Quick Thoughts: The Apple Tug of War Continues – Sorting the Arguments

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–          Bulls see Apple transforming television and broadening its product line.  Bears fear iPhone subsidy cuts, the absence of Steve Jobs and the law of large numbers

–          The iTelevision faces more obstacles than bulls perceive, and an entry into mass market smartphones is out of character.

–          At the same time, subsidy cuts are not likely, Jobs’ vision should last a long time, and Apple has plenty of runway to sustain growth and profitability.

 

Apple is a celebrity.  Like a Hollywood A-Lister, Apple has an army of reporters, bloggers and industry pundits watching its every move, badgering its friends and neighbors for dirt, and even sifting through its trash.  For its own account, Apple feeds the hungry masses a thin gruel of guidance, while taking extraordinary steps to protect its secrets.  This absence of real information has inevitably boosted the cottage industry of Apple speculation: Will they or won’t they offer a television?  Will they or won’t they bring out a 7” tablet?  Will they or won’t they offer an entry level iPhone?   Can carriers force lower subsidies on the iPhone?  Does the loss of Steve Jobs mean the end of innovation at Apple?  How long can this hypergrowth go on, can they maintain these margins, and will Apple go on to be the first trillion dollar company?

Like everyone else, I have opinions.  These are based on my firm belief that the entire TMT sector is in the midst of a massive set of paradigm shifts, catalyzed, in part, by Apple’s own portable device innovations.  These shifts are putting enormous economic value into play for internet-based businesses and changing the nature of competition to capture that value.  These changes are mostly good for Apple, but raise some interesting strategic questions that make for a fairly wide range of possible long term scenarios.

Can Apple transform TV?  Walter Isaacson’s terrific Steve Jobs biography reveals that one of Jobs’ last product obsessions was television and that he claimed to have “cracked” the problem before his death.  This has spawned a flood of predictions as to the timing and form of a presumed Apple iTelevision launch.  I am a true believer that channelized broadcast video entertainment will eventually be marginalized by on-demand streaming video, and that hundreds of billions of dollars in advertising and subscriptions will be addressable by cloud-based services.  I also have no doubt that Apple can design a transformative user experience for TV, making it as easy and intuitive as the iPhone.  Furthermore, I am certain that Apple can sell beautifully designed LCD TVs at a considerable premium.

However, there are some speed bumps en route.  First, as many observers have noted, Apple needs to secure access to content.  In applications, music and publishing, Apple takes 30% off of the top – it is very unlikely that the networks that control the most popular programming would accept terms anything like that.  Moreover, with the recent history of the music industry in mind, the networks are likely wary of any special deal with Apple.

Second, and just as importantly, Apple must rely on 3rd party CDNs to deliver its streaming media.  Unlike Google and Amazon, which have invested billions of dollars in distributed data centers all around the world to deliver applications locally, Apple provides its cloud services from two massive data centers, one in California and one in North Carolina.  Streaming media to distant users, each router along the way adds geometrically to latency and error, badly disrupting performance, so Apple will need to sign on Akamai, LimeLight, or some other content delivery network to cache the content and serve it from closer in.  Given the wave of traffic that “iTV” streaming media could generate, these partners would likely need to make massive infrastructure investments of their own to accommodate Apple.  With no sign of that build out from any of the usual suspects, it suggests that a major TV product launch may be further away than many anticipate.

Will Apple expand its iPhone/iPad product line to accommodate new form factors and price points?  Of course Apple COULD offer a cheaper iPhone or a smaller iPad, but the question is whether they WOULD.  Apple has already taken a step toward a cheaper iPhone by keeping the 3GS model on the market at a lower price as it has successively launched the 4 and 4S.  However, while this strategy can make Apple affordable to a second tier of customers, the $340 unsubsidized price remains squarely in the high end on a global basis, where competitors are already selling Android smartphones for less than $100.  Selling last year’s model for cheap is a bit of a limited strategy – out of date components are not always cheaper than the next generation, design choices meant for a flagship product add cost, and design does get tired.  If Apple intends to get after the broader market, it needs to purpose build devices for a low price point – cheaper materials, off the shelf components, and compromised performance.  Not only does this seem contrary to Apple’s core DNA, but it unnecessarily puts Apple’s aspirational brand halo at risk.  Given that they have had years to make this jump, it seems unlikely that it is in the game plan now.

As for expansion of the iPad line, Steve Jobs famously pooh-poohed the idea of a 7” tablet, suggesting that users would have to shave down their fingertips to make use of the smaller screen.  I’m inclined to chalk that up to competitive rhetoric.  The issue is whether the jacket pocket tablet is a sufficiently attractive product category and whether or not Apple can translate its iPad environment to the tighter real estate without compromising the experience.  The rise of the Kindle Fire suggests that the real market for smaller tablets centers on the e-reader application.  In this, the recent U.S. Government suit against Apple over e-book publishing could be a delaying factor for a 7” iPad, as the company resolves the killer app.

Will carriers drive down iPhone subsidies?  Well, they would certainly like to.  We have written about the increasing co-operation between Verizon and AT&T in the US market around service pricing, data caps, and capital spending.  While the U.S. carriers are setting stricter guidelines for how often their subscribers can receive a subsidized upgrade and raising the fees for upgrading before the end of a contract term, those factors have a relatively small impact on device demand.  The real issue is whether carriers can reduce the size of the subsidy itself and here, history is discouraging.  Customers will churn for higher phone subsidies, and the history of the wireless communications industry is littered with examples of carriers that tried to unilaterally cut subsidies only to be forced into raising them again shortly thereafter.  Given that the iPhone represents 71% of smartphone sales at AT&T and 51% at Verizon, Apple remains in the negotiating driver’s seat, able to play one off of the other.  Rather than accept lower subsidies, it is likely that Apple would just cut off the offending carrier, inflicting huge churn on the unlucky party.  AT&T and Verizon are far better off colluding on service price and accepting the subsidy.

Can Apple innovate without Steve Jobs?  Last week, in an opinion piece published by Forbes, George Colony, the CEO of Forrester Research, boldly predicted that Apple will decline, comparing the company post-Jobs to Sony post-Morita and Disney post-Disney.  Colony quotes from Adam Lashinsky’s terrific book “Inside Apple” to point out that Jobs made all of the important decisions and that the rest of the organization was not encouraged to be entrepreneurial.  The assertion is that without this entrepreneurial and dictatorial leader, Apple will coast on its momentum before losing its mantle as a leading innovator.

My first thought is “So what?”  24-48 months of coasting off of Apple’s current trajectory would still make it the fastest growing company of the five largest market caps by a fairly large measure.  I also note that iPhone and iPad owners have an increasing commitment to the iOS interface and a set of applications that are common to a growing set of household devices.  The hurdle for churning customers from these products is far higher than the impetus to choose a new Samsung TV over Sony.  Moreover, having established this integrated consumer experience, Apple’s further innovations need not be revolutionary –adding new services to the mix or extensions to the device line-up do not really require Jobs’ brand of entrepreneurial genius to be successful.  Apple may miss the next BIG paradigm shift without Jobs, but they got this one dead right and, as we have written, the next one may be many, many years away.

How can Apple sustain its growth and margins?  The short answer is that it can’t and they don’t really need to, at least not at the current level.  In Apple’s recently announced 2nd quarter, Apple delivered sales growth of 59% YoY and EPS growth of 92%.  For the next two quarters, consensus is projecting an stark slowdown to 35% growth, with a further slow down to 20% growth for FY2013, which itself suggests quarterly YoY growth below 15% to accommodate the deceleration.  At the same time, EPS is only expected to rise 15% in FY2013, implying a 4% drop in net margins for the year, an abrupt reversal of the rising trajectory of recent Apple margins.

Of course, taking this at face value is misleading, as Apple has routinely beaten the street’s published numbers like a drum and it is evident that investors factor that in when evaluating the stock.  Apple’s current forward P/E is 10.9x, and if the estimates turn out to be 10% too low – not a stretch given that the most recent quarterly profits topped consensus by nearly 23% – the stock would sport a single digit trailing P/E in one year’s time.  I had a front row seat for Cisco’s free fall after its market cap peaked at $557B in March 2000, about the same valuation as Apple today.  However, Cisco’s trailing 12-month earnings at the time were $3.9B – Apple earns the same in about three weeks and is sitting on more than $100B in cash and marketable securities.

The skepticism around Apple seems to derive mainly from a dubious application of probability theory’s “Law of Large Numbers”, which postulates that average actual results should approach the statistical expected value and tend ever closer as the number of observations grows larger.  While it is silly to think that Apple can sustain 50% sales growth in perpetua, it is not silly to think that it can deliver better than expected growth and profitability for an investable future of 3-5 years.

Apple has plenty of runway left.  Smartphones are penetrating new geographic territories.  Tablets are poised to replace hundreds of millions of PCs.  Apple COULD make a play in TV.  These devices give Apple an advantaged platform to play for massive swaths of value being absorbed by the cloud – advertising, retail, media, services, transactions and software.  This advantaged platform, controlling the apps through which users access web-based services, also protects Apple’s profitability, as collecting fees is an inherently high margin activity.  Moreover, Apple’s scale-based cost advantages and powerful brand are not assets likely to deteriorate overnight, particularly given the customer stickiness inherent in Apple’s integrated cross-device user experience.

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

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