The problem with most analyses of Apple (AAPL) is the tendency for investors to get caught up in high level ratio analysis or complex discounted cash flow models. Analysts fail to appreciate that most valuation models of Apple have the arrogance of quantitative methods paired with the weaknesses of totally qualitative high-level assumptions--also known as guesswork.
To deeply understand Apple's prospects, one must accept that Apple, at its core, is a product company subject to discontinuous innovation. Traditional value investors have made this mistake over and over again with companies such as Dell (DELL), Hewlett-Packard (HPQ), Nokia (NOK), and BlackBerry (BBRY). They simply do not understand or accept that technology companies are totally susceptible to discontinuous strategic moves on the part of their competitors, which drastically change the relationship between variables at a rate far greater than that in any other industry. Literally, cash flow can change on a dime from one quarter to the next, making steady-state ratio analysis useless at best, and deadly to the investor's wallet at worst.
So, to understand Apple, the focus has to be on the micro level of its products. Specifically, to make any conclusion whatsoever about its potential growth, one must evaluate its competitors' phones. So I would argue that rather than high level valuation work, or event driven analysis of buybacks or dividends, that one must view the company's overall competitiveness through the lens of its phones' competitiveness.
But first, why the focus on potential iPhone killers as opposed to other product categories? The answer is clear. Out of $35.3 billion in net sales last quarter, $18.1 billion sales were from the iPhone. It was the only category other than iTunes, Software, and Services which grew at all, hitting 15% sales growth for the quarter. Indeed, even if the iTunes, Software, and Services segment continued its 25% sales growth and all other product categories had steady revenues, it would only add $1 billion in quarterly sales to a $35.3 billion quarterly revenue pie. So to drive growth, Apple needs to either successfully reinvent a whole new product category again from scratch, or grow iPhone sales.
Investors should keep in mind that you buy a tech stock to make a lot of money as it grows. If it doesn't grow, you have to realize that the technology wave that you were surfing is over, shoot the stock like a rabid dog, and move on with your life. The cresting wave above you could be the discontinuous shift in innovation that's about to crash over you and wipe you out.
Before we go through phones at the product-centric level, keep in mind the larger competitive context. According to research firm IDC, 79.3% of all smartphones shipped in the latest quarter were Android based phones. Apple's iOS based phones only accounted for 13.2% of global smartphone shipments last quarter. But why is this significant? Even more than hardware, an operating system represents an ecosystem or platform for the consumer. And smartphone wars are ecosystem/platform wars. Most consumers who have become comfortable with an Android ecosystem, like the Windows users of old, will be permanently lost to Apple's iOS ecosystem, even though one could argue that iOS is superior. Since Apple has refused to license its iOS to other smartphone manufacturers as I have suggested, the adoption of the iOS ecosystem is totally tied to its phone shipments, as opposed to competitors which share a common Android platform. So, with that context, let's take a walk through the competitive landscape and identify 3 potential iPhone killers that could threaten continued revenue growth:.
I. Samsung's (OTC:SSNLF) Galaxy S4, Galaxy Mega 6.3, and upcoming Galaxy Note 3. I know that I am cheating a little here with three phones, but I believe that each of these phones will prove to be far superior to the iPhone 5. And indeed, Samsung increased its smartphone shipments last quarter by over 50%. If critics weren't convinced that the Galaxy III and Note II were clearly superior to Apple's iPhone 5, there is no doubt that Samsung's latest offerings destroy the current generation of iPhones.
Specifically, Apple's iPhone 5 has a measly 4 inch display. Each of the Samsung phones has a massive screen which totally dwarfs it at 5 inches for the S4, 6.3 inches for the Mega, and 5.7 inches for the Note 3. But how could Apple let this happen? Steven Jobs famously stated that 3.5 inches was the sweet spot for phone display size, and for all his brilliance, he has been proven famously wrong. The concern was that consumers would feel awkward with a "phablet" held to their ear, but the convenience, lightness, and thin profile of phablets have been a winning combination. And the overall dimensions have been kept reasonable by pushing the displays right out to the edge of phones' frames. Indeed, phablets may render most tablets obsolete as the categories of phone and tablet computer continue to merge. And Samsung's offerings have excellent performance, cameras, and battery life.
Notably, Samsung has the supply chain and carrier relationships to mount a mortal threat to Apple's iPhone growth. And as we learned with the technologically excellent HTC One, which suffered from a camera component shortage which stunted its rollout, supply chain and carrier relationships are key since technology does not effectively exist for the mass consumer until it is put in front of them.
II. Sony's (SNE) Xperia Z Ultra is also a total iPhone slayer. Imagine performance equal to or faster than that of Samsung's line-up depending upon the benchmark used, but then add unique features like water-resistance and shatter proof glass displays. And the Xperia Z Ultra makes a statement as the smartphone with the largest display in the world at 6.4 inches, beating out the Samsung Mega 6.3, and again dwarfing the iPhone 5 and demolishing it with 441 pixels-per-inch, it is hands down the Rolls-Royce of smartphone displays. With its high-end cameras, and its own unique software skin which runs on top of Android and makes for a seamlessly smooth user experience, it may prove to be the world's finest smartphone. Watch in future iterations for the potential ability of the phone to have add-on camera lenses and become a category killer for stand-alone cameras.
III. LG has had a 108% increase in smartphone unit shipments last quarter compared to the year before and the LG G2 could accelerate its market share gains. With a 5.2 inch display, the principal attribute of this phone is extremely high speed, coupled with the best camera on the market according to some critics. While it was tempting to discuss the HTC One or the Huawei Ascend P6, LG's proven ability to quickly ramp up smartphone market share, means that technology is paired with distribution, breaking any potential ties for 3rd place as a potential iPhone killer.
My overall conclusion is that Americans have zero emotional appreciation of the relentless, continual, and systematic nature of Asian competition. On every metric which can be quantitatively measured, the Japanese and Koreans can be counted upon to constantly respond to Apple's innovations with objectively superior speed, displays, and cameras. And then they will throw in gee-whiz options for good measure, place price points at brutal levels, and throw ever larger resources behind grinding out the competition until they have achieved dominance, scorched earth style.
"iHeads" who continually proclaimed the imagined superiority of Apple smartphones vs. those of Samsung now have grudging respect for the Korean giant, and will soon be awed by Sony and LG. But, as Yogi Berra once said, "It's hard to make predictions, especially about the future." With that acknowledged, investors should engage in scenario planning consisting of triggers for their reactions to events as they unfold, keeping in mind that nine months is a lifetime in the tech world:
I. If Apple does not release a new iPhone in the next nine months that exceeds, or leapfrogs its competition on the quantitative metrics of speed/performance, display, and camera quality, the stock should be excluded from investment consideration and/or sold until this occurs, if ever.
II. Barring a new iPhone that equals, exceeds, or leapfrogs its competition, if Apple does not release a category-killing new product line in the next nine months that has the potential to dramatically increase sales (and does), the stock should be excluded from investment consideration and/or sold until this occurs, if ever.
III. Barring the release of an iPhone which exceeds/leaps frogs its competition or the release of a category-killing new product line, Apple's stock should only be held or considered for investment if it engages in a dramatic new strategic initiative, such as licensing its iOS and Mac OS X operating systems with an historic shift to becoming a major software player, as opposed to its current strategy of vertical integration.
One need not be a prophet to understand Apple, but one must have a game-plan for rationally responding to events as they occur. And all unfolding events in the tech world are discontinuous in nature, whether positive or negative.