitive moves into the developed world markets. Despite this, the supposedly “bargain” iPhone 5C hit with a $550 price tag, with the older 4S model repriced as Apple’s entry level at $450.

Exh 2: Smartphone OS Market Share in Major European Economies

This is excellent news on the margin front, but an issue for market share. A recent survey by Kantar Worldpanel suggests that, despite the splashy launch of the 5S and 5C, Apple’s share of smartphone sales in the US and in the 5 largest economies of Europe during the September to November period was down fairly sharply vs. the same period last year (Exhibit 2). This data suggests that almost all of the consumers in those markets with the wherewithal to buy a $450+ smartphone already have one, and that the incremental buyer is mostly looking at devices at the midrange on down. Given this, the volume strength suggested by the opening weekend sales figures may have been driven by the broader launch distribution, and in particular, Japan, where iPhones apparently accounted for nearly 70% of all smartphones sold during the holiday season (Exhibit 3-4).

Exh 3: Smartphone OS Market Share in US, China, Australia, and Japan

Exh 4: Top 20 Handsets in Japan (2014 YTD)

On the whole, the scuttlebutt points toward a strong 1QFY14 – expectations are for a big iPhone unit number, say 58-59M and a clear beat on the $57.3B published consensus, with gross margins up meaningfully vs. last quarter’s 37%. Given the product barrage, the wider distribution and the healthy price points, all of this is probably reasonable. 2QFY14, which includes the heralded China Mobile launch, is also teed up for a strong report, although more bullish expectations for an incremental 30M+ iPhones from this new partner are likely quite overaggressive given the realities of Chinese demographics.

Exh 5: Apple Quarterly Revenue by Segment, FY2012 – FY2013

Peering into the Abyss

For FY13, Apple generated $171B in sales – 53.4% from iPhone, 18.7% from iPad, 12.5% from Macs, 9.4% from iTunes (media, apps and software), 3.3% from accessories, and 2.6% from the iPod line (Exhibit 5). Looking at it with a long view, iPods are nearing end-of-life, and Macs caught in the long, slow decline of the PC form factor. Apple may realistically take market share with the Mac in its strong segments, but it is extremely skewed toward the consumer PC market, where the carnage is worst. That’s 15% of 2013 sales in inexorable decline.

Frankly, the iPad is only a bit better off. 2013 iPad revenues were up a mere 3% YoY, despite the launch of the well-received Mini. The 15 month old original iPad Mini sells for $299, a 30% premium over the Google Nexus 7 and the Amazon Fire HDX. The new Retina Mini (as well as the older model full size iPad 2) sells for $399, a nearly 75% premium over either the Nexus or the Fire HDX. The new iPad Air has a $499 sticker price, a 30% premium over the slightly smaller HDX 8.9 and the year old Nexus 10 (which is expected to have a major refresh introduced within weeks). The 32GB version of the Air sells for a 33% premium to a similarly equipped Microsoft Surface 2. Meanwhile, a raft of sub-$100 Android tablets, with specs comparable to 2-3 year old high end devices, have hit the world markets – including a new entry from fierce Apple rival Samsung. Without carrier subsidies, Apple’s huge price premium is fully exposed to the withering glare of the consumer buying process.

Exh 6: Implied Phone Subsidy Levels in the US for Major Flagship Phones

Saturation

Those subsidies DO give Apple an advantage in smartphones. US carriers offer the new iPhone 5S at $199 with a 2 year contract, the same price as other popular models, such as the Samsung Galaxy 4 or the LG G2. Yet, without contract, the iPhone 5S with 16GB costs $649 and the competitive alternatives sell for less than $600. Similarly, the brand new Samsung Galaxy Note 3 carriers the same $699 unsubsidized retail price, yet is offered at $100 premium to the iPhone with contract. Essentially, US carriers are paying Apple a bigger subsidy than they do to any of their other vendors, thus masking the price gap for consumers (Exhibit 6).

This may be changing. Unlike the US, many global markets have moved away from opaque device subsidies, with carriers offering financing to consumers looking to amortize the cost of their smartphones. Unsurprisingly, the iPhone market share in non-subsidy markets is considerably lower than it is in the US (Exhibit 7). This differential makes T-Mobile USA’s subsidy-free “Uncarrier” initiative potentially problematic for Apple. If the tide of consumers churning to T-Mobile’s low service prices and device amortization plans continues, market leaders AT&T and Verizon could be forced to follow suit.

Once smartphone prices are viewed in clear relief, the same picture emerges as we saw in tablets. Apple’s cheapest iPhone, the 27 month old 4S with 8GB of memory, sells for $450 unlocked, with the 16GB 5C at $550 and the flagship 5S at $650. Unfortunately, the real growth in smartphones is now happening at much lower price points. While Apple grew its iPhone business 16% in FY2013, aggressive Asian brands, like Lenovo, Coolpad, Xiaomi, and Micromax, were growing their smartphone sales at better than 150% on the strength of their sub-$200 Android smartphone offerings. Even downtrodden Nokia delivered 200% growth for its Lumia smartphone line in 3Q13, driven by its popularly priced mid-range Windows Phone models (Exhibit 8).

The reality is this: smartphone penetration in most developed countries exceeds 65% – most of the customers that can afford a $450+ smartphone and a capable wireless data plan have already bitten the bullet (Exhibit 9). The remainder are sorely tempted by the increasingly capable devices available at lower price points, even if they can afford to spring for an iPhone. The existing customers are tied into a fairly fixed upgrade cycle by their amortization or service contracts. As the untapped pools of possible customers – of which China Mobile and NTT DoCoMo are, by far, the biggest – are tapped, the high end smartphone market is becoming a zero-sum game of replacement and churn. Given that Apple has been crystal clear that it is not interested in addressing significantly lower price points, the current iPhone trajectory looks like a descent to slow or no growth.

Exh 7: iPhone 5S Pricing as a % of GDP, Subsidy Availability, and Market Share by Country

Exh 8: Quarterly Global Smartphone Shipments, 1Q2011-3Q2013

Exh 9: Smartphone Penetration in Select Developed Markets

Put Your Seatbacks and Tray Tables Up

The $91B iPhone business is decelerating – 16% growth in 2013 came after 71% growth in 2012 and 87% growth in 2011 (Exhibit 10-11). To match the 2013 growth rate, Apple needs to sell 24 million more iPhones in FY14, without suffering deterioration in the average selling price. At first glance, this is doable, as adding China Mobile and NTT DoCoMo to its carrier mix has the potential to deliver more than enough units, all other things being equal.

Unfortunately, all other things may not be equal. The November Kantar numbers suggest that iPhone sales figures from developed markets may be down YoY, raising the bogie for new carriers to pick up the slack. Verizon’s 4Q13 results revealed that its activations of new smartphones were down more than 10% YoY in the quarter. Moreover, while the $650 5S has been a success, at least anecdotally, the $550 5C has not, leaving a possibility that Apple’s mix could be shifting even further to the $450 4S, particularly given a greater reliance on developing markets to carry growth. The average selling price of an iPhone, which dropped 4% from $630 in FY12 to $606 in FY13, could easily slip again (Exhibit 12).

Even if China Mobile and NTT DoCoMo are enough to boost the iPhone growth rate in FY14, the effect will be front end loaded. Over the past several years, Apple’s seasonality has grown ever more skewed, with significant drop offs in the June and September quarters (Exhibit 13). Strong iPhone sales growth in 1QF14 and 2QF14 could be a set up for disappointment. Moreover, after China Mobile and NTT DoCoMo, there are no obvious hold-out carriers to add to the mix in FY15, likely exposing investors to the decelerating organic growth rate at that time.

Exh 10: Quarterly iPhone Revenue, 2010-2013

Exh 11: Quarterly iPhone Unit Sales and YoY Growth, 2010-2013

Exh 12: iPhone Average Selling Price, 2010-2013

Exh 13: Quarterly iPhone Sales, Launch to September 2013

Market Saturation, Rising Competition – What Do You Do?

Given the current trajectory of decelerating iPhone sales, stagnant iPad sales, and declining Mac and iPod sales, we are concerned that Apple stock could languish on top-line disappointments, even if the underlying cash flows remain robust. We see three main levers that CEO Tim Cook could use to try to reinvigorate revenues: a) Recover market share in the high-end smartphone and tablet categories; b) Establish new hero devices with potential to be big enough, fast growing enough and profitable enough to move the needle; and/or c) Greatly expand the post-sale revenues earned from loyal Apple device users.

In pursuing market share, addressing the explosive global demand for considerable cheaper smartphones and tablets is, apparently, off the table (Exhibit 14). In September, after announcing the new iPhone 5C at $550 in the face of market expectations that it would be a much cheaper model, CEO Tim Cook emphatically asserted that “We are not in the business of junk products”, implying to his Bloomberg interviewer that lower price point products were, in fact, “junk”. Given Apple’s 45%+ gross margins on iPhones, it would seem that Apple has plenty of room to deliver much cheaper products to emerging market customers without offering “junk”, but Cook’s assertion can be read as a clear statement of Apple’s commitment to a high margin strategy as well.

Exh 14: Higher-End Emerging Market Smartphones, Q1 2014

Broader Product Line, More Frequent Introductions

While Apple is almost certainly not releasing a $200 iPhone, strong rumors persist that Apple WILL launch at least one new larger screen model in June, just nine months after the introduction of the 5S and 5C. This would be a considerable break with the longstanding iPhone strategy standardized on 1-2 relatively small screen sizes and a single annual product update. Indeed, the late Steve Jobs was adamant that the original iPhone screen with a 3.5” display was the “perfect” size for the human hand and the first 5 versions of iOS were hard coded to those screen dimensions. With the iPhone 5 in 2012, Apple finally stretched the screen to 4”, but keeping the width the same in recognition of those standard sized human hands. The hard coding in iOS was adjusted to allow for an extra half-inch or so of screen height, while older apps were simply presented with banding at the top and bottom. A 9-month update would also be foreign to Apple’s traditional iPhone practices, although it bowed to competitive pressure with a 6 month update to its full sized iPad in the fall of 2012 while also bucking its history with the introduction of the iPad Mini (Exhibit 15).

Exh 15: Quarterly iPad Sales, Launch to September 2013

Arch competitor Samsung made its bones in the smartphone market by pushing the size of its displays, first to a ~5 inch diagonal in its flagship Galaxy series and then to the 6 inch threshold for its popular Note phablets. The hotly anticipated Galaxy 5 is expected to be available by April, right on the heels of the recently launched Note 3, and should raise the bar on performance specifications. A June big screen iPhone – or according to some whispers 5” iPhone AND a 6” iPhablet – would certainly make Apple more competitive for new high-end smartphone buyers.

However, expanding the product line is not costless. Apple’s enviable device margins stem, in part, from its narrow selection of long lived and high priced phones. Spreading demand over a larger number of models and replacing profitable older models (or discounting them to address a lower price point) on a more frequent basis is a recipe for lower margins. Given further rumors of an 8GB iPhone 4 re-launch in India, Apple could be supporting as many as 6 different iPhone models, with 5 different cases, 4 different displays and 3 different processors. Inevitably, manufacturing costs will be higher, particularly for devices with larger displays, and the expenses for developing and supporting the broader line may also rise. The higher cost of the larger products could be offset with price increases, but this will dampen their appeal in a high end market already fiercely competitive and nearing saturation. The various sized screens would also play havoc with apps – unlike Android, iOS does not automatically resize apps to fit different screen dimensions and resolutions.

If Apple were to introduce a larger screen flagship in June, it could badly cannibalize demand for the then 8 month old and presumably, maximally profitable, iPhone 5S. Upgrade demand could be pulled forward from the fall, setting Apple for a holiday quarter disappointment, rather than a September quarter swoon (Exhibit 16). Perhaps Apple hopes to set a new product introduction rhythm with a large screen update in the spring, followed by a small screen update in the fall – this will smooth seasonality somewhat, but may not substantively boost demand as saturation proceeds, given device amortization obligations and early upgrade penalties borne by users. It is also possible that the “me too” introduction of 5” and 6” inch form factors would erode some of the sheen from the market’s perception of Apple exceptionalism.

Exh 16: Estimated iPhones Eligible for Upgrade, 2Q09-3Q15

Of course, it could be that a new iPhone introduction delivers some innovation so compelling that it drives a dramatic and sustainable long term share shift toward Apple. However, we note that Apple has not delivered such an innovation for the iPhone in several years, and rivals have whittled away at its biggest points of differentiation – e.g. display resolution, processor speed, app availability, etc. It is not at all obvious what Apple could deliver in a new iPhone that would turn the tide.

A Broken Watch is Right Twice a Day

During the 9 year stretch from October 2001 to April 2010, Apple delivered 3 radical, game changing products. Starting with the iPod (and iTunes) which changed the way the world bought and listened to music; to the 2006 launch of the iPhone, which catalyzed a shift from desktop to mobile and from browsers to apps; and on to the introduction of the iPad, which revealed that a PC was the wrong form factor for most consumers and for many enterprise applications; Apple was the most innovative company in the world. This iHat-Trick of excellence and invention had journalists and investors believing that the next blockbuster was right around the corner.

Exh 17: Global Connected TV- Penetration

Almost 4 years later, we are still waiting. TV was going to be the next big thing. Steve Jobs told Walter Isaacson that he had cracked it before he died. Annually, analysts wrote their “this is the year for iTV” scoops while bloggers turned up blurry pictures of Apple big screen prototypes that were supposedly on their way to production. Meanwhile, a range of rivals has taken the bit on revolutionizing TV. Google whiffed with GoogleTV, but is rumored to be back in the hunt with an Android approach. Microsoft has launched Xbox One with a voice/gesture/mobile/controller interface that jumps in front of the cable box. The big TV makers, Samsung, Sony, LG, Sharp, Panasonic, HiSense, and others, are on 3rd and 4th generations of their “Smart TVs”, some of which finally seem to be more useful and less gimmicky. Cable operators are rolling out (slowly) new internet connected systems with better user interfaces and access to more content. Verizon just bought Intel’s OnCue internet delivered TV initiative, with the thought that it will use it to offer cable competitive service with a slick front-end interface to the 100M US households without access to its FiOS service. Other device makers, from Sony with its PS4, to Roku, and even Apple itself with its “hobby” AppleTV, are selling adjunct TV boxes to improve living room access to internet delivered content (Exhibit 17). With all of this activity and attention, it’s hard to see how Apple can shock the world.

Part of it is the control that network-owning media companies and heavy handed cable/satellite/telco distributors have over the most popular video content. This control is weakening, but not enough that Apple can dictate the terms of content deals, particularly given its history in strong arming record companies and wireless carriers. Perhaps more importantly, the TV market is ill suited to Apple’s preferred business model. If Apple is to sell big screen TVs, as has been rumored, the large majority of the cost of the product is in the display itself, an area where Apple has no real advantage. Moreover, the replacement cycle for televisions is nearly 7 years and households contain an average of 3 TVs, typically of different vintages and makes, with the expectation that any “reimagining” of the TV experience would be available across the household. Add in that competition in the big screen TV market is cutthroat with razor thin margins, it is hard to see why Apple would want a part of it.

The adjunct TV box is more Apple’s speed, but it is already in that market with a $100 box with sales too insignificant for Apple to break them out as a line item. The global set-top-box market is a less than $30B industry, growing in the low single digits, dominated by sales of devices sold to multichannel system operators and built to their specifications. It is very hard to imagine this business growing enough to make a dent in the sales of a $170B revenue company.

Exh 18: Global Export Sales of Swiss Made Luxury Watches, 2007-2012

The iWatch is the other great hope. More than 1,200,000,000 wrist watches are sold annually, but at least a billion of these sell for prices below $10, a market unlikely to be addressed by a smartwatch. Another 30 million are fine timepieces, mostly produced in Switzerland, with average selling prices approaching $800 (Exhibit 18). Some of these customers may be addressable by smartwatches, but for the most part, it is a different market. What is left is a 125-175M unit annual market for mid-range watches, but one where social trends have been running against watch ownership in the very smartphone-owner segment targeted by the legion of companies now targeting the smartwatch opportunity.

And it is a legion. Samsung is out with its poorly received Galaxy Gear smartwatch, vowing to get the product right on the next generation. Start-up Pebble used Kickstarter to successfully bring its $100 smartwatch to market, and gain some publicity in the process. Qualcomm recently launched its TOQ smartwatch, highlighting its unique Mirasol display technology. Google was a pioneer in wearables with its Glass initiative and is widely believed to be readying its own electronic wrist watch product. That is a lot of attention for what is likely a $10-15B addressable market. Even if it could capture and sustain half of this market, $5-10B is chump change for Apple. IF Apple brings out an iWatch, it will be best thought of as an accessory that could help sell incremental iPhones than a hero product in its own right.

So if not TVs or watches, couldn’t Apple deliver an amazing product that would come as a complete surprise? It certainly COULD – it did when it launched the iPad in 2010 – but it is difficult to build an investment case based on the surprise delivery of a black swan product that can quickly grow into a $20B business and keep growing from there.

Send in the Cloud

The cloud IS big enough to deliver growth to Apple, yet the company has been strangely indifferent to it over the years. Google has built a $60B advertising business that is still growing at nearly 20%. Amazon’s dominant e-commerce business is even bigger and growing even faster. With an installed base of roughly 230M relatively well-heeled iPhone users, and those 450M credit cards on file at iTunes, Apple should be able to tap into this stream.

Apple has a $16B iTunes media and software distribution business that grew a healthy 25% in FY13, but that faces some headwinds in 2014. Music downloads made up about 35% of this revenue, but downloads are believed to have peaked in the face of streaming music products and are projected to decline from here on. Apple software made up another 30% of the sales in this bucket. Given the recent pledge to make all software upgrades free going forward and given the generally weak state of the PC market served by the Mac, it would seem that this slice could recede as well. The remaining $5.5B comes from app and media distribution, of which almost half is paid out to media companies. (NB the developer’s share of app revenues does not run through the income statement). This business should continue to grow very nicely (Exhibit 19).

Still, by just taking its 30% share off the top and leaving advertising, e-commerce, consumer services, and other revenue streams to 3rd parties, Apple has left a lot of money on the table. Previous attempts to build cloud revenue streams – iAd, iCloud, amongst others – have been hamstrung by clumsy implementation and Apple’s proprietary approach. Even cloud-based platform services designed to complement the experience of iPhone and iPad users, like Siri and Apple Maps, have been poorly received.

Apple got a very late start in the cloud and has never fully embraced it. Much of this is related to Apple’s culture – at its heart it remains a device driven company and the rock stars in Cupertino are the device and user interface software engineers and designers. The original iPod was always intended as an adjunct to a Mac – the music files were downloaded and managed on the computer, then synched to the device. The first iPhone was also designed to be tethered – Apple was late to the party with over the air synch and eventually, with system updates and downloads directly from the cloud. iTunes remained a music download only service for years while Pandora and Spotify established their streaming services with iPhone users.

Exh 19: iTunes Ecosystem Value Structure

Even where Apple has not been late with cloud services, they haven’t been very good – again, see Siri, iCloud, Maps, etc. Apple’s cloud infrastructure is not nearly as advanced as Google, Microsoft, or Amazon, all of whom have longstanding and popular consumer cloud services and commercial cloud hosting businesses. Apple’s data center scientists and web application developers do not have the status that they do at these rivals, who have been competing over top talent from the top universities for over a decade. Moreover, Google, Amazon, Facebook, Twitter, and even, on occasion, Microsoft support their applications across multiple platforms, broadening their reach and monetizing even on Apple’s platform. In contrast, Apple keeps its apps proprietary, limiting their adoption to their loyal following and truncating their reach.

As such, despite Apple’s towering strength in device design, it remains an also ran in the cloud. Unless it changes its approach of making cloud services subsidiary to its devices, takes real steps to close its infrastructure and skills gaps, and addresses a culture that systematically devalues cloud solutions and their developers, Apple will likely continue to leave huge revenue opportunities unaddressed.

What Does it Mean?

Apple is a huge and wildly profitable company. Adjusting for its $150B cash hoard, its $490B market cap is just 7.5x its $45B operating cash flows ex Capex. Arguably, Apple is cheap even if it doesn’t grow, as long as it can sustain its cash profitability.

But that is the rub. An Apple that doesn’t grow is an Apple that is more likely to fall behind in elements of its overall business system, eventually pressuring margins and thus, those prodigious cash flows. An Apple that doesn’t grow is an Apple that could lose its edge on a generation of innovation, like mobile device leaders Nokia and Motorola before it, thus turning a plateau into a decline. An Apple that doesn’t grow could lose its leadership of global “cool” and the price premium that its devices command. Finally, an Apple that doesn’t grow is unlikely to excite investors to take its multiple higher, even if margins and cash flows can be sustained.

The addition of China Mobile and NTT DoCoMo to the carrier list for iPhone may make up for saturation and deteriorating market shares in the US and Europe, and Apple’s 1HFY14 may show upside relative to expectations for a modest reacceleration from recent quarters. A June launch of new big screen iPhones could pull some upgrades forward and stem share losses in the increasingly saturated high-end smartphone market. Still, the longer term trajectory for Apple sales is at best, uninspiring.

We have a model for a large, iconic, cash-rich company that struggles with growth after a leadership transition from a respected founder and fails to inspire investors. We are concerned that Apple stock could fall into the same sort of prolonged malaise with which Microsoft investors are so painfully familiar (Exhibit 20).

Exh 20: Microsoft Share Performance and Sales Growth, December 1999 – January 2014

 

 

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