Submitted by Doug Kass
* Apple's abrupt and sizable preannouncement heralds the end of the company's growth and best days
* Apple pushed the envelope of demand elasticity
* The miss is a sign that the dangerous path of China/U.S. trade negotiations may lead the U.S. into recession
"For everything there is a season, and a time for every purpose under heaven: a time to be born, and a time to die; a time to plant, and a time to pluck up that which is planted; a time to kill, and a time to heal; a time to break down, and a time to build up; a time to weep, and a time to laugh; a time to mourn, and a time to dance; a time to cast away stones, and a time to gather stones together; a time to embrace, and a time to refrain from embracing; a time to seek, and a time to lose; a time to keep, and a time to cast away; a time to rend, and a time to sew; a time to keep silence, and a time to speak; a time to love, and a time to hate; a time for war, and a time for peace."
- Ecclesiastes 3:1-8
As it is said in the Bible injunction, to everything there is a season. And this winter season has enveloped Apple (AAPL) - after the disappointing lowering of guidance after the close of trading on Wednesday. (Here is a solid summary from TheStreet's Eric Jhonsa)
Companies (particularly of a hardware-kind) and even NBA legends (like Larry "Legend" Bird who had 13 seasons of brilliance) have finite life cycles and careers that never continue forever.
I recently warned that the one of the core problems facing the U.S. stock market was the maturation and expanding problems at Apple and in the ecosystem of Apple suppliers - from "The Top Ten Reasons We May Be Entering a Bear Market" on December 10, 2018:
#6 The Apple Complex (and its Suppliers) Have Been Upended By a Maturing High-End Smart Phone and Weakening iPhone Market and the Social Media Space is Under Increased and Costly Regulatory Scrutiny: These factors have a broad impact on the market leading technology stocks and for the market as a whole. Moreover, over the last decade technological progress has outpaced regulatory supervision - but this is now being reversed as the social media companies now face the existential threat of rising regulations. The costly imposition of regulatory oversight is something I have been writing about for over a year.
And regarding that, here was a summary of my recent piece, Apple Share Price Still Remains Vulnerable.
It is now time, after the recent fall, to consider the current risks still associated with holding the company's shares:
- The iPhone is a mature product and the high-end smartphone market is saturated, with most of the unit growth a function of the replacement cycle. In support of this view is the company's decision to stop disclosing iPad and iPhone unit shipments.
- Since the introduction of the iPhone X, Apple has been raising prices. ASPs (average selling prices) in the most recent reporting period buoyed sales (up 24%) even though unit sales were flat. This briefly buoyed Apple's shares, but it is more likely representative of "Peak Apple (Margins)." (Note: Beginning in late 2017 I began to get concerned about demand elasticity from high-priced iPhones.)
- With a lack of significant product innovation, those higher iPhone prices will likely elongate the replacement cycle from slightly under two years to as much as four years.
- In order to grow, the company has monetized its installed base of Apple products by selling services (apps, music, movies, etc.), sales of which reached $10 billion in the most recent quarter. But Apple's digital store has had its share of failures. An example is Apple's email product (MobileMe) and its iCloud data-storage service, which respectively lost their relevancy to Alphabet Inc.'s (GOOGL) Gmail and to Google Drive and DropBox Inc. (DBX) . Apple Maps only exists as it is a default service on the iPhone. Meanwhile, Apple competes versus Amazon.com, Inc. (AMZN) in streaming music and movies. Its closed systems don't allow Apple music to work on speakers furnished by Amazon and Google. Finally, there is Siri, the quality of which is materially lower than both Alphabet's Hey Google and Amazon's Alexa, which have opened their digital voice assistants to other developers.
- Apple is a products company (two-thirds of its sales come from the "closed" iPhone) that has developed complex and expensive operating devices that evolve over time. By contrast, services (software) require more prompt revisions and almost continual improvements and usually are inexpensive, as much of services is commoditized. Consider that Apple speakers will not play Spotify (SPOT) , one of the most popular music services and a competitor to Apple. So, in a sense, Apple in the services arena is fighting with one arm tied behind its back in order to protect the iPhone (hat tip to my contrarian friend, Vitaliy Katsenelson).
- There is no apparent new category that lies ahead in the relatively near future that will move Apple's sales/profits needle.
- Should Apple's installed base growth ease in rate-of-change terms, the valuation argument that Apple should be valued as a consumer packaged goods company -- something I have consistently rejected -- versus a lesser-valued hardware company may prove to be faulty.
Given Apple's current size, the maturity of the iPhone market (iPhone unit shipment growth is slowing) and legitimate questions as to whether the service strategy will be successful as the installed base slows down, a large and new product offering -- more than, say, Apple Watch sales, which is nothing more than a rounding error -- is urgently needed to support the share price and its elevated valuation based on historic comparisons and based on the history of other hardware companies. But, there is no apparent large opportunity that would have any material and incremental impact on Apple; the company's past successes and size are impediments to moving the needle.
The iPhone, priced at $800 per unit, which is high compared to other smartphones with similar functionality, poses a fundamental risk of accelerated commoditization and lower margins. And the likelihood of a longer replacement cycle, as we already have seen at the high end of the market, provides a hurdle to future sales and profit growth on Apple's already large sales base.
Then there is China, where almost 25% of Apple's Chinese business may be subject to the imposition of tariffs. And, even more significantly, elevated disputes with China could dangerously disrupt the company's supply chain, which has swung over to that region over the last decade.Stated simply, Apple's iPhone may be in the crossfire of the trade dispute with China and its share price, despite the imprimatur of Warren Buffett and the recent fall from grace, may still be vulnerable.
Finally, distilling my concerns was one of my 15 Surprises for 2019 (regarding Apple):
Surprise #9 The China/U.S. Rift Intensifies as Trump's Anger Shifts Towards That Region:
The Chinese retaliate against major American brands like Apple.
"Peak Apple" actually happens and its shares fall below $125/share. (Apple's shares are currently trading at about $144, down -9% from Wednesday's close)
The Warnings Were Conspicuous
The signposts were there (but were ignored by many, including Warren Buffett and Berkshire Hathaway (BRK.A) (BRK.B) ) - starting with the persistent supplier weakness over a month ago and the company's decision not to provide unit guidance going forward. (It was almost like management knew a big unit miss was coming (from slowing demand and excess inventory) when they issued their most recent - and far too optimistic - guidance.
There were also signs of an elongated iPhone replacement cycle (in China and around the world) - also ignored by many.
The Apple "miss" notes are rolling out this morning, but surprisingly the numbers are still being hockey sticked in the out quarters and into next year.
As Grandma Koufax used to say, "Rotzaruck!" It remains likely that more misses and estimate reductions may lie ahead. (I don't buy the China spin - a miss of this magnitude likely includes developed markets weakness).
I see no reason to buy Apple and get in front of the share price decline unless a material new product offering (very unlikely) is delivered.
On the basis on total market cap and price to sales, Apple, a hardware company, is still not inexpensive. And there are no apparent short-to- intermediate term catalysts.
As to the widely heralded "sticky" installed base, the next big thing for Apple is likely a slowdown in services.
Apple is in a pickle with 60% of the company experiencing shrinking revenue.
Apple has been losing market share globally for years and not innovating for years as well, besides price gouging innovation (as it pushed the envelope of demand elasticity by ever increasing its ASPs). Wall Street analysts and investors looked through this because sales were expanding. But now, with contraction comes pain and the reality that the company's business cycle has passed its best days.
Apple seems to have two choices - neither is good for the stock. Handsets are no longer cool. Apple is no longer a status symbol. The company can keep average selling prices where it is and keep losing market share and eventually become less relevant.
Or, Apple can cut their selling prices in an attempt to get market share back.
Neither will help EPS over the next year or two.
Apple has made a mistake. They should have focused more on share and not exclusively on ASPs. Share is what matters in an industry like this, especially when trying to grow a services annuity. You want an installed base to do that.
As things stand now, a shrinking share of a hardware company that hasn't innovated - trading at 10x EPS looks generous looking at history. But, because EPS will keep getting worse like it does for nearly every hardware and computer company that gets themselves on the wrong side of things (too high priced products) in a mature industry.
As always here are some observations, while we learn some more lessons from the Apple experience:
- Be skeptical of company buybacks - they are often executed poorly (near the highs) and they are almost always a signpost of a maturing company
- $1 of cash should will never be valued as $1 in the market because history shows some of the cash hoard will be pissed away (and it was in ridiculously high buybacks at Apple)
- Be skeptical of unanimity of investment opinion ("groupstink") - until recently Apple was a large percentage of the Indices, the accepted "market leader" and there were a preponderance of buys over sells (virtually none) from Wall Street's research departments
- Don't automatically follow the "whales," even Warren Buffett's Berkshire Hathaway (which has lost more than $20 billion on Apple's shares from its peak price four months ago)
- Study history (specifically, the history of hardware/computer company "life cycles") - as they have a finite shelf life and they almost always end badly
- Be wary of non rigorous analysis - always do your own homework
- Does anyone believe the aggregate S&P 2019 EPS estimates held by the consensus?