I Like Apple's iPhone Strategy

I felt Apple did a good job today. For the first time Apple will be selling two brand new phones, including one for under $100 in the U.S. A brand new iPhone for under $100. I wouldn’t underestimate the impact of such a feat. 

While there were some interesting technologies introduced, including a fingerprint scanner and a motion coprocessor, I have learned to control my long-term predictions on what such technologies may mean for Apple’s product line. Time will tell if such innovations become major cornerstones in future Apple products. 

The most controversial aspect of today’s event was iPhone pricing. I see a schism developing among the tech punditry. On one hand, there is the belief that market share is king and Apple must address the bottom of the market because developers will begin to focus on Android’s sheer numbers instead of iOS. On the other side, where I stand, market share is not created equal. It is okay if Apple doesn’t address the lower end of the market since five consumers who don’t buy mobile apps or content is not equal to one who does. Looking at today’s events, I think Apple is doing the right thing gradually moving down market (iPhone 4 and 4S have not been discontinued). This strategy will only expand in coming years. With approximately 400M-500M (and growing) active iOS users with credit cards, I view the iOS ecosystem as now self-sustaining, capable of app innovation as long as the hardware and software back developers up.  If I changed sides and instead only looked at market share, I’m sure I would have been championing Symbian, then Blackberry, and now Android. Market share is not everything. 

Moving to more minor topics, Apple is still addicted to case money, now selling iPhone 5s and 5c cases. Selling cases is a good and easy business decision and judging from the popularity of iPhone cases, Apple will make a decent amount of profit (and margin) from going down that road.  Apple also announced it will give away $40 of software with new iPhone and iPad purchases. While I am not a big user of Apple’s mobile productivity apps, quite a few people are and I suspect there will be many happy iOS users. 

There are still plenty of questions remaining about Apple and strategy. 

Did Apple’s keynote contain a bit too much of tech jargon? Maybe. 

Will mainstream consumers accept iOS 7 without any major complaints? Maybe. 

Will Apple’s margin actually benefit from the new iPhone line? Maybe. 

Nevertheless, with a new flagship phone that has enough differentiation to stand out from competitors, a more value-oriented option for consumers with slightly different priorities, and the desire to maintain older iPhone models in order to address the mid-tier phone market, I like where Apple is sitting and the outlook for the iPhone business over the next 6-12 months. 

Here's My Platform. Vote for Me.

The first half of 2013 felt weird.  Even though plenty of phones and tablets were sold, as well as several laptops, the excitement level seemed less inflated compared to last year.  Consumers are content with their gadgets and remain busy uploading personal information to a dozen or so social and messaging networks.  Nevertheless, there were some stories in the first half of 2013 primed for riveting Twitter debates. To sum up my stance on these issues, I came up with an easy to remember platform, akin to a politician. I am pro-iWatch, pro-expensive cheap iPhone, anti-Glass, and pro-Schiller.

Pro-iWatch.  Wearable gadgets interest me and I think there is something there.  Back in February, former Apple designer Bruce Tognazzini began what turned into a multi-month parade of chatter related to Apple developing its own smartwatch. I still think Bruce’s piece is the best words on the device and I have a feeling that a few years from now most of his post will have become reality. My conspiracy theory is that Bruce was frustrated with iWatch progress and released some of the work Apple had already done as a bribe to get Apple to finally decide to give the project the green light. In reality, Apple probably has been working on a gadget for the wrist for years (yes, that would make it a Steve project) and there was enough chatter floating around for Bruce to collect into a post. 

I suspect Apple did give the iWatch a green light as seen by numerous talent acquisitions and other signs including industry and management chatter. I think consensus is unsurprisingly naive, if not downright clueless, when it comes to thinking of how an iWatch would look and function. People need to stop picturing a classic watch when rethinking the watch.  I am not a fan of today’s smartwatch as the genre fails to answer many questions that the 21st century has placed on the classic watch; primarily purpose and functionality. The current smartwatch market isn’t seeing massive adoption and the industry lacks a cash-rich leader. Samsung and other giants are quickly rushing to market with their own smartwatch, but I am not optimistic that much will come from these early efforts. Instead, I would look more towards Nike’s Fuelband for signs of reinventing the watch. Add in device independency and fashion conscientiousness, and we start to peel the skin to iWatch’s core. 

Pro-Expensive Cheap iPhone. Apple continued to show healthy iPhone sales last quarter with 20% unit growth. Average selling price (ASP) fell as consumers continued to buy the discounted iPhone 4 and iPhone 4S. It seems fairly certain that Apple will release two new iPhone models next month; a “5S”, or the latest iteration to the iPhone 5, and a less expensive iPhone (think iPhone 5 only with a plastic casing and I suspect lacking the ability to support iOS 7 features exclusive to the iPhone 5S). Price points remain a controversial topic, boiling down to two schools of thought; the cheap iPhone will be priced closer to $200 in order to gain traction in emerging markets where phone subsidies don’t exist versus priced closer to $399-$499 as Apple continues to gradually move downmarket, attempting to create demand in the $399-$499 no-man’s land of new phone pricing.  Even though Apple may be able to manufacture a phone for $200 and still make an “ok” profit, I suspect Apple’s larger strategy is to make sure that all profit layers are captured as the iPhone moves downmarket. If the strategy backfires, Apple can discount the one-year old iPhone 5C for $299 next year and give it another try.

I also think a new $399-$499 iPhone fits well within a possible pro-forma iPhone lineup of iPhone 5S for $650, iPhone 5C in various colors for $450, and iPhone 4S for $350. Such a line-up could be sold across the world, including subsidy land. While a $450 “cheap” iPhone does not address the army of Android phones selling for $99, I wonder if that target is something Apple needs to even shoot for in the near-term. 

Anti-Glass. I summed up my Google Glass angst in a prior AAPL Orchard post, largely questioning the product on poor industrial design. Having a product on my face, during both usage and non-usage, strikes me as terribly inefficient and ineffective, not to mention obtrusive. Regardless of design, I also suspect the widespread popularity of contact lenses represent a strong case that glasses aren’t exactly a desirable body modifier. Sure, Google Glass represents something new, but new is not the same as good. Many pundits are hedging bets with assertions that Google Glass may find its niche audience. In retrospective, such a statement can be said about any new product as long as the company making that product remains committed to funding the project. Instead, I think Google Glass will largely be ignored once wrist devices flood the market.  

Pro-Schiller. This is the pro-freedom part of my platform, the idea that probably isn’t too controversial yet often goes unnoticed. I consider Apple SVP of Marketing, Phil Schiller, as the embodiment of Apple’s culture. Yes, Jony is Apple’s soul, but Schiller represents the hard work that occurs at Apple HQ, along with the fun, jokes, and general love for the journey taken. Any quick YouTube search would reveal plenty of clips showing wacky Schiller during Apple keynotes. Earlier this year, Schiller made headlines for pumping a bit of Apple PR before Samsung’s keynote unveiling the latest version of its flagship phone. In retrospective, Schiller didn’t need to say anything as Samsung relied on racist and sexist undertones to unveil a phone that didn’t live up to Apple-like expectations.  Looking ahead, Schiller’s input on product pricing placement and marketing will continue to take the spotlight. 

Apple 1Q13 Review; Thoughts on Guidance and AAPL

1Q13 Review

Apple’s 1Q13 results were largely in-line with my expectations.

• Revenues beat ($54.5 billion vs. my $53.1 billion)
• Margin beat (38.6% vs. my 37.9%)
• EPS beat ($13.81 vs. my $12.75)
• iPhone was an exact match (47.8 million - equal to my estimate)
• iPad was slightly stronger than expected (22.9 million vs. my 22.4 million)

While I was pleased with the quarter, my estimates were considered somewhat bearish compared to the crowd; so needless to say, there were more disappointed faces than smiles.  Apple reported healthy growth metrics for iPhone and iPad, while iPhone ASP remained strong and iPad ASP declined due to the iPad mini.  

2Q13 Guidance

Management altered the way guidance is presented. While the reasoning was not disclosed, I don’t think its much of a stretch to assume its management’s way of ending analysts’ nasty habit of severely overestimating guidance.  When Apple’s earnings report was initially released, the stock was trading in the $490-$495 range.  Guidance seemed to be of Apple’s conservative nature - in that case, guidance was O.K.  When Apple clarified that it would no longer give EPS guidance, but instead release ranges (including upper limits) for several line-items used to reach EPS, the stock quickly fell to the $460-$465 range as guidance was considered NOT O.K. (it can be debated what management meant by guidance ranges, but I am assuming Apple’s actual results will fall within these ranges). 

I didn’t find Apple’s 2Q13 guidance (with the new ranges) to be overly concerning. Going into the quarter, I knew 2Q13 was going to be tough due to difficult year-over-year comparisons to 2Q12. Judging from the stock’s decline, I guess I was in the minority. 

Did Anything Actually Change? 

Taking a step back from all of the earnings noise, I didn’t learn much new about Apple. Both iPhone and iPad unit growth is slowing, margin remains pressured due to newer products, and EPS growth will be difficult to achieve in 2013.  Minor details such as the iPhone 4 remaining supply-constrained (most likely due to limited resources and parts allocated to iPhone 4 production), iPad mini coming into supply/demand balance by the end of this quarter, and the mix between new and old iPhones remaining constant weren’t exactly market-moving data points.  

AAPL 

It is interesting to read the differing opinions on Apple’s quarter between the Valley’s reaction and that of Wall Street.  In the Valley’s eyes, Apple did great and is firing on all cylinders, but according to Wall Street, AAPL stock is broken as growth is slowing. I think reality is somewhere in the middle of those two extremes.  

AAPL has now been in a 4-month tailspin, including widespread shareholder rotation (meaning many of Apple’s shareholders as of the end of September are selling and being replaced by new shareholders). Such a rotation is often quite volatile, resulting in lower stock prices as the new shareholder base has different priorities and expectations for Apple (often of a lesser nature).  

Back in January 2012, the consensus view on Apple was that EPS from iPhone and iPad would plateau around $60. An additional premium for Apple optionality (i.e. new products) may push EPS to $70. P/E multiple and dividend payout ratios were then calculated accordingly.  Things certainly have changed.  The consensus view is now of Apple EPS topping out around $40. It’s tough for a stock labeled as *the* momentum tech growth story to keep its luster when EPS expectations are cut by 30%. Of course, investors and traders love to panic and overreact, so not only is Apple’s EPS problematic, but Apple’s business model is apparently broken, management is clueless, and the company is the new Microsoft. It is what it is and I don’t see a reason to fight it. 

Investors buying AAPL today (or for that matter - the past year) should not be buying it on iPhone and iPad predictions, but rather Apple’s ability to disrupt itself and introduce new product categories. Not surprisingly, when things are good and AAPL is up, everyone assumes Apple is in great shape. When AAPL is down, management is assumed to be inept; unable to innovate and remain relevant. 

Looking ahead, I think it will be difficult for Apple to report EPS growth in 2Q13 and 3Q13, due to tough year-over-year comparisons related to margins. Modest growth should come back in 4Q13 and moving into 2014.  I am assuming anyone with an earnings model is well aware of these trends, but judging from today’s stock price action, I may be too generous in my assumptions.  Catalysts such as China Mobile selling the iPhone (not in my model) or new products are most likely not being contemplated by Wall Street and one can argue even if catalysts come to fruition, many will simply brush them off as a non-event.  Just as funds had to own AAPL last year to beat certain performance benchmarks, many funds now have to sell AAPL because the stock is down. 

Many are trying to find rational answers with AAPL’s price action, but since the following statements are often true, I’m not sure how many answers are actually out there:

A stock often goes up because it has been going up. 

A stock often goes down because it has been going down. 

A stock’s valuation matters only when valuations start to matter. 

Fundamentals are important only when fundamentals become important. 

AAPL 1Q13 Preview; Near-Term Volatility Continuing

Revenue: $53.1 billion (AAPL guidance: $52.0 billion/Consensus: $54.5 billion) 

• I expect Apple’s revenue to increase 23% year-over-year after adjusting for the 14 weeks in 1Q12.

GM: 37.9% (AAPL guidance: 36.0%/Consensus: 38.4%)

• Apple’s margin is expected to decline sequentially from 4Q12 primarily due to the wide range of updated products. Margin remains a key near-term unknown for AAPL. Management’s 36% margin guidance is 870 basis points less than the 44.7% margin reported in 1Q12, making EPS growth difficult to achieve. I still include expanding margins throughout 2013.  Further weakness, or a shallower rebound, may result in an additional EPS growth headwind.

EPS: $12.75 (AAPL guidance: $11.75/Consensus: $13.33) 

• I expect Apple to report a 1% yoy EPS decline, when adjusting for 1Q12. While my $12.75 estimate is less than the Street’s $13.33 average, I attribute much of the variance to my lower gross margin expectation.

Product Unit Sales and Commentary

Macs: 5.2 million (flat yoy growth)

• Mac growth continues to slow as tablets and smartphones satisfy many consumers’ computing needs. I expect 10% growth in portables driven by holiday shopping to be mostly offset by nearly a 30% decline in desktop sales due to the new iMac release schedule.

iPad: 22.4 million (56% yoy growth - when adjusted for 1Q12)

• I expect Apple to report record iPad sales for 1Q13. My iPad estimate assumes approximately 8-10 million iPad minis and 12-13 million iPad 2 and fourth generation units. The iPad mini went on sale November 2 with an aggressive rollout, despite significant pent-up demand and limited supply. Apple was able to sell three million iPads in the three days following the iPad mini and fourth generation iPad launch. My estimate assumes approximately 25-35% cannibalization of the larger iPad models (1 out of 3 consumers willing to buy a larger iPad purchased an iPad mini instead). Going forward, I expect iPad mini sales to approach, if not exceed, those of the larger iPad models. 

iPod: 12.0 million (16% yoy decline)

iPhone: 47.8 million (39% yoy growth)

• Apple made significant progress in reaching supply/demand balance for iPhone 5 in the U.S. and other launch countries. My quarterly estimate is largely based on AT&T’s recent comments on October and November smartphone sales (and additional extrapolation). Historical averages for AT&T’s share of global iPhones (and assuming a slighter higher mix of international sales) would imply 40-50 million iPhone sales, which I would consider the high probability estimate range.  I then assume channel fill of at least 1 million units, which positions my estimate in the narrower 46-48 million estimate range. 

Apple has missed Wall Street consensus EPS for the past two quarters, and unless estimates come down in the following weeks, a third miss isn’t out of the question. While it is hard to point to any one factor as driving a fundamental change in Apple’s operating performance, Apple’s prior two quarters have contained a few concerning metrics, including contracting margins and declining iPad and iPhone growth.  Did the weak global economy finally catch up to Apple? Were product release cycles continuing to wreck havoc with consumer demand? 

The bear argument would label Apple’s two-year stretch from 2010-2011 as an outlier, when two new products (iPhone and iPad) produced a perfect storm for EPS explosion.  Going forward, bears would argue margins will decline further, effectively limiting EPS growth. Future products would then lack the size to move the EPS needle. 

The bull argument would focus on iPhone and iPad as product leaders in its respective industries, while a temporary margin drop is indicative of product updates and not a fundamental change in the operating landscape. Apple’s future product plans would also occupy a spot in the conversation. 

Will 1Q13 represent an AAPL inflection point? I don’t think one quarter is capable of shedding enough light to figure out where Apple stands in its long, storied history. With iPhone now entering its 6th year (iPod recently celebrated its 11th birthday), the days of 100% revenue growth may be over for the product line, but should that statement even be considered controversial? There is also evidence suggesting Apple may be looking to smooth out demand cycles by updating products more frequently, a move that may bring long-term benefits, but at short-term costs.    

While much of the recent AAPL discussion has been focused on slowing growth and falling margins, it is easy to overlook fundamentals that would be considered very strong for any Apple competitor:

• A smartphone pulling in $80 billion of revenue annually and growing at least 30%.
• A tablet pulling in $30 billion of revenue annually and growing at least 45%.

A few AAPL loyalists have recently declared another “bad” Apple quarter (where bad is judged merely by EPS) will signal a new Apple, an Apple not deserving of their attention and instead lumped in with the rest of the tech crowd.  I disagree. One quarter, especially in the midst of an obvious change in business performance (product updates and management reshuffling), is not enough to conclude the long-term Apple story has changed. If an investor wanted to run away from Apple for near-term volatility, that decision could have been made a few months ago. Continued margin volatility may produce a scenario where EPS growth can accelerate throughout the year and 2014, even with slowing product sales growth. 

AAPL’s next 3-5 years will depend on management’s ability to introduce new product categories into an ecosystem that values a set of beliefs, including two that I tried to put into words following my first days with an iPad:

That technology is too powerful of a force to enjoy without acquired perception and natural intelligence.

That product design has the power to momentarily satisfy the never-ending search for order and reason.

Anti-Apple Militia's Shifting Tactics; Attacking Apple's Cool Factor

A few years ago, I coined the phrase “anti-Apple militia” to describe the disjointed and incoherent group of SAI commenters that were not happy with Apple’s growing success. As Apple’s increasing dominance became clearer, the anti-Apple militia would desperately think of a new plan of attack,  often shifting themes within weeks. Some of my favorites were:

1) iPhone 3GS will flop because it looks just like iPhone 3G.

2) Palm Pre will crush the iPhone.

3) People don’t want a curated Apple App Store.

4) Android will crush Apple in the U.S.

5) iPad will flop because it’s just an oversized iPhone.

6) No one is buying iPhone 4 because of Antennagate.

7) No one is buying iPhone 4S because it looks like an iPhone 4. 

8) No one is buying iPhone 5 because of Maps.

Recently, I’ve seen the anti-Apple militia shift tactics and instead of attacking a specific iPhone or iPad feature, the detractors are going after the intangible; Apple’s popularity and coolness. Many anti-Apple comments are falling under the same genres, including:

"My daughter says all of her classmates are switching to Samsung and Windows phones. iPhones just aren’t cool anymore.” 

"Has anyone gone to an Apple store lately? They are empty and the only people I see are older folks. Meanwhile, Microsoft stores are packed with kids. So crowded."

"I was at the market yesterday, and some kid came up to me and couldn’t stop asking about my kick-ass Samsung phone. Youth just aren’t interested in the Phone anymore."

I think one of the main catalysts for this new attack campaign was Samsung’s ads that mocked people waiting in-line for the iPhone 5, including the scene of a son holding a spot in line for his parents. Samsung is going after one of Apple’s largest competitive advantages: it’s coolness. I look at these shifting attack tactics as desperation.  If using the battlefield analogy, Samsung and the anti-Apple militia are firing all remaining ammunition in the general direction of the enemy hoping something will stop the advance.

In reality:

1) Kids can’t get enough of iPhones and iPads (literally - parents are often not willing to buy new iPhones for their children until at least 8-9th grade).

2) College students continue to embrace Apple products at an alarming rate. 

3) Apple stores are more packed now than ever, with some complaining about how loud the stores have become.  Will the anti-Apple militia soon proclaim “no one goes to Apple stores because they’re too loud”?

4) Despite much broader product roll-outs, including massive pre-order allotments, people are still lining up for new Apple products.

Apple competitors see the writing on the wall. Not only is Apple continuing to broaden its reach across the world, including advances into enterprise and education, but it’s coolness factor is actually expanding.  As for the surveys and guesstimates showing Apple’s market share is getting trounced in China and markets where Apple has a weaker presence;  a true battle is one where both sides are present.