Forget What You've Heard Elsewhere, This Is What's Really Happening to Apple's Margins. The Stock Has Yet To Factor the Facts In...

Listening to many investors scream as a result of logical, unbiased
(I don’t even have a position in Apple… Yet) analysis and off the wall
thinking that is just so different from what the retail is used to
getting from the sell side shops that routinely rip them off, or the
institutions that pay 2 and 20 for leveraged beta rides that often do
little else than follow the crowd… I’ve decided to throw some more fuel
on the fire to see if I can make some baked Apples
. Bloomberg did an article on a survery of 2500 analysts, and the
number one ranked analyst since Jan. 2008 only racked up 38% in correct
calls, see Did Reggie Middleton, a Blogger at BoomBustBlog, Best Wall Streets Best of the Best?
I dare you to compare that to BoomBustBlog! I am not trying to impinge
upon the sell side guys that give it their honest all, for I know there
are a lot that work hard under very political conditions, but the
investing public should know better by now.

You see, I thought it was rather prescient to call margin compression, live on CNBC
(3:40 into the video), just hours before Apple announced… Margin
Compression… At a time when just about everyone who could spell Apple
shouted Buy! Buy! Buy! Buy! Buy!!! It’s not as if the stock didn’t tank.
It’s not as if I didn’t tell you so. I actually like Apple as a
company. It’s quite successful and a whiz at marketing and product
design. What I don’t like is how everyone decides to shut their brain
off and let their hearts do the talking (and investing) when it comes to
Apple – and to do so with passion if not downright blind idolism at
that. Because of this “social phenomenon” that used to be research and
analysis, I’m giving it raw, straight up, and uncut. Many have emailed
me and said the margin compression was due to the inability to source
components, not competition. Well, my dear future and potential
BoomBustBloggers – that makes no sense. Competition will always
challenge margins, and competition on the scale that Apple is going to
encounter will do so even more. You cannot separate component sourcing
from competition, and in the case of Apple, the two are literally joined
at the hip, to Apple’s disadvantage as I will illustrate in graphic
detail below.

So, following up on the piece that I did just a few hours ago – Reggie Middleton Wasn’t the ONLY Openly Apple Bear in the Blogoshpere, Was He? along with this cute chart…

I wanted to excerpt a few snippets from this Bloomberg piece,
which actually had money managers thinking realistically on Apple as
well as a few comments by Steve Jobs, in order for me to set the stage
for illustrating how we at the BoomBust attempt to model reality. First,
we start off with a realistic way of thing…

“The rising popularity of devices
using Google’s Android software may hurt Apple in the long term, said
Michael Obuchowski, chief investment officer of First Empire Asset
Management, which holds Apple shares. “Everyone is closing in and it’s a
huge question of how they are going to respond,” said Obuchowski, whose
firm oversees $4 billion. “I’m really worried about Apple; I’m not convinced that I’m going to hold Apple two years from now.””

“‘Commodity’ Experience
Jobs dismissed the threat of rivals. Apple’s approach of designing the
software and hardware for its devices results in a better user
experience, he said. By contrast, Google gives Android free to handset
makers including Motorola Inc. and HTC Corp., creating a “commodity” experience,
he said. “We are very committed to the integrated approach, no matter
how many times Google tries to characterize it as closed,” Jobs said. He
said Apple is outselling BlackBerry-maker RIM and he doesn’t “see them
catching up with us in the foreseeable future.”"

Notice how he failed to say Apple was outselling Android. This is
material, because they were materially outselling Android 2 and 3
quarters ago. Androids growth rate is simply phenomenal, and its
business model may prove unassailable unless Apple makes some drastic
changes (ex. allowing cloning) – changes that I doubt management will be
willing to make. Jobs also (understandably) failed to mention that the
“commodity’ Androids materially outperform the iOS products in terms of
features and functionality. This is pretty much in direct contravention
to the concept of the term “commodity”, isn’t it???? I don’t think many
Samsung Galaxy S, Droid X or HTC Evo owners will characterize their
devices as “commodities”.

“Munster, who estimated Apple would
sell 11 million iPhones, said last week that supply shortages likely
held back sales of both the smartphone and iPad. The cost of making the
iPhone may be increasing, said Andy Hargreaves, an analyst at Pacific
Crest Securities in Portland, Oregon. The device accounts for 43 percent
of Apple’s revenue [and much more of their profit!!!].
‘‘We saw what we think is a pretty remarkable increase in iPhone
costs,” and that’s fueled concern over margins, Hargreaves said in an
interview with Bloomberg Television.”

Good to know he’s been reading BoomBustBlog. Remember, supply
shortages can very well stem from competition for suppliers and
supplier’s attention. Is it Android again??? Here’s a hint… Does the
sole patent holder and sole manufacturer of Apple’s branded IPS Retina
Screen plan to become one of the most prolific Android phone vendor’s in
the world? If so, where does that leave Apple? Margin compression!!! Or
worse. Read up on your proprietary Apple content BoombBustBlog
subscribers!

“Verizon Phone – Even so, competition
is increasing. The Android operating system was the most popular
smartphone software in the U.S. in the second quarter, according to
Gartner Inc. Samsung, HTC, Motorola and Dell Inc. are among the
companies using Android in tablet computers to rival the iPad.
Hewlett-Packard Co., the largest computer maker, is developing a tablet
computer.
Apple may get a sales boost by expanding the availability of the iPhone
in the U.S. Verizon Wireless may begin selling it in January, two
people familiar with the matter said in June.”

You can bet your left nostril hairs that the deal Verizon cut is NO
WHERE near as sweet as the one AT&T gave Apple. What does this
spell? Margin COMPRESSION in the quest for wider distribution to prevent
Android (to late) from gaining critical mass and taking over.

“Jobs also said he’s been surprised
by iPad purchases by business customers. “We haven’t pushed it real hard
in business and it’s being grabbed out of our hands,” Jobs said. “The
more time that passes, the more I am convinced that we’ve got a tiger by
the tail.”

I agree that the business adoption for the iPad is cool and big
positive development. I don’t see why Jobs would be shocked, for simple
consumption the iPad is truly a marvel. But, the caveat still remains…
Will Android devices outperform at the same or lower price points?
Probably. Will Android proliferation drive up costs and drive down
margin? Most definitely, and in ways that most retail and many
institutional investors don’t realize!

Higher Production Costs for the iPhone 4 Are All But Guaranteed!!!

The Most Critical Parts of the Device are Sourced From the Biggest
Vendors of Android Devices in the World! For these vendors, Android is
one of their (if not the) most lucrative revenue drivers. Where do you
think their loyalties lay?

The margin-destructive risks and higher costs of the iPhone 4 are due
to two specific parts which are unique to this iteration of the iPhone –
the sharp display and the very snappy CPU. The “retina display,” which
Steve Jobs himself has admitted is “the most important component of the entire phone”,
is also the most expensive. iSuppli states that each display, built by a
subsidiary of LG Electronics of Korea, costs $28.50. I quote Steve
Jobs, via CNET:

“We think this will set the standard
for displays for the next several years.” | “Display is the most
important component of the entire phone, he says.”

^{(Credit: James Martin/CNET)}

Here’s a newsflash. LG Electronics is vying to become the largest
vendor of Android phones in the world and they own the IPS Retina
Technology, as well as being the sole manufacturer of the screens. My
readers are smart enough to connect the .dot(s) themselves. Spell it out
again – margin COMPRESSION!

This is an excerpt of the note that I sent over to my analysts on
8/25, insisting that they rehash the freshly built Apple model. Yes,
even they were Apple bugs, so eventually I sat down with them and we did
it together. This is why the Apple forensic analysis is not ready, it
(as well as the Google report) had to be done over (twice!) in order to
remove bias and perform a more granular analysis and achieve a more
realistic result. I actually bounced the project from one team to
another and participated significantly in the model theory, structure
and fine tuning process; I rarely participate in the structuring process
anymore. I usually create the theory and then fine tune the end
product. Here’s an excerpt of my note sent to the original crew:

1)    …It is unlikely that Apple will
be able to replicate the sweetheart deal it cut with AT&T,
particularly after several telcos worldwide have actually taken losses
selling iPhones despite the fact that unit sales were brisk. This, in
combination with the threat of Android is bound to bring ASP down, and
probably more than 1%. I see there is a differentiation between iPhone 4
and older models in the revenue cells, this needs to be trended. I
believe cost to the consumer may be fairly static for the time being due
to telco subsidies, but telcos will definitely be more hardnosed than
AT&T has been due to the benefit of hindsight and the availability
of other popular options in the Android lines, plus the ability to
customize Android to their liking. The customization is a strong selling
point for Android to telcos, thus although more (possibly many more)
units will be sold, ASP will probably drop as well as development and
costs increasing. There may be component sourcing conflict as well as
Apple competes with its own suppliers in smart phone sales, ex. LG Group
who controls LG Display who sells the technology behind the IPS screen
also makes a direct iPhone competitor, the LG series phones running
Android. See this quip from Wikipedia:

LG Electronics (Korean: LG??, KRX: 066570, LSE: LGLD) is the world’s second-largest manufacturer of Television sets^[1] and third-largest producer of mobile phones.^[2]With its headquarters in the LG Twin Towers in Yeouido, Seoul, South Korea, LG Electronics is the flagship company of LG Group, one of the world’s largest electronic conglomerates.
The company has 75 subsidiaries worldwide that design and manufacture
televisions, home appliances, and telecommunications devices. LG
Electronics owns Zenith Electronics and controls 37.91 percent of LG Display.^[3]

2)       LG Display is the exclusive
maker of the IPS Retina screen, the iPhone’s single most expensive
component (about $28, and its most differentiating attribute, by far),
and is literally controlled by a direct competitor, LG electronics, all
under the LG Group of companies. LG Electronics has put substantial
resources behind the Android effort, the single biggest threat to
Apple’s dominance in Smart phone margins, profit and revenue growth,
mindshare/market share growth. More on LG Electronics Mobile
aspirations: LG Electronics (Korean: LG??, KRX: 066570, LSE: LGLD) is the world’s second-largest manufacturer of Television sets^[1] and third-largest producer of mobile phones.^[2]

3)       LG Electronics is bound to
crowd out Apple for competition of the limited production capacity IPS
retina screens. See the following article for a backgrounder., and keep
in mind that with this level of competition, the better case scenario is
that prices go up  – the more likely scenario is that Apple may not be
able to secure the parts and may have to switch technology and supplies
since the supplier of its most expensive, most mandatory and most
differentiating component is owned by a direct competitor using the OS
that is the biggest threat that the iPhone franchise has ever faced — http://www.androphones.com/lg-android-phones.html.

a.        —– Even if it wasn’t on the
top of choices with its Android phones, LG is now bringing on the
market two smartphones from its Optimus Series with Android 2.2 on
board. While other owners of Android phones are still waiting for an
official update, LG doesn’t waste time and announces the Optimus One and
Chic. 
LG has only one phone running Android OS so far, LG Ally from Verizon, but things will change, because
the company is determined to introduce around ten new smart devices “in
the second half of this year under the LG Optimus label” as well as
Android Tablet PCs.
But the launch of more Android devices depends of the impact of Optimus
One and Chic over in the UK. Both models, the Optimus One with Google
and LG Optimus Chic has incorporated the speedy Android Platform 2.2. No
other specs for the phones have been revealed at this point.

The LG Android phone series

The
iPhone 4’s second most differentiating component is the snappy
processor. It is the Samsung-powered A4 chip, designed in-house by
Apple.

You should be saying to yourself, “Hey, wait a minute. Doesn’t
Samsung make those Snazzy Galaxy Android phones and that new Android
tablet???” There ya go!

Samsung Galaxy S Android Phone Series	The Samsung Tab Android tablet

Samsung (the 2nd most prolific Android vendor, behind HTC), makes
the A4 chip that costs Apple $10.75 each, and is probably the 2nd most
expensive (and critically differentiating) component in the iPhone!!!

Samsung and LG, literally two of Apple’s staunchest competitors in
the space where they derive a whopping 70% of their profits, literally
has the company by the short and curly(s) in regards to sourcing of the
(Steve Jobs admitted) most important, most differentiating, and most
expensive components in the company’s most important, proftable and
strategic product. That is a most compelling argument to make a mostly
assured case for (I can’t practically fit “most” in here again, but I’m
going to give it a shot anyway) a most material increase in margin
compression!!! Ha, I dd it – so there

So, why is it that I can publish this and the bigger analysts at
Goldman, et. al. can’t? Subscribers can download the data that shows
the blatant game being played between Apple and the Sell Side here: Apple Earnings Guidance Analysis. Those who need to subscribe can do so here.

Below, I drilled down on the date and used a percentage difference
view to illustrate the improvement in P/E stemming from the earnings
beats.

Those that are interested in my take on Apple’s potential and actual margin compression issues should subscribe and download Apple iPhone Profit Margin Scenario Analysis Model.

More on the Creatively Destructive Pace of Technology Innovation and the Paradigm Shift known as the Mobile Computing Wars!

1. There Is Another Paradigm Shift Coming in Technology and Media: Apple, Microsoft and Google Know its Winner Takes All
2. The Mobile Computing and Content Wars: Part 2, the Google Response to the Paradigm Shift
3. An Introduction to How Apple Apple Will Compete With the Google/Android Onslaught
4. Don’t Count Microsoft Out of the Ultra-Mobile Computing Wars Just Yet
5. This article should drive the point home: An iPhone 4 Recall Will Hurt Apple More By Opening Additional Opportunity for Android Devices Than Increased Expenses
6. A First in the Mainstream Media: Apple’s Flagship Product Loses In a Comparison Review to HTC’s Google-Powered Phone
7. After Getting a Glimpse of the New Windows Phone 7 Functionality, RIMM is Looking More Like a Short Play
8. RIM Smart Phone Market Share, RIP?
9. Android is gaining preference as the long-term choice of application developers
10. A Glimpse of the BoomBustBlog Internal Discussion Concerning the Fate of Apple
11. Math and the Pace of Smart Phone Innovation May Take a Byte Out of Apple’s (Short-lived?) Dominance
12. Apple on the Margin
13. RIM Smart Phone Market Share, RIP?
14. Motorola, the Company That INVENTED the Cellphone is Trying to Uninvent the iPad With Android
15. Android Now Outselling iOS? Explaining the Game of Chess That Google Plays in the Smart Phone Space
16. There
    Goes Those Fancy eBook Aspirations from Apple, Barnes and
    Noble, and Amazon: 100,000’s of FREE eBooks from the
    Public Library
17. How
    Google is Looking to Cut Apple’s Margin and How the Sell
    Side of Wall Street Will Enable This Without Sheeple
    Investor’s Having a Clue
18. Empirical Evidence of Android Eating Apple!
19. More of the Android Onslaught: Increasing Handset Revenues and Growth
20. Many More Black Eyes for the Blackberry? A Complete Forensic Analysis of Research in Motion
21. The BoomBustBlog Multivariate Research in Motion Valuation Model: Ready for Download
22. The Complete, 63 pg Google Forensic Valuation is Available for Download
23. iSuppli Continues to Validate BoomBustBlog’s Original Thesis: Android as the Viral Game Changer!
24. BoomBustBlog Research Hits Another One Out the Park! Google up nearly 10% after hours, true blowout earnings unlike JPM
25. As
    I Warned in June, DO NOT DISCOUNT Microsoft in This Mobile Computing
    War! Their Marketing Campaign is PURE GENIUS! and it Appears as if the
    Phone Ain’t Bad Either
26. Reggie Middleton Wasn’t the ONLY Openly Apple Bear in the Blogoshpere, Was He?

Comments

[Nihilarian]

Apple needs this: http://www.youtube.com/watch?v=LJG1pbLkSBM

[I am a Man I am...]

How did your iPhone sales projections end up?

Please, please let us know when you decide to short aapl.  So far lots of talk.  Once again, Apple iPhone unit sales up 91% y-o-y and net income up 70% y-o-y.

[Nihilarian]

Apple shareholders are fanboys of the stock like iPhone owners are fanboys of Apple's products. Apple shareholders are so in love, you're crazy to think they're going to start dumping the stock. If anything, they'd buy any and every dip. I wouldn't short it if it had a P/E of 100.

[Chemba]

Well thank goodness every analyst at every sell side brokerage firm, every buy-side institutional shop, and every hedge fund, across all industries and all sectors, both debt and equity, can simply retire.  After all, Reggie Middleton and the "Boom Bust Blog can cover all companies and all sectors and get everything right all the time.

Give me a major league f#%&g break.  Seriously, you are too much...

[Reggie Middleton]

Maybe, but I noticed how you failed to comment on the subject of the article. Enough talking about me, and discuss the argument at hand.

[long-shorty]

Nice. You go, man! Call out the puffery!

[Grand Supercycle]

Today marks an important turning point for global markets and the USD strength I warned about has arrived.

http://stockmarket618.wordpress.com

[Husk-Erzulie]

Outstanding analysis, thank you.

[carbonmutant]

Great forensics, as usual.

Sounds like Apple is reaching peak production...

Time for them to move to the next big thing...

[Djirk]

Agreed this may be a current peak for them, but still solid growth numbers and chunk of cash.

Reminder that Android is a mobile (cell) phone operating system owned by Google which is included in several phone manufactors units.

While from a platform and app store perspective it makes sense to compare Apple and Android market share but not from a smart phone handset market share. 

Sentiment switch?

[SheepDog-One]

RIMM was here at $149, margins showed weakness, and lost $100 rather quickly. Hell with 'investing' in the latest must-have rage for teenage girls, buncha MOMO BS.

[patience...]

Damn, should have bought the dip.

[TaggartGalt]

Reggie, you are the best.  Thanks.

[Printfaster]

Reggie, if your purpose is to get a green close on AAPL, this is the kind of article that will propel it to new highs.

The market is in its ballistic phase where it keeps going higher even when the rocket propellant has burned out.

[Dolar in a vortex]

Well done Reggie, one day soon Jobs will be calling you out instead of competitors!