The update to our Apple analysis is now available to subscribers Apple Margin & Valuation Note [14]. This is a more comprehensive, more "scientific" update and approach to our piece from last year Apple - Competition and Cost Structure [15]. Next week, pro subscribers will see a downloadable version of the model behind this that will deliver more Apple stuff than you can ever digest in one sitting. In review, it is interesting to note certain viewpoints in the previous Apple research note, particularly considering Apple's stratospheric rise in price, ex:
"At current price of $347 Apple trades at 2011 calanderised PE of 12x on our estimates and 14x on consensus estimates. Yes, we are more optimistic than consensus, but more realistic concerning future prospects as well."
We were considerably more bullish on Apple's fundamentals than the consensus, but alas we were off the mark, and Apple's share price has went stratospheric - stratospheric to the point that it deserves its own conversation (more on that later). But (yes, there always is a but), the hypothesis behind the afore-linked note still holds. As a matter of fact, not only is it as strong now as it ever was, it is actually playing out now as I type this. I will delve into this, but before I go on I must acknowledge that the mere topic of Apple seems to bring out the immature and impolite in the blogoshpere. So much so, many are literally afraid to mention anything that is no "Pro Apple". That's right, literally "AFRAID", as was pointed out in this recent WSJ article "Apple: Deutsche Dares to Doubt [16]".
The subscriber document is evident on its face with a variety of valuation scenarios, an indepth that the original research document didn't have - an error in execution. So, for those that don't subscribe, let me toss out food for thought, and even more telling, proof that clearly proves the premise behind articles such as:
- 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 [17]
- Sliced Apple Margins For Dinner? [18]
- Steve Jobs Calls End Of the PC, We Call The End Of The Fat Margin Tablet – Including The Pretty iPad, With Proof! [19]
What many fail to understand is that what Google as released with its reincarnation of Android is not a new mobile OS, or a flexible handheld technology, but an innovative business model that harnesses to open source software to profitability turn the suppliers and vendors of fat margined leaders against it - literally ingenious and very, very difficult to counter without compressing your own margins. Those interested in reading more can referenceLooking at the Results of Google's "Negative Cost" Business Model Employed Through Android [20]. So, let's get started by reviewing portions of my hypothesis from last year...
Did Android overtake iOS in marketshare and growth – Yes, Even With Apple’s Successful Launch On Verizon, Google Continues To Increase It’s Lead In The Smarthphone Space [21]
Did Apple miss in 4 to 8 quarters – Yes, as a matter of fact, they missed exactly 4 quarters later. The Only, and I Mean the Only, Investment/Research House To Warn Of An Apple Miss Is Vindicated!!! [22]
I've had many commenters say things such as "You've been crowing about Apple crashing for two years!" The fact of the matter is simply "no", I have never said such a thing. What I did say was that Apple will deliver an unpopular and unforeseen miss and margin compression due to competition. I said this in Oct. of ’10 live on CNBC, and I also said on BoomBustBlog that miss will occur 4 to 6 quarters. It is telling that they couldn't get anyone else to say what should be obvious (reference the fear and loathing surrounding the Deustch Bank analyst note, Deutsche Dares to Doubt [16]). Well, they did miss and they are starting to feel the effects of margin compression from competition. this effect on margins is well hidden due to management's excellent execution (Kudos to you guys, btw) combined with the fact that the mobile market is growing so wide, fast and deep that it easily conceals margin compression behind massive unit sales. Although I did start to issue warnings in 2010 about Apple margins, but I made it very, very clear that this will occur over many quarters. I also made it clear I was not short at the time of the declaration. Short term traders were able to profit from my initial short notes [23] with tight stops that I suggested...
.. but alas, the time to short was premature for a strategy guy (as opposed to a trader), and obviously so. That does not obviate the validity of the compression theory though.
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From Hudson Square research: This morning we spot surveyed 20 people at locations in Connecticut New York and found shorter lines than for the iPhone 4s or the iPad 2. We counted roughly 550 people on line at 5 locations combined, vs. the 2,300 people we counted in our iPad 2 survey last year.
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I’m a fundamental and forensic strategist, not a short term trader. In addition, I run a subscription site, hence I do not – and will not – give valuation bands or price targets to the public for free – plain and simple. As a strategist, I make medium term projections, and they have been – on balance – rather accurate. This article started out with For some absurd reason, the mere topic of Apple brings up the most immature in the blogosphere. For instance, I started saying Greece would default [24] considerably before I warned of Apple margin compression –both stances indicated that this would be a medium term occurrence. Well, exactly two years (8 quarters) later Greece defaulted, see Greece Is Trying To Convince Portugal To Make F.I.R.E. Hot!!! [25] For some reason, that is a lot easier to swallow than waiting even less time for Apple margins to shudder, even though the miss that I called for came at the first month of the window that I anticipated and market share and margins are exhibiting behavior congruent to what I anticipated. Of course I know what the issue is, the share price has spiked. Alas so did Greek bonds at a point, and so did the shares of RIM, who faced the same margin compression scenario that Apple faces, see RIM Gets RAMMED! Again... Remember That Contrarian Call 1st Quarter of 2010 [26]. Apple's management is head and shoulders over that of RIMM's (who should have been replace two years ago, alas it's too late now), but compression is still compression.
Now, I hear many saying, "... but Apple's margins are at all time highs!!!" Really? Did iPad margins shrink due to competition – Yes.
Okay - This is the part that the immature are bound to ignore, so I can save some of you some time and you can stop reading now. Those who are actually curious about how I come up with margin compression while others state record margins...
As it stands now, Apple is rapidly (much more so than can be gleaned from sell side analyst reports and the media) losing market share in both tablets and smartphones!
As Apple loses market share, its costs to manufacture are actually increasing due to massive competition…
Apple's losing tablet market share faster than it lost smartphone market share
Android has moved to over 44% market share in tablets from less than 3% in less than a year and a half. That's amazing and much faster growth than it exhibited in smartphones – a category in which Android literally dominated in worldwide and US smartphone growth (as well as installed base re: US) in just a few short years. Apple dropped from just over 96% to just under 55% in the same time frame. Again, as with the smartphones, the Android tablet tech is superior to that of iOS products and as iOS normalizes the difference, margins will suffer. Margins will drop (is dropping) faster for tablets because prices are coming down as fast as tech is increasing.
Prices are dropping…
Costs are increasing…
So what does all of this add up to? Margins dropping!!! Just as I said last summer... Steve Jobs Calls End Of the PC, We Call The End Of The Fat Margin Tablet – Including The Pretty iPad, With Proof! [19]
Hey, I would hope that I raised the specter of margin compression just now in all but the staunchest of fanboys, but why isn't it showing up in the reported numbers? Because Apple had what appears to be an unrepeatable blowout quarter that allowed them to shovel large quantities of deprecated iPhones to consumers at full price. In said quarter iPhones where just over half of the company revenue. With stiff competition from Android, they will have to show and prove in terms of R&D and/or discounted pricing and that's going to cost some margin reducing, real money. The upside? The iPhone 5 should be an amazing device. You see what a little competition provides?
Still, the iPad is 20% of revenues and if it grows, margins drop even more...
Have I been wrong on Apple? – Not yet, at least not any more wrong than I have been on Greece, or RIMM. Granted the share price has soared, but remained within 10% to 13% of the recommended valuation bands for about 5 months, with benefits to nimble traders (of which I am not). The stock price has performed well, but I never said the stock price wouldn’t do well. I don’t discuss stock prices outside of paid subscriptions. If or when I’m wrong, I’ll be the first to admit it. In 4 quarters if there’s no further sign of my thesis bearing out I’ll admit it, but guess what’s happening already….
Will I be wrong on Apple? Of course its possible, but things are looking like they are following the thesis rather well.
This is the story. Apple is a phenomenal story that makes a lot of money…. But… They make supranormal profits through supranormal margins in a highly competitive space wherein they have extremely competent competition since Google arrived on the scene. Until Google, everybody else was fumbling so Apple printed money Bernanke style!. Most importantly, though… They compete directly with their own suppliers! Does anybody who is not the staunchest fanboy truly believe their profit position is sustainable competing against the very same companies they have to rely on? They can still be wildly successful, and just have a normalizing of sales growth combined with a slip in margin and there goes the rosy share price projections. Is there a chance of this happening? Once more then, shall we
Well, they are currently losing marketshare (which the media never reports)
They are forced to drop the prices of their key products (which the media seldom reports).
They are losing margin (which the media never reports)
Despite this, the company is growing profits and revenues like bananas. Why? Because the market in general is growing like bananas. There’s a lot of risks to this growth though:
- Patent litigation (the company was forced to remover the iPhone from German shelves just a month or two ago, and got it overturned)
- Natural competition (should be self explanatory)
- Margin normalization (ditto)
- Direct competition with suppliers
- Heavy macro headwinds (high unemployment, Euro crisis, China hard landing) for its two primary products, both of which are essentially luxury products
Despite this. Apple as a retailer, now has a larger market capitalization (at $542 billion), than the entire US retail sector (as defined by the S&P 500), as per Zerohedge: It's Official - Apple Is Now Bigger Than The Entire US Retail Sector [27]
[28]
Is Apple truly worth more than the entire retail industry in the 500 stocks of the S&P 500. Just sit back and let that settle right next to the margin compression theory. And in closing, also borrowed from ZH: Apple Responsible For 90% Of Intraday NASDAPPLE Gain [29]
If the biz class 101 rules ring true, this could very ugly very fast... The Company had a slam bang quarter last, but much of that is essentially unrepeatable in the near term, reference Anecdotal Observations On Apple's Recent Quarter [30].