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Apple's (AAPL) earnings report on the 23rd seems to have calmed investors' fears and removed, at least temporarily, the intense selling pressure the stock was under leading up to the report. Apple was up 9% in the five trading days after the report. Although the report made clear that things weren't as bad as the rumors had made it seem, I still consider the company to be in trouble.

A Company in Trouble

Apple's quarterly revenue of $43.6 billion was up only 11% from the previous year, while Samsung's revenue of $48.0 billion was up 16.8 percent. Worse, Samsung increased unit shipments of Android smartphones by 60.7% y/y, while Apple's unit shipments of iPhone increased only 6.6%, according to IDC. The table below summarizes the IDC data for Q1 2013:

Vendor

1Q13 Unit Shipments

1Q13 Market Share

1Q12 Unit Shipments

1Q12 Market Share

Year-over-year Change

Samsung

70.7

32.7%

44.0

28.8%

60.7%

Apple

37.4

17.3%

35.1

23.0%

6.6%

LG

10.3

4.8%

4.9

3.2%

110.2%

Huawei

9.9

4.6%

5.1

3.3%

94.1%

ZTE

9.1

4.2%

6.1

4.0%

49.2%

Others

78.8

36.4%

57.5

37.7%

37.0%

Total

216.2

100.0%

152.7

100.0%

41.6%

With the smartphone market having grown by nearly 42% y/y in unit sales for the quarter, growing at a much slower pace means that Apple is just falling further behind.

Note that I haven't pointed to Apple's margins as a source of concern. As I'll discuss below, I consider margins to be something of a red herring, which has mainly been useful for beating down Apple's share price.

I tend to focus on unit device market share because it's a key indicator of the health of the major mobile device ecosystems of iOS and Android. Numerous virtuous cycles take hold as the user base of the ecosystems increases. Selling the smartphone or tablet is just the beginning of the revenue generating process for both ecosystems. The respective operating systems are contrived to direct the user's commercial attention to preferred venues for apps, digital content of all types, services, and in Google's case, various forms of online advertising. In Q1, iTunes, software and other services accounted for over $4 billion in revenue, while Google (GOOG) Play accounted for most of its "Other" revenue of $1.049 billion.

Despite being disadvantaged in market share, Apple is still considered to have an advantage in monetization, taking about 74% of all revenue generated by mobile digital content stores, according to a recent Canalys report. But at the rate that the Android ecosystem is growing, it will eventually overwhelm this advantage through sheer numbers.

Commodity Producer

What must Apple do to reverse this trend? Is there anything Apple can do? Unlike most Apple analysts, I don't subscribe to the notion that Apple must inevitably be overwhelmed by commodity mobile devices as it was by commodity PCs in the 80's and 90's. The analogy with PCs ignores significant historical differences. Back then, Apple's cost structure was very different, since it manufactured its computers in company-owned facilities around the world, including a large Mac assembly facility in California.

With outsourcing, Apple has been able to achieve manufacturing costs comparable to commodity producers such as Samsung, while retaining its distinctive brand and reputation for quality. This can be seen in the manufacturing cost estimates published by IHS/iSuppli for Samsung and Apple. In the table below, I summarize the cost estimates for the Galaxy S4, S3, and iPhone 5:

Samsung Galaxy S4 (LTE version)

Samsung Galaxy S3

Apple iPhone 5

Total Bill of Materials Cost

$233.00

$205.00

$199.00

Manufacturing Cost

$8.50

$8.00

$8.00

BOM + Manufacturing

$241.50

$213.00

$207.00

Selected Component Costs

Display and Touchscreen

$75.00

$65.00

$44.00

Processor

$20.00

$17.50

$17.50

Cameras

$20.00

$19.00

$18.00

Mechanical

$22.00

$21.40

$33.00

For all practical purposes, Apple already is a commodity producer of mobile devices, since its costs are in line with the rest of the industry, and Apple enjoys the benefits of economies of scale attendant upon its very high unit volume, which is second only to Samsung.

What Apple Must Do

Here's what I think Apple needs to do to resume growing market share:

1) Compete on price, even at the risk of further margin erosion. The dismay that has greeted the erosion of gross margin, which stood at 37.5% as of the latest quarterly report, is rooted in the stereotype that Apple can't be competitive on price because it's not a "commodity" manufacturer. The fixation on margins also lacks historical perspective. As the chart below shows, the peak in margins in Q1 2012 was something of an anomaly, and margins are currently around their norms.

(click to enlarge)

I also believe that gross margin doesn't provide the best comparison between companies, since different companies have different cost structures and book costs at different levels. GAAP operating income provides a better basis for comparison, since it's defined the same way for all companies. As the table below shows, Apple's operating margin is in the middle of the pack.

Company

Apple

Samsung

Microsoft

Google

2013 Q1 Revenue ($ billions

43.603

48.410

20.489

13.969

Gross Profit ($ billions)

16.349

19.520

15.702

8.025

Gross Margin (%)

37.5

40.3

76.6

57.4

R&D ($ billions)

1.119

3.025

2.640

1.837

R&D % of Revenue

2.57

6.25

12.9

13.15

SG&A ($ billions)

2.672

11.550

5.450

2.711

SG&A % of Revenue

6.13

23.9

26.6

19.41

Operating Income ($ billions

12.558

7.978

7.612

3.477

Operating Margin %

28.8

16.48

37.15

24.89

Judging by the gross margin guidance for the next quarter of 36-37%, Tim Cook clearly gets this point and made clear that the lower margins were driven by the need to compete.

2) Double R&D spending. For a company that prides itself on innovation, Apple spends a paltry amount on R&D compared to its competitors, and as a percent of revenue, R&D spending has remained roughly constant since the end of 2009. This goes back to another popular myth about Apple, that it needs a charismatic leader like Steve Jobs in order to be innovative.

This myth betrays a complete lack of understanding of how R&D actually works. As someone who has done R&D and managed technology development projects, I can attest to the fact that most innovation comes from hard working scientists and engineers who are passionately interested in their research fields. Most of these are decidedly uncharismatic, but most importantly, have no clue whether their research will lead to a profitable product. The researchers really don't care about profit; that's not what motivates them. And the ugly truth is that innovations don't necessarily translate into hit consumer goods.

One of the roles of management in a technology company is to try to figure out if a research project will lead to a marketable product, and they often don't do a very good job of it. It's a difficult cross disciplinary skill that few have mastered, but Steve Jobs did master it, and this was his fundamental strength. Because of his unique ability to spot winning products latent in the research work at Apple (and elsewhere), as well as direct and focus that research, Apple was able to get by on a very lean R&D budget.

Most other companies, lacking a Steve Jobs, simply resign themselves to the fact that a significant fraction of their research will never go anywhere and spend more to compensate. Now that Jobs is gone, Apple needs to do the same, because there's no magic formula for innovation. It just costs money. Unfortunately, there's no indication that Tim Cook gets this point. During his tenure as CEO, R&D budgets have continued to be flat (as a percent of revenue), and the introduction of new products appears to have slowed down as a result.

3) Continue to diversify the iOS and Mac OS product lines. One of the few advantages the Android ecosystem has over iOS is the variety of products available to consumers. For years, Apple took the approach of offering just one new model iPhone or iPad while repeating the Jobs mantra that "we just want to build the best device we can." I was always uncomfortable with this, since what constitutes best is in the eye of the beholder. I've pointed out that Apple offers its Mac and iPod lines in a variety of form factors and price points, without any qualms that it is sacrificing quality. iPod has been very successful in defending its market share of MP3 players (roughly 70% in the U.S.), partly by virtue of that variety. I was delighted when Tim Cook echoed these sentiments in the January earnings call:

The most important thing to Apple is to make the best products in the world that enrich customers' lives. . . So what does that mean for market share. We've been able to do that and have had a great track record on iPod of doing different products at different price points, and getting a reasonable share for doing that. I wouldn't view the things as mutually exclusive.

However, Apple has only taken the baby step of introducing the iPad Mini, and continues to rely on older iPads and iPhones to round out the product lines. It simply hasn't been enough, especially with respect to iPhone screen size. Apple badly needs an iPhone with a ~5 inch screen. Tim Cook indicated an openness to this, so I think it's only a matter of time.

In Mac OS, Apple needs to start introducing touch screen enabled Macs. Although Cook made the famous "anything can be converged" statement berating Windows 8, the fact is that Microsoft (MSFT) got the jump on Apple in this matter. Apple just needs to accept that touch screens will become ubiquitous and swallow their pride that they didn't think of it first. With little modification, Mac OS would make a great touch screen OS for Mac Books and even iMacs, and it wouldn't suffer from the split personality of the current version of Windows 8.

4) Take some risks. Lacking the insight of Steve Jobs, Cook simply needs to release some new product categories and see if they'll fly. Both Microsoft and Google have taken risks with products such as Surface and Chromebook, both of which haven't been huge sales successes, but I admire their courage. Even if Google Glass or the next Xbox (720) turn out to be flops, I don't think anyone will hold it against them. Speculation has been rampant about an iWatch or iTV for some time, and I'm sure these have been in development. It's time to end the handwringing about whether the products will sell and just put them out there and see what happens.

Apple's Prospects

Although progress on the above four points has been slow or non-existent, I'm not one of those calling for Cook to step down, yet. Only a few months ago, Cook could do no wrong in the eyes of some analysts, but I've never been so unrealistic about Cook, and I'm not so unrealistic now. To address the above points adequately will take time. For instance, Apple couldn't double their R&D budget over night. They wouldn't have anywhere to put all the people. Likewise, product development takes many months, even years, so we may have to wait a while for the next Apple Breakthrough.

But I expect significant progress by the Fall. I expect an enlarged iPhone and iPad product line with a new version of the iPad that gets an iPad mini makeover with a larger edge-to-edge screen. I expect a new iPhone with a much larger screen. If Apple delivers at least this much, as Cook indicated in the Q1 conference call on April 23, this will be progress in the product category. I also expect to see R&D spending start to ramp up, and gross margins to continue to come down.

New product categories, whether iMac touch or iWatch appear iffy for the Fall and probably won't appear until next year. However, I do expect a developer preview of the next major release of a touch enabled Mac OS by the end of the year. Of course, a new refreshed iOS 7.0 is almost a given for WWDC.

If Apple demonstrates progress in the above areas, then I think its long-term prospects are very good. Market share will start to improve in Q4 for iOS devices, and for Mac OS devices once touch becomes available (probably in 2014). If Apple picks up the pace by showing a new iPhone or a touch enabled Mac OS at WWDC in June, so much the better.

Share price, on the other hand, probably won't improve much at all, given the continuing concern about gross margin, before the end of the year. Investors in Apple, such as myself, have to think very long term, as the fruits of Apple's product development labors and competitive struggles may not fully emerge until 2014.

And if Cook doesn't deliver by the end of the year? Then there's no doubt in my mind that he'll be out. But even this will only be a temporary set back, since I'm sure that Apple's new management will have learned from his mistakes.

Source: What Tim Cook Must Do To Turn Apple Around