Quick Thoughts: Apple – A Frightening Glimpse of the Future


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Quick Thoughts: Apple – A Frightening Glimpse of the Future

–        While AAPL delivered an EPS beat and in line revenues, poor iPhone unit volumes, weakness outside of Japan/China, and cautious March guidance fuel serious questions of long term growth

–        AAPL’s high price strategy delivered margins, but it is trapped in an almost saturated segment. Despite 2 new iPhones, share is down YoY in almost every major economy but Japan.

–        China Mobile began selling iPhones this month, but tepid guidance squashes hopes of a 2QFY14 windfall, and raises the possibility of an even worse 2H as the new iPhones and iPads age.

–        1QFY14 casts a pall over expectations of future growth – China/Japan slows, high end device demand plateaus, competition intensifies, Mac succumbs to PC weakness. What then?

At first blush, Apple’s 1QFY14 looked like a beat – sales of $57.6B topped the $57.5B consensus, while EPS of $14.50 cruised past the published $14.09 expectations. However, given talk ahead of the report, it is likely that investors were expecting even more. Furthermore, a few paragraphs further into the press release, the 51M iPhones sold stood out like a warning beacon, a 10% miss against expectations of more than 55M units in a quarter where the company released two brand new smartphone models, launched them to more countries on a faster schedule than it ever had, and added NTT DoCoMo and its 63M iPhone crazed subscribers to the list of carriers for the first time. Add in guidance for mid-point March quarter revenues almost 6% below the current consensus, and the after-hours rout was on – at the end of the conference call, shares were down more than 8%.

We published a piece on Apple last week (http://live.ssrllc.com/2014/01/january-22-2014-apple-is-apple-the-new-microsoft/), laying out the case for a cautious long term outlook on the stock – high end segments becoming saturated, competition in devices growing fiercer, shortening product life cycles, high- price premiums becoming more of a liability with less differentiation, etc. While we anticipated these headwinds to become more apparent for Apple in subsequent quarters, today’s earnings release suggests that this hypothesis is coming true sooner. The iPhone, which makes up over 56% of Apple’s revenue, is ubiquitous in developed markets and the quarter shows evidence of saturation at the high end. While the NTT DoCoMo deal helped drive 11% YoY growth in Japan, where, according to Kantar Worldpanel, iPhone’s share is well north of 60% of smartphones sold, the Americas were a serious disappointment, with aggregate sales in the home region off by about 120 basis points.

According to Tim Cook, the weakness in the Americas was largely due to carriers becoming stricter on upgrade terms. But as rivalry among US Carriers has increased, their willingness to pay for devices has not. Disruptor T-Mobile USA has gone from subsidizing phones to offering more transparent amortization plans while promising more generous device upgrade cycles for an added cost. In the meantime, the T/VZ duopoly seized on the opportunity to enforce more stringent upgrade terms. A 2-year wireless agreement with T/VZ used to have an early upgrade clause allowing customers to move up to new devices after 18 months. Not anymore – the carriers have begun to enforce 24 month upgrade cycles and begun programs like AT&T Next and Verizon Edge where shorter upgrades are allowable for additional fees. These new policies increase costs for consumers and are not a good deal for Apple, which is used to masking the true price of its phones in markets where subsidies are the norm.

With the last iPhone launch in September 2013, Tim Cook & Company committed Apple to the saturated high end despite widely forecasted double digit growth of low priced smartphones in emerging markets. The strategy worked to reverse Apple’s gross margin declines. With the iPhone’s ASP up over 10% sequentially, Apple delivered its best margins in a year. Sure, Apple brought in carrier heavy weights NTT DoCoMo and China Mobile, with the latter making the iPhone to some 760M subs starting this month, but realistically the cost of an iPhone is well over a month’s salary for the average Chinese subscriber. Indigenous Chinese smartphone makers Huawei, Lenovo, and Xiaomi all have sleek flagship quality devices running the latest Snapdragon 800 processor and massive 4.5”+ screens at a third the cost of an iPhone. Further, China Mobile’s high speed 4G network is only available in 16 cities, negating some of the device’s benefits if it can’t be used everywhere. We just don’t see a compelling case for Apple to sell all that many iPhones at current prices in China once the pent up demand of fanboys is satisfied. In fact, based on Apple’s less than confident guidance and the early reports from China, perhaps there aren’t all that many fanboys either.

Of course Apple has other products. Sales of iPad and Mac were respectable for the quarter, with Apple moving some 26M iPads – a quarterly record and Mac volumes were up almost 20% YoY. Still the iPad and Mac categories only make up about 20% and 11% of sales respectively. iPad did well on fresh product with iPad Air and iPad Mini Retina selling for only a portion of the quarter with reported shortages. Post-holidays, we don’t expect an iPad boost from pent up demand given the company exited the December quarter with near supply and demand balance. Both categories also have longer term flaws. Tablet growth has failed to keep pace with the smartphone penetration curve given lower replacement rates and smaller margins in the absence of carrier subsidies. The Mac faces an existential threat as the PC market declines as a whole.

Then there is the 12.5% of Apple’s remaining revenues. iTunes, software and services are almost 8% of the business and grew 19% YoY, though it’s the first quarter in memory that growth was sub 20%. This is somewhat concerning especially after Apple entered the internet radio market with iTunes radio. Apple’s history in software and services is also littered with failures: iAd, Siri, iCloud, and Apple Maps amongst many others. With high payouts to media partners and developers, as well as a commitment to give away some software like Apple’s productivity suites, we don’t expect the category to move the needle under current management. The remainder of revenue is accessories and the dying iPod, which has been displaced by music playing apps on iPhone and iPad. Hardly sources for growth.

Of course, Apple’s product pipeline makes for great rumors and there continues to be talk of iWatches and iTVs dropping sometime in the future, but we don’t expect these categories to be substantial enough to drive sales for a $175B revenue company. Apple has shown the world nothing in terms of wearables and it’s been more than a couple years since we heard Steve Jobs cracked TV. As time passes, an Apple launch into either category seems less likely. Given its size, Apple is in a difficult position. A “hero” product would have to be massively successful and on scale larger than many industries in the double digit billions to satisfy TMT investor demands for growth. If anything, the quarter gives us more evidence that Apple may be turning into a cash flow annuity like the MSFT of the first decade of the 2000s.

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

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