By: Jake Mann
At Insider Monkey, we wrote near the end of 2012 that Apple (AAPL) wasn't as cheap as Wall Street claimed it was. Our reasoning was based on shrinking analyst estimates, the risk of margin deterioration, and a potential change in consumer preferences. Almost ten months later, many of the readers who heckled this analysis now understand our concerns, and we thought it'd be best to explore this topic a bit further.
Let's consider why any rational investor could reasonably hate Apple stock.
Lack of protection, shrinking margins
By relying on the iPhone to generate nearly two-thirds of its profits, Apple's margins are far less protected than a company like Microsoft (MSFT), which is dependent on the less-competitive operating system space. This is a point that we at Insider Monkey have harped on before, and mutual fund giant Donald Yacktman even mentioned it at the Value Investing Congress a couple weeks ago.
In its latest quarter (Q3 FY2013), Apple reported a gross margin of 36.87% and an operating margin of 26.05%. In comparison with the third quarter of its 2012 fiscal year, these represent a decline of 5.31 and 6.99 percentage points, respectively. The previous quarter's results fell by an even sharper amount, with gross and operating margins down 9.87 and 10.46 percentage points year-over-year. In fact, since hitting a peak in the second quarter of its 2012 fiscal year, Apple's margins have fallen for five consecutive quarters.
Some bloggers may argue that the iPhone 5S and 5C can help margins temporarily. Others even go as far to say that continued margin compression will not occur because the 5C is priced at a fairly high level ($550 off-contract, $100-on contract).
Close substitutes, lack of innovation
Regardless of your opinion on where Apple's "cheap" iPhone should have been priced, anyone in this camp is ignoring the main risk facing the company, i.e. the point that Donald Yacktman was trying to make at the VIC. We were in attendance, and Yacktman's reasoning was simple: peers like Samsung and Google (GOOG) provide close substitutes to the iPhone.
Because of this reality, a sustained lack of innovation or a change in buyer preferences could hurt profitability further into the future. The fact that Apple's margins are dropping is likely a result of many factors, and it's quite possible that Yacktman's thesis is beginning to play out.
So how can we measure if a lack of innovation has already begun?
The polls are a place to start. According to Bloomberg's latest global poll, subscribers were asked if Apple "had lost its caché as an industry innovator." A whopping 71% of respondents said yes, with more than a quarter of those surveyed saying they're confident the loss is permanent. The margin of error on this study was estimated at just 3.3 percentage points.
Meanwhile, the co-designer of the original Mac, Hartmut Esslinger, shares the same sentiment. He told Quartz earlier this month that he thinks Apple "has reached in a certain way a saturation" when it comes to innovation.
Similarly, many tech critics have been bored and confused with iOS7, and routinely point out the striking similarities between the platform and Android. At this point, it looks clear that innovation and originality go hand in hand. Nothing about Apple's new operating system indicates that it will cure the company's perceived innovation loss.
With Android still leading Apple significantly in smartphone platform market share according to the likes of IDC, Gartner and comScore, it's also evident that consumers-at least on an aggregate level-agree.
While many investors love Apple stock, we think the reasons discussed above give some rationality why one would hate it. That fact alone, along with deteriorating innovation and a lack of margin protection, should make any bull think twice.
Looking ahead, and risks to our bearish view
Additionally, it's also worth noting that while we're not in line with how Wall Street feels about Apple, sentiment is shifting downward ever so slightly. The number of analysts who think the stock is an outright buy now sits at 35, down five from three months ago. At current prices, over one-fourth of all analysts holding Apple coverage think the stock is a hold or worse, versus about 20% last quarter.
More specifically, though, Credit Suisse recently said in an updated comment last week that it's questioning Apple's momentum, stating that it expects the company's "smartphone share will decline to 15.5%/13.1% this year and next from 18.1% last year." As you could probably guess, Credit Suisse notes that this five-percentage point shrinkage is expected to be a result of "strong competition" from Android. The report does, however, mention that the bank's price target still predicts that Apple's stock price has upside of about 7% from current levels, adding that it expects gross margins to improve by the end of the year slightly (37.6%) before gaining 1.4 percentage points by the end of next year (unfortunately, this report isn't publicly available).
S&P Capital IQ -this report isn't publicly available either- said on September 23rd that it expects Apple to generate gross margins of 38% by the end of this year, with this figure staying relatively constant through the end of the company's 2015 fiscal year. Despite the fact that it doesn't think Apple's efficiency can get back to where it was last year, when gross margins were above 40% (as mentioned above), S&P still thinks the stock can flirt with $590 by this time in 2014.
Now, both S&P and Credit Suisse's forecasts represent a key risk that challenges our negative assertions. If margins do improve by 1 to 2 percentage points as both firms expect in the next year, it would alleviate the concerns that some bears have, and thus, likely improve investor sentiment enough to revalue shares above the $500 mark.
Secondly, most analysts are expecting Apple to sell between 51 million and 54 million iPhone 5C and 5S models combined this quarter, so if sales do build off of a great opening weekend, there's a greater chance for appreciation as well. Most likely, if total iPhone sales did beat analyst estimates, this would indicate that Apple's margins had also beat forecasts, so these points are really two in the same.
Lastly, the biggest risk to any bearish Apple thesis is innovation. If the company is able to reinvigorate consumers with a game-changing product like a smart TV, augmented reality glasses, a smart watch, or a curved-glass iPhone, there's the chance that the company can reach peak margins again. Any attempt to forecast the release of such a device is usually widely inaccurate, but we would like to point out that Apple holds patents on all of the devices we just mentioned.
With that being said, we're still confident that if Apple fails to deliver on a new product launch by the end of next year and undershoots Wall Street's iPhone forecasts, it may very well pay off to be a bear over the intermediate term.