Quick Thoughts: Parsing the Apple Chatter


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–          Early data suggests a strong Holiday season for Apple, but Android tablets likely took share from the iPad and smartphone market forecasts suggest Android outgrowing iOS for 2013.

–          Rumors are flying of an early iPhone update – evidence is credible, rationale is reasonable, but margin implications have been unacknowledged.

–          Analysts have laid out conflicting visions – Will Apple ease into life as a slow growth luxury goods cash machine or will it invest to find growth in potentially lower margin new business areas?

–          Either way, estimates implying an accelerating top line, stable margins and double-digit free cash flow growth seem optimistic – expect the negative revisions trend to continue.

It’s January and the TMT illuminati are once again peering into their crystal balls for insights to the coming year.  Next week, the Consumer Electronics Show in Vegas will suck up most of the available punditry bandwidth with breathless talk of razor thin and razor smart TVs, talking connected refrigerators, and more tablets than an aspirin factory.  This week – and to be honest, most weeks of the year – the main topic of conversation amongst analysts and bloggers has been Apple, which is far too important to waste its time with a plebian trade show.

Mobile market research firm Flurry estimates that more than 50 million iOS and Android devices were activated globally during the week from Christmas to New Year’s Eve, a near trebling of the pace established by Apple and Google’s most recent comments on the topic (Exhibit 1).  Mobile ad network Chikita showed the iPhone5 with a 111 basis point bump in its share of the ads that it served to US and Canadian smartphones during the week after Christmas, implying strong sales of the product over the Holidays, but behind the 117 basis points gained by Samsung’s Galaxy III and Galaxy Note products in combination off of a smaller baseline.  Chikita’s numbers for tablet ads showed an inevitable 714 bp drop off from the iPad’s previous 86% share, with Amazon’s Kindle Fire (+303bp), Samsung’s Galaxy Tab (+138bp) and Google’s Nexus 7 (+92bp) taking up most of the slack (Exhibit 2).  All of this suggests that Apple had a strong Christmas, but that its biggest rivals may have enjoyed the Yuletide even more.

On Friday morning, industry analyst Strategy Analytics weighted in with its 2013 smartphone market share forecasts, projecting that Apple’s iPhone would outpace the overall market unit growth, 33% to 28%, but that Android champion Samsung would extend its market leadership with 35% growth.  The Strategy Analytics estimate assumes that Apple will not bring out a lower cost (and almost certainly, lower margin) “iPhone Mini” to play for a piece of the red hot emerging market smartphone space, where the sub-$200 unsubsidized price point is driving most of the market growth.  Apple’s cheapest phone, the nearly two and a half year old iPhone 4, runs more than $400 without subsidy.  An iPhone Mini would have to sacrifice both margins AND product quality, directions that have been anathema to Apple in the past.

I believe that it will be very difficult for Apple to outpace the overall smartphone market without a viable product for the entry-level emerging market segment, and nearly impossible if it does not accelerate the pace of its product updates.  Apple missed consensus expectations in both the June and September quarters in 2012, almost entirely because its iPhone 4S model had grown stale in comparison to the freshly updated Android competition.  The excuse that Apple’s customers were waiting for the expected iPhone5 release was belied by the tens of millions of Samsung Galaxy III and Note smartphones sold over the summer.  If Apple waits until fall to deliver an update to the iPhone5, the effect will be even worse this year.

However, rumor has it that Apple IS working on a spring update to the iPhone5 – mysterious photos of subtly different smartphone chasses and cases have dribbled out of Asia, reputed to be prototypes for a 5S product refresh.  The sell side and blogosphere have been hard at work speculating as to what Apple might change in a 5S model.  Hardware improvements could see the 4th Generation iPad’s A6x processor, ramping toward production on TSMC’s 28nm process, shifted into the iPhone to replace the Samsung fabricated A6.  Apple could also add NFC radio chips to directly address mobile payments, a strategic vector suggested by the Passport functionality added in iOS6.  Other hardware improvements could include wireless charging and tweaks to improve battery life and camera performance, if the speculation is to be believed.  Changes along these lines would keep the iPhone more current with its rivals, albeit with a more expensive bill of materials and several steps backward on the fairly steep manufacturing experience curve.

The bigger changes could come on the software side.  The departure of iOS guru Scott Forstall opens the door for Jony Ivie to do a major refresh on the aesthetics of the user interface, likely a death knell for the “skeuomorphism” of fake leather and wood loved by Steve Jobs and Forstall, but hated by most everyone else.  Apple Maps and Siri are screaming for performance fixes and enhanced functionality, while rumors of a streaming audio Pandora and Spotify killer service seem too logical to be false.  Some of these, and other, unanticipated, goodies are almost certain to be integrated into an updated iPhone, whenever it surfaces.

All of this is good for users, and the sooner, the better, from a market share perspective.  The problem lies in Apple’s extraordinary margins.  Gross margins had bumped to an all-time high of 43.9% in FY2012 driven by the iPhone, which enjoyed a carrier-subsidy derived price advantage and superior costs born of long product life spans (Exhibit 3).  Carriers may or may not be successful in negotiating lower subsidies, but production costs will suffer if Apple ramps two new models a year rather than one.  The best gross margins are gained after early manufacturing hiccups associated with the first few months of shipments are long in the rear view mirror – a sweet spot that will be badly squeezed if the rumors are accurate.  Add in a mix shift toward the faster growing, but lower margin iPad line, and higher development expenses associated with a broader product line with more frequent updates.  Gross margins had already fallen to just over 40% in the September quarter miss.  It would seem that consensus forecasts for a recovery back to nearly 42% for FY14 are a bit optimistic.

Pondering Apple’s future steps, Analysts seem to be looking at several different scripts.  My former colleague at Bernstein, Toni Sacchonaghi, argues that slowing demand for smartphones and tablets will have Apple revenue growth back to single digits within a couple of years, but that fealty to the differentiated product, premium price and operating excellence strategy that built their dynasty will allow premium cash flow yields at much higher multiples.  Henry Blodgett of Business Insider argues for a product line expansion strategy – low priced phones, new form factors and innovative new product categories – that would reset margins permanently lower, but return Apple to an accelerating growth trajectory.  In and between are a range of apparently less realistic analyst who are forecasting that the company can have the cake of double digit long term growth while eating margins more than double those of their rivals.

Seeing smartphone competitors achieving similar market scale to Apple’s flagship iPhone model and platform rivals willing to subsidize device sales to build their installed base for lucrative web applications, leaves me skeptical that the high margin status quo approach can be sustained for more than a few more years, and even then, I see inherent margin pressures that are not reflected in consensus estimates.  The more aggressive strategy seems the better one from a long term perspective, but will entail substantial cultural change (as detailed in our recent Apple piece), a significant re-investment of capital, and a more certain and certainly more painful hit to profitability.  I don’t believe that this Sophie’s choice of a strategic dilemma is well appreciated by investors nor do I expect them to react well to future negative surprises, disappointing guidance, or downward estimate revisions.  Apple may not be expensive, but it is hardly cheap with that potential overhang.

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

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