Is the Sky REALLY Falling for Apple? Analysts Find the Glass is 5% Empty

Analysts and media pundits would have you believe that Apple’s stock collapse is due to huge underlying problems at the company, and that these problems are causing it to lose share, stop growing, and see a collapse in its margin. Moreover, they’ve expressed frustration that Apple has refused to release its cash hoard in any meaningful way to shareholders, and it should start introducing products such as a low-cost (and low margin) iPhone purely to protect and grow share.

These criticisms are often wrong, and certainly misguided.

For example, after three months of speculation that Apple’s top line revenue growth had stuttered due to “supply chain checks” by analysts, Apple released its results this week for the March 31^st quarter:

• Record revenue of $43.6 Billion – highest ever for this quarter
• EPS of $10.09, beating consensus profit estimates of $10.00
• iPhone volume growing from 35.1 million to 37.4 million (up 7%)
• iPad volume growing from 11.8 million to 19.5 million (up 65%)
• Mac volume flat in a market where the industry declined 14%, although Mac revenues were up 7%
• iTunes/Software/Services revenue growing from $3.1 billion to $4.1 billion (up 30%)

And if all that good news wasn’t enough, Apple announced it was doubling down on returning cash to shareholders -- including promising to return $100 billion to shareholders by 2015:

• Apple announced it will be raising its quarterly dividend 15% to $3.05 per share. That translates to a 3% yield which is 50% higher than the yield on the S&P 500.
• The $60 billion share repurchase is the largest buyback in the history of the world. At Apple’s current price a $60 billion buyback would sop up nearly 148 million shares, or nearly 15% of current shares outstanding.

But rather than rejoice, analysts shrugged their shoulders, lowered their earnings targets, and the stock hardly moved. HUH?

So just to set the record straight, here is the “95% full” story on Apple, since you are unlikely to see the facts anywhere else in this biased world of “only bad news on Apple makes headlines”:

• Four times as many iPhone users switched from an Android phone than to an Android phone in the fourth quarter (per Apple)
• iPhone leads in JD Powers customer satisfaction poll for 9^th straight year
• In March 2013, 70% of iPhone owners were “very satisfied” compared to second place Samsung’s 54%. Another 12% of iPhone users were dissatisfied with IOS but plan to stick with iPhone on their next purchase because of the ecosystems. That’s extremely sticky in terms of Intent to repurchase (per ChangeWave)
• In Q4-2012 Apple captured 72% of mobile phone industry profit with only 7% of the market. This is up from 69% for all of 2012 (per Canaccord Genuity)
• In Q4-2012 Apple captured 45% of the worldwide PC industry profit with only 5% of the market (per Asymco)
• In Q1-2013 Apple’s app store generated 2.6 times as much revenue as Google Play Store on roughly the same download volume (per App Annie)
• In Q1-2013 Apple had 40% of app downloads but generating 74% of app revenue (per Canalysis)
• In Q1-2013 Apple IOS captured 45% of mobile ad traffic and 49% of mobile ad revenue (per Opera Media Works)
• In March 2013 Apple IOS had 62% of mobile browsing (per NetMarketShare)
• In March 2013, Apple had 81.9% of US /Canadian tablet web traffic (per Chitika)
• For 2012, iTunes captured 63% of paid music industry downloads and 80% of digital music purchasers used iTunes (per NPD)
• Market growth remains robust in phones and tablets. IDC expects the smartphone market to double between 2012 and 2016 to 1.4 billion units annually. Gartner thinks tablets are growing even faster, from 125 million units in 2012 to 325 million in 2016
• During 2012 Apple was responsible for one out over every five dollars spent on consumer electronics in the U.S. Specifically, Apple captured 19.9% of the dollars, compared to 17.3% in 2011. Second place went to Samsung at 9.3% in 2012 (per NPD)

So how fair is the current valuation? Apple is trading for about 9 times earnings and 7 times earnings after backing out their cash. This compares to 18 times earnings for the S&P 500.  Apple is in two fast growing markets (smartphones and tablets) with the dominant product in each and is holding its own.  Yes, margins are lower than they were last year, but Apple still makes 72% of the phone industry profit and 45% of the PC industry profit.  The sky is not falling, and the current valuation just does not make sense.

Disclosure: I’ve owned Apple shares since 1985

How Apple Can Sell a Low-cost iPhone Without Making a Low-Cost iPhone

Hardly a day goes by without some analyst clamoring for a low-cost iPhone as a strategic necessity for Apple. Apple is largely silent, but occasionally they try to deflate those expectations such as Phil Schiller’s interview on January 10, 2013: "Despite the popularity of cheap smartphones, this will never be the future of Apple's products….In fact, although Apple's market share of smartphones is just about 20 percent, we own 75 percent of the profit."

Clearly, there would be demand for a cheaper iPhone, particularly in countries such as India and China where there is an enormous population that has limited incomes coupled with business models in those countries where carriers do not subsidize phones. But there would also be significant cannibalization from a low-cost iPhone, and Apple would likely earn less than its current 70% share of total phone industry profits. Further, industry profits would likely decline as such a move would shift volume from high margin products to low-margin models and hence transfer profit from the industry to the consumer’s pocket.

The problem Apple faces is not high cost to manufacture, it is the upfront price to the consumer; shaving $50 off the manufactured cost of an iPhone does not make a $650 phone affordable. Apple is not building in too much functionality into its iPhone and not utilizing too expensive materials thus driving up the cost beyond reach. In markets such as the US, a consumer can purchase a subsidized iPhone 5 for $199 - $399 (with a contract) or $649 - $849 (without a contract); this range extends down to $0 for an iPhone 4 and $99 for an iPhone 4S.  But the contract option does not exist in some huge markets such as India and China.

Apple is pursuing a much more intelligent and appropriate strategy to accomplish the same goal of reducing the upfront cost of buying an iPhone:

·      Every year Apple has dropped the price of the older iPhone model to $99 or less in “contract markets”; currently an iPhone 4 can be had for $0 in the US. This has allowed Apple to appeal to price sensitive consumers without introducing new low-cost models and complicating their product line.

·      In the US, T-Mobile is now experimenting with payment plans that allow the customer to pay for the phone over 2 years without having a “contract.” Some view this as just semantics, but the economics are actually different if you don’t upgrade your phone after 2 years (you start paying less each month).

·      More importantly, Apple has introduced similar plans in India with very positive results -- Apple last quarter took the #2 spot in Smartphones with 15.4%, compared to #3 Sony at 9.4%.

·      Recently, Apple has experimented with a trade-in program in India where consumers get a large discount by trading in their old phone. The retailer recoups most of the discount by selling the old phones, and the customers reduce the upfront outlay of cash. This has been wildly successful, and Apple’s competitors have quickly followed suit by introducing clones of this Apple innovation.

Apple means it when they say they are willing to forego market share and only make premium products. They’ve done this for years in computers by resisting pressure from analysts to drop the price of MacBooks to compete with netbooks. Apple was right, and Apple now makes 45% of all PC industry profit from only 5% market share (see http://tech.fortune.cnn.com/tag/horace-dediu/) . Netbooks have nearly vanished as a segment. Apple actually knows better.

Focusing on the premium segment (where the profits lie) works for Apple, just as it works for BMW. Chasing the low-end of the market is a distraction and Apple should leave that to others. However, capturing some of these customers through innovative payment plans helps Apple by expanding the reach of its IOS ecosystem without cannibalization. That makes sense.

The answer is business model innovation, not cheaper products.  Apple understands that, and hopefully Apple will stick to that strategy.