Apple

Thoughts on Apple's 6.4% Stock Drop

Everyone wants to create a story for why Apple’s stock dropped more than 6% today. While daily stock fluctuations are hardly worth mentioning, a 6% drop on seemingly no news does stand out as an outlier. 

I have difficulty believing that a stock moves up or down on a specific news item because I am unable to verify why everyone is selling (and buying) a particular stock. Those selling shares at 9:30 AM may have a completely different motive compared to those selling at 3:59 PM. The same philosophy applies for a stock on the rise.  

As Apple’s stock collapsed throughout the day, news sites were fumbling over each other trying to guess what could possibly cause Apple shares to fall.  Several reasons floated around the web included:

1) A DigiTimes Article. I assume this article talked about all iPhone production coming to a halt, because I have a hard time thinking of any other topic that can cut $30 billion of Apple market cap in a few hours.

2) Tax Selling.  This one just won’t die.  Are investors selling their Apple shares today (25% off the high) only to avoid paying 5% more taxes on dividends and maybe 5-10% more for long-term capital gains?

3) China Mobile Approves a Nokia Phone.  So Apple loses $30 billion of market cap in a few hours because China Mobile announces it will sell a Windows Phone made by Nokia?  Really?

4) Samsung is Crushing Apple. Let me guess. Teens are ditching their iPhones and iPads and switching to Samsung phones because they are just that cool. Surely that would cause Apple to lose $30 billion of market cap in a few hours. 

5) Some rumor about retail margin requirements being increased for only one stock; Apple.  At first glance, this one at least sounds somewhat plausible, until one realizes most individual investors highly levered with margin already faced tough times a few weeks ago when the stock crashed to $505.  Even if this rumor was true, individual investors would be unable to account for $30 billion of Apple value vanishing in a day. 

6) Apple Maps. If all else fails, blame Apple Maps (ok…maybe I was the one to tweet this one as an excuse for Apple’s drop).

All of these possible explanations for today’s stock drop are nothing more than attempts of adding context to mystery; creating a story out of the unknown. Unfortunately, many are missing the big picture. 

There are very few news items that are even capable of moving Apple’s stock price by 6% in a day (the worst daily decline in years). Such a move is typically left for monumental events such as a CEO departure or natural disaster impacting production or distribution, and even then those events would often be met with a rush of buyers willing to support the stock.

Is there anything we know for sure about today’s price action? Yes.  

For every trade, the marketplace needs a buyer and seller. A stock price is the equilibrium where a buyer and seller are willing to exchange a share. Today, sellers were outnumbering buyers at $569 (Apple’s stock price at 9:31 AM), so the marketplace had to lower the price until sellers and buyers were in equilibrium. At 3:59 PM, the equilibrium for Apple’s shares was down to $538.  Selling pressure remained elevated for most of the day, and as the share price declined further, additional selling pressure came in, forcing the shares to fall even more. Apple shares haven’t seen this type of price action in years (the typical retracement was only around 15%, which would take a few weeks to occur). Buyers would typical come in and support the stock (the Flash Crash of 2010 stands out as another notable exception). 

The next question is what caused all of this selling? Unfortunately, we are forced to think of possible reasons for the selling to create a story because we hate the unknown.  I could end this post right here and call it a day, but what’s the fun in that? Sometimes even I need a story or two. 

I’m skeptical that any rumored (or even factual) news story was capable of causing the world’s most valuable company to drop 6% in a few hours. Instead, I think the intense selling pressure was caused by several mid-sized hedge funds forced to sell Apple positions because their computer models were programmed to sell Apple. In an effort to remove emotion from trading, some funds program models to buy and sell stock given certain market conditions (most likely momentum characteristics). By removing the human from the equation, one is unable to avoid selling a stock on no news (in many ways, for the model to be successful, all decisions have to be followed).  I think a rather large fund (or a few) were forced to liquidate or reduce their Apple positions simply because the stock was in collapse mode. Add in differing degrees of leverage (money borrowing) and you can see how things can snowball out of control very quickly. I also believe a similar thing happened last month when Apple shares fell 8% in only two days. The harder Apple fell, the faster the models said sell.  Meanwhile, buyers were simply unable to outnumber the sellers, causing the equilibrium price to remain under pressure. Of course, I’m sure there were plenty of retail investors selling Apple shares for completely different reasons, which supports my skepticism for labeling specific news items as stock price drivers.

Looking at the long-term, Apple is facing several headwinds that may give buyers pause. I have a difficult time modeling much in the way of EPS growth in 2013 given tough year-over-year margin comparisons. In addition, recent Apple management changes have not been tested in the marketplace.  I’m sure one can also come up with a few other things that would elicit fear about Apple’s future, but at a certain price and after a set amount of time, these fears are fully realized and digested by the market. I suppose one can also come up with good scenarios for Apple, but what’s the fun in that? When Apple’s stock plunges on heavy volume, skepticism should take hold, helping to usher in clear thoughts. Short-term stock trading is a fool’s game and I would love to be proven wrong. 

Marketing a Smaller iPad

Marketing is an art, not a science. We were fortunate to see this art first-hand on January 27, 2010 as Apple unveiled the iPad. Technological and engineering marvels aside, Apple faced the daunting task of marketing a disruptive product that had to grow into its role of replacing the modern-day PC. Jump ahead 33 months and it appears Apple has had some initial success, selling 84 million iPads. Within weeks, the world will see Apple’s second test marketing iPad, but this time it will be a new form factor, a smaller iPad.
 
Marketing; Portraying the Product
 
The most important aspect of marketing is the product; the look, feel, and sound (fortunately iPad’s smell and taste aren’t a major factor in this discussion). Apple eloquently marketed the iPad as a sexy device that could do a few things extremely well, all the while feeling great in your hand. The consumer was left focusing on iPad’s strengths, and not its short-comings, or mysteries, such as if its weight becomes an issue after extended use. In subsequent years, Apple began the task of marketing the iPad as a device capable of content creation, in an effort to begin cementing its path to replacing the modern-day PC. When unveiling a smaller iPad (7.85-inch screen) in October, Apple will be given 60 minutes to tell a story; why a smaller iPad should exist.
 
Apple may take two paths:
 
1)      Positioning a smaller iPad as a replacement to the current 9.7-inch iPad. Apple’s presentation will include all of the features a smaller iPad could do well, such as web surfing, content consumption and creation, but in a smaller form factor and at a lower price point. Consumers will have to decide between a small or large iPad.
2)      Positioning a smaller iPad as a companion to the current 9.7-inch iPad. Apple’s story will include the few things a smaller iPad could do extremely well, such as content consumption, in a more convenient form factor for extended passive use, such as reading or watching movies. Consumers will understand the differences between a small and large iPad and come away from the event wanting both, not one or the other.
 
Apple will most likely choose the second path, positioning the smaller iPad as a companion device to the current iPad line-up, and in doing so will not only sell a lot of small iPads, but keep the large 9.7-inch iPad as the powerhouse in the tablet market.
 
The Tablet Story
 
On January 27, 2010, Apple could have unveiled an iPad with a 7-inch screen, or 8 inches, or maybe even 12 inches, but settled on 9.7 inches. Apple knew there would be plenty of television commercials marketing iPad, but the biggest marketing ploy would be the product itself, a device capable of eventually replacing the modern-day PC as the primary form of computing. Apple wanted (or needed) consumers to begin thinking of an iPad as a possible laptop replacement from the start. The “iPad as your new laptop” thought didn’t need to be completely formed on Day 1, or even by Year 3, but Apple needed to plant the seed on Day 1 and a 9.7-inch device was an easier sell than a smaller 7-inch device.
 
Fast forward a few years, and the tablet market is now flooded with smaller 7-inch tablets. Besides not being given an adequate reason for their existence, consumers are confused by these 7-inch tablets labeled as a “full tablet” despite failing in comparison to a laptop’s immense feature list.  
 
So why should Apple introduce a smaller 7.85-inch tablet now? It is time because the 9.7-inch iPad is a success.
 
A Smaller iPad; Companion to the Current iPad
 
The iPad is now well established as a successful tablet and cornerstone to Apple’s product line-up. While many have fallen in love with iPad, the device does have some minor drawbacks, namely form factor for extended use and price. The device tends to feel heavy in hand after extended use, such as reading or movie watching, while the $499 entry price is still unattainable for a large swath of the population, including education and business, leaving wiggle room for competitors to try something at the bottom-end of the price ladder. Are these two factors (heavy form factor and price) enough for Apple to introduce a smaller iPad?
 
In October, Apple will address the space between an iPhone and a 9.7-inch iPad and most likely market a 7.85-inch iPad as a companion to the 9.7-inch iPad. Books, movies, TV shows, podcasts, and games will be shown as more enjoyable given a smaller iPad form factor. Apple will need to walk a delicate line though positioning a smaller iPad as the best way to consume content, as many will continue to enjoy content on their large iPads (as well as on their iPhones).

More importantly, Apple needs to portray a small iPad not as a 9.7-inch iPad replacement, but as an iPad companion. If consumers begin to think of a smaller 7 to 8 inch device-great at content consumption but not so great at other aspects-as an iPad replacement, the effort of positioning iPad as the disruptive force will be in jeopardy since wide-spread adoption would come under pressure and laptops would continue to appear superior to the average 7-inch tablet.
 
For those who would buy a smaller iPad due to price, proper marketing will position the smaller iPad as a gateway drug to a larger iPad. If a consumer enjoys content on a small iPad, the thought of not only consuming the same content, but also creating content on a larger iPad will only be enhanced.
 
Other Musings
 
Price. If given three $5 casino chips and told to guess the small iPad’s price, the $199, $249, and $299 squares would be occupied with a chip. If given one $15 casino chip, the $249 price point would be occupied. Not only is the product itself a form of marketing, but a device’s price can say a lot. Priced too low, a small iPad may have a hard time losing the “just a content consumption” tagline, while priced too high and the small iPad becomes an iPad competitor as consumers assume the two devices must be similar in compatibility. A $249 price point would be the best of both worlds; a device $150 less expensive than the entry-level iPad 2, but still more expensive than other 7-inch tablets.
 
Future iPads. One could replace any mention of “small iPad” in this piece with “larger iPad” and the same overall thesis would apply. A larger iPad (greater than 9.7 inches) for content creators (movie makers, artists, designers, etc.) would certainly make an interesting proposition.
 
iPod touch. The updated 5th generation iPod touch (and all of its amazing features) is sold for just $299, which could very well be more expensive than a 7.8-inch iPad. Apple is positioning the iPod touch as that powerful guard, awake all night, preventing any Trojan horse from causing havoc.
 
Product Quality. It says a lot that throughout this entire discussion, the idea of Apple selling a small iPad with superior quality and craftsmanship is simply assumed to occur.  Anything else would be a disappointment. High expectations can be both a blessing and curse.

Microsoft’s Interesting Week

 
With WWDC winding down in San Francisco and chatter concerning next week’s Google I/O picking up, few would have expected this week to be dominated by Microsoft news. Late Monday evening, after the East Coast had largely gone to sleep, at an event that was oddly so secretive that the press was not made aware of the venue until a few hours prior to start time, Microsoft announced its revamped Surface tablet and I felt somewhat duped. A team of executives got on stage in Los Angeles and put on a scripted show, only I was led to think it was reality. Microsoft faces an uphill battle and while consumers are now talking about the company and Surface, I have little confidence that Microsoft’s ultimate destiny was altered this week.
 
 
Surface Event Lacked Direction and Message, but Microsoft Accomplished Goal
 
At Apple’s iPad unveiling in 2010, Steve carefully crafted his sales pitch to show why the iPad should exist and be worthy of consumer’s precious dollars (pundits still questioned iPad’s purpose for the weeks, months, and years following the event). On Monday, Microsoft lacked a similar sales pitch, instead relying on teleprompters, and hobbling through failed demos, in an attempt to show that the lights were still on in Redmond. Microsoft’s event actually reminded me of HP’s TouchPad event in early 2011, where HP showed a general lack of direction and enthusiasm for the device. Reading off of teleprompters can really kill the passion. It has been four days since the Surface was unveiled, and with more questions than answers, I think Microsoft’s primary goal was accomplished; being mentioned in tablet (and phone) discussions between WWDC and Google I/O.
 
The Big Question
 
The Surface discussion can be reduced to one question:  Is the Surface a proof of concept device meant to spur OEMs into action or is the Surface a sign that Microsoft is entering the tablet hardware space in response to changing market dynamics? It is easier for one to assume that Microsoft intends for OEMs to remain in the game, announcing the Surface as a means to drum up support and give OEMs confidence that there is interest for devices running Windows. However, if MSFT is looking to change strategies and develop the entire Surface device alone, I will give Steve Ballmer a pat on the back as that is one daunting move given the sheer difficulty in manufacturing desirable hardware.
 
Prototyping
 
The lack of available Surface devices for journalists to play with (unattended) and horrid onstage demos leads to me think that the Surface is very far from a shippable state. While working prototypes are common place in Silicon Valley, it is incorrect to assume mass production is only a few short months away as the task of figuring out how to turn a prototype into a mass-produced product at a particular price point (not discussed by Microsoft) by a specific deadline (also not discussed by Microsoft) may end up being just as difficult as building the original prototype.
 
Hardware Delicacy
 
Tablet hardware is tricky.  From my initial iPad 2 review:   “After a few minutes of using iPad 2, I found myself forgetting that I was using iPad 2. My entire thought process was given to the app that I was using.  While iPad looks and feels amazing, the iPad dissolves away when in use, exactly how Apple planned it. Remove the intermediary and let users interact directly with innovation.  I don’t care what is or isn’t inside iPad 2, as long as iPad 2 has the ability to run the highest quality apps possible.”  After 15 months, I am unsure if the iPad’s software or hardware is more intriguing. Apple, a company built on the seamless integration of software and hardware, spent years mastering the art of making iPads. Does Microsoft, a company built on software, have the capabilities of designing and producing an intriguing tablet offering in a few months? While some point to Xbox and Zune as examples of Microsoft’s hardware success, the world is now a different place with substantially higher barriers of entry for hardware makers. HP, a company built on hardware, was forced to manufacture the TouchPad with parts deemed unworthy of the iPad since Apple had procured all available resources through long-term contracts.  Meanwhile, PC OEMs are seeing their sales decline as their designs are falling flat with changing consumer preferences.  I enjoy iPad because the hardware melts away.  Is Microsoft capable of beating Windows OEMs and produce tablet hardware that is truly revolutionary, but still let app interaction resonate? Daunting would be an understatement.
 
Expectations
 
Microsoft faces an uphill battle with tablets, regardless if they intend OEMs to help out or they go it alone. The most likely scenario is that Microsoft will try to have one’s cake and eat it too; bring the Surface to market while keeping OEMs in the loop about broadening the Windows mobile platform. Microsoft will likely face an increasing number of manufacturing difficulties leading to certain things being left out, or altered, in order to stay near competitive prices.  I would look at HP TouchPad and RIMM PlayBook hardware and price points as goals that Microsoft will try to meet, let alone beat (the TouchPad and PlayBook failed in the marketplace). I expect subpar Surface hardware, wrong price points, and limited distribution to become major headwinds for Microsoft. In order to beat iPad 2’s $399 price point, the Surface needs to come in at least $100 lower given Apple’s superior brand – a price I don’t think Microsoft will be able to meet without reporting huge losses. Instead, Microsoft will talk up the increased functionality of Surface (to validate a higher price) and the message will go in one ear and out the other as consumers realize laptops already fill that spot of the market. The Surface’s software, which many have continued to give praise for, will probably be up to Microsoft’s standards, however hardware limitations may spoil the treat, and as the iPad demonstrates (along with every other tablet), hardware cannot be ignored, regardless of how great the software is. Microsoft faces an uphill battle. Arriving at the baseball game in the 4th inning can make winning the game somewhat of a challenge.

Final Thoughts on Apple's 4Q11

iPhone. We Still Don’t Know How People Buy Phones. 

While everyone has been quick to blame unrealistic expectations for Apple’s 4Q11 “miss”, I think the rare earnings disappointment was partially due to a lack of understanding on how iPhone demand fluctuates and how people buy phones. Apple just became a much harder company to model.

It is incorrect to say that analysts never considered people waiting to buy iPhones ahead of a rumored iPhone refresh. Almost every analyst note published in the past three months mentioned an iPhone refresh and the tendency for pent-up demand to build as consumers wait on iPhone purchases.  Apple management forewarned the same scenario on Apple’s 3Q11 earnings call. People were expecting it.  Even my analysis was based on the idea that a slowdown in iPhone 4 sales in countries that typically get the new iPhone on launch would be offset by continued strong iPhone 4 sales in countries where the new iPhone would take months to reach. That didn’t happen.

Instead, the world pretty much stopped buying iPhones in September.  I don’t think it’s much of an exaggeration to say that iPhone sales almost came to a screeching halt towards the end of September. Apple specifically mentioned that sales slowed further in the second half of the quarter.  Running rough calculations, I estimate iPhone sales may have been tracking down 20-40% yoy in the U.S. towards the end of September. Pretty remarkable. I wonder if Apple retail stores saw this noticeable decline in demand? Analysts underestimated how many people were aware of iPhone rumors and were waiting to buy. Apple was surprised too, with both Tim Cook and Peter Oppenheimer mentioning “rumors” as one cause for weak iPhone sales.  Anecdotally, I talked with quite a few BlackBerry and Android users over the summer, all of whom were well aware of a new iPhone coming out sometime in the fall. I assumed there were other people still buying iPhones.

The iPhone miss (and let me be clear, the iPhone number was pretty negative at only 21% yoy growth) came as a huge surprise with analysts and the investment community thinking the iPhone demand cycle had become independent of product transitions. We thought that sequential quarterly iPhone growth is the new normal, regardless of how a new iPhone impacts deferred sales. Apple’s significant 3Q11 iPhone beat cemented the idea of sequential quarterly growth. Ironically, many analysts thought the new iPhone was going to be unveiled at WWDC and had modeled for declining iPhone sales in 3Q11 due to deferred sales (people waiting). Instead, Apple beat everyone’s iPhone estimate by a mile as iPhone rumors really didn’t grow until August. Independent Apple analysts (including myself) concluded it would be unlikely that Apple would report a sequential quarterly decline in iPhone shipments in 4Q, which meant Apple would sell more than 20.3 million iPhones (their 3Q11 total). We weren’t necessary making a call on growth assumptions, or at least I wasn’t. Some analysts did get it right. Goldman Sachs modeled 16.9 million iPhones – essentially spot on. Still wondering why Goldman was picked first for Apple’s earnings Q&A?

I don’t think our iPhone expectations were overly optimistic though as our previous demand forecasts have now shifted to 1Q12. Our annual iPhone sales estimates remain largely unchanged. Instead, our timing was wrong. I think iPhone’s increasing demand complexity was the main culprit for the iPhone miss. Even Apple management thought they would sell more iPhones in 4Q11.* We still don’t understand how consumers buy phones. For many, buying a phone is categorized as “the big purchase” even though the actual cost of the phone is spread over 2 years. A $110 monthly cell phone bill 17 months from now is not as important as the difference between a free subsidized phone and a $199 subsidized phone today. People wait to buy phones until their contract is up and - this is key - they are willing to wait after their contract is up to take advantage of the carrier’s subsidy and buy a phone that they really want, even if it means holding off on a new cellphone for an extra 4 or 5 months. This trend will only grow as smart phones flourish.

Reports of record iPhone 4 sales over opening weekend (including positive commentary from AT&T, Verizon, and Sprint) are evidence that iPhone demand is back. Going forward, analysts should model a slowdown in iPhone sales during product transitions. If a new iPhone is rumored for October 2012, one should assume people will stop buying iPhones in September. Seems obvious now, but many got it wrong. In addition, a new form factor will also lead to difficultly in meeting initial supply, which could hurt early sales.

iPad. The Wild West. 

Apple sold 11.1 million iPads in 4Q11. I expected 11.7 million and I had originally expected 11.1 million, so iPad is performing near my expectations. Unfortunately, many independent analysts have been running with extremely aggressive iPad expectations. I do think these expectations need to come down.  Apple noted iPad supply and demand is now in balance. Apple sold every iPad that consumers desired; 11.1 million/quarter.  I still get nervous with iPad because it is such a young product.  What if demand really isn’t as good as we think? It doesn’t mean the product is a failure, instead maybe people just haven’t yet become comfortable with tablet computing. Sales fluctuations will occur and people need to plan for it. I found it interesting that Tim Cook made the claim that iPad could turn out to be larger than the PC market. In the past, Apple’s remarks were more vague and general. Apple wants to set the tone for iPad. This is the bet. This is the future.

Mac. Steady as She Goes. 

Apple’s forgotten child (at least in many investor’s eyes) continues to do well, taking market share from Windows with both hands. Strong 37% yoy growth in portables (thank you Macbook Air) speaks well of Apple’s growing brand in the traditional PC market. Yet compared to iPad and iPhone, Mac’s influence is just too small to impact earnings to any large degree.

iPod. Out to Pasture.

Declining iPod sales are now normal and to be expected. In fact, iPod declines are accelerating. Sure, the “newer” iPods might change this trend a bit in the near term, but when excluding iPod Touch, the iPod is only a fraction of its former self.

Guidance. Strong. 

Apple’s 1Q12 guidance was very strong, near current consensus (which is very rare). Management indicated they will sell a record number of iPhones and iPads during the holiday quarter (not that shocking). Since Apple “missed” earnings, analysts will be more conservative with their forward expectations, unsure of how much cushion Apple built into its guidance. Many analysts were already running with conservative assumptions so the 4Q11 “miss” should not weigh much on forward EPS estimates.  

Thoughts on Apple. Quarterly Results Rarely Matter For Superior Management Teams

Earnings misses are not the end of the world.  They can be healthy, serving as a foundation for further gains. Misses act as a reset for increasingly lofty expectations. Problems arise though when people look for answers to an earnings miss and are quick to make incorrect assumptions.  A prime example is Apple’s retail store trends. Same store sales were down approximately 10% (which means that your local Apple store reported 10% less revenue, on average, this past quarter vs. last year – a pretty sizable decline). Well, hello, iPhone sales were miserable. With an ASP of over $600 and a concentration of Apple retail stores in the U.S., a slowdown in iPhone sales (maybe as much as 30-40% in September in the U.S.) will have an impact on total retail store revenue. It doesn’t take a genius to figure that out. 

Apple will get penalized in the near-term because of its earnings “miss”. People will remain more cautious on iPhone and iPad growth.  Expectations are being reduced (especially among the independents).  Apple bears are getting louder. People are wondering. People are asking. Earlier this week, the biggest question was how high the stock would gap up after earnings. Now people are thinking of the “what ifs”, what if people stop buying iPhones, what if iPad sales slow down. While such questions might seem silly to think given the technicalities of Apple’s “miss”, its nevertheless happening.

Good companies sometimes have “bad” earnings reports (who would have thought 50% EPS growth would be considered bad). In such circumstances, time is your friend. For long-term investors, quarterly results shouldn’t even matter much, instead attention should be given to the current management team and its ability to innovate.  

*UPDATE: Thanks to @adamthompson32 for pointing out that Apple actually said 4Q11 iPhone sales were better than expected. Tim Cook: “And as we have predicted…(iPhone) sell-through decline did occur in the quarter, but not nearly to the extent that we thought and therefore, we significantly beat our guidance.”