Apple's Earnings Mediocrity

Oct.29.13 | About: Apple Inc. (AAPL)

Unwilling to take the risks necessary to achieve substantial revenue growth, but unwilling also to defend its profits by reverting to the role of "boutique" electronics manufacturer, Apple (NASDAQ:AAPL) has steered a middle course that has achieved only minimal revenue growth and declining earnings. In Q3 Apple's revenue grew by only 4%, while net income fell by 8.6%.

Apple is on the verge of suffering a slow, agonizing "death by half-measures" that is the fate of corporations with unimaginative and risk-averse managements. By being excruciating careful not to fail, they deny themselves any opportunity to succeed.

The "Amazing" Year

In Apple's earnings conference call, CEO Tim Cook stated that Apple had posted "a strong finish to an amazing year. . ." But Apple's performance can only be amazing to those Apple bears who at the beginning of the year were forecasting the collapse of Apple (with share prices in the $200s).

My expectations for Apple were considerably higher. I never bought the bear case, since it was largely fueled by a fantasy of Microsoft (NASDAQ:MSFT) trouncing Apple in mobile the way it did in desktops in the 90's. In past articles such as "Is Windows 8 a Success?", I've given the reasons I didn't expect Windows 8 to do particularly well, but basically it comes down to the fact that even 8.1 is still a clumsy pastiche of desktop and mobile operating systems. That consumers are not turned on by Windows 8 can be seen in the 22% q/q decline in consumer-oriented Windows OEM revenue that MS reported for Q3.

Relief that the bear scenario never panned out, combined with an excellent, if not amazing, lineup of products for the Fall, have served to minimize negative investor reaction to the earnings report. The new iPhone 5s, which is selling exceedingly well and still back ordered 2-3 weeks on the Apple Store, is a major bright spot. The 64-bit A7 processor of the phone is the one true innovation that Apple brought to consumers in 2013. When I last wrote about the A7, it was being given short shrift in business articles, which barely made mention of it. I also read numerous comments to the effect that the benefits of the A7 processor would be minimal.

This viewpoint was thoroughly demolished by Anandtech's review of the iPhone 5s, in which Apple's claimed 2X speed improvement (over the iPhone 5) was amply confirmed. Not only that, the 5s turned out to be faster than any other smart phone Anandtech tested. Bringing the A7 to the new iPad Air and mini will also benefit sales.

Safe and Predictable

Except for the A7, every one of Apple's "amazing" new products have been safe, predictable upgrades. The analyst disappointment with the lack of new product categories was palpable during the earnings call. At one point, Cook fielded a question that assumed that Apple had promised new product categories for Fall 2013 and asked if these had been pushed back into 2014. Cook quickly corrected the question's assumption: no new product categories had been promised, and Cook went on to clarify that he only meant that Apple was "capable" of introducing new product categories based on the strength of Apple's talented workforce.

This seemed to push the arrival of iWatch or iTV even further into the future. Could Apple have brought these products to the public by now? Speaking as an engineer and Apple developer, I'm willing to state with certitude bordering on the metaphysical that there is absolutely no technical reason that Apple doesn't offer those products right now, and I'm certain that they exist as experimental prototypes in Apple's labs.

What it comes down to is the process by which such R&D projects get approved. The role of traditional management is mostly inhibitory, filtering the various projects based on criteria usually summed up by the phrase "business case". The upper management of technology companies, mostly MBAs, always want the "business case" for the product, while the scientists and engineers working to develop a product struggle to figure out what the managers mean. The two groups, speaking fundamentally different languages, often struggle to communicate.

How do you make a business case for something consumers don't yet know they need? It's difficult. Managers often resort to consumer focus groups to test reactions to new products. But the focus groups usually aren't given much time with a new product, and the results are often superficial. The best managers, the ones considered "visionary", such as Jobs or Morita, stand at the juncture of the technical and business viewpoints and somehow manage to create a synthesis of the two.

So Apple's truly new products languish in the laboratory, unable to run the gauntlet of "business case" reviews set for them by management. It's easy to obsess about this, but I've also never bought into the idea that Apple can't be successful without "the next big thing". It can, by continuing to introduce new products, even if these are not new product categories.

Some Progress

In "What Tim Cook Must Do to Turn Apple Around" I advocated greater product diversification especially in iPhone and iPad. Here, there has been some progress. With the iPhone 5c, Apple finally started introducing a new lower cost iPhone rather than simply discounting older models. But the lack of a larger screen iPhone was a major disappointment.

Apple further diversified the iPad line as well, but once again in a minimal way. The iPad mini received an A7 processor and retina display, but the form factor remained unchanged. The iPad Air received new packaging along with the A7, after a two year run with the 3rd gen mechanical design.

There has also been important progress in another area I discuss in the "Turnaround" article, R&D spending. While revenue only grew by 4%, R&D spending increased by 29% y/y. Clearly, Cook has gotten the message with regard to R&D spending. Here, my message is a simple one: technology innovation mostly depends on the hard work of the scientists and engineers who work in R&D and whose salaries are paid out of the R&D budget.

Where I fault Apple the most is the issue of gross margin. Here I take a very contrarian view. There has been altogether too much attention paid to profit by analysts, Apple investors, and even Apple management. What Apple needs is the "Damn the profits, full speed ahead!" approach of Jeff Bezos, CEO of Amazon. With $130 billion (cash less long term debt), Apple doesn't need profits. What Apple needs is more growth, growth in its customer base, device sales, and total revenue.

This is necessitated by the fact that Google (NASDAQ:GOOG) is growing explosively, with y/y revenue growth of 12% for Q3 and Android activations topping 1 billion. While Microsoft struggles to gain consumer traction with Windows 8.1, Google is Apple's principal threat.

Yet we see Apple management more concerned about protecting margins than pursuing growth. At the conference call CFO Peter Oppenheimer was quite pleased that projected margins for the December quarter would be about the same as the 3rd quarter. This is completely misguided, and panders to "activist" investors mostly interested in relieving Apple of its excess cash.

Doomed Contradictions

With all my complaining about Apple, the reader may well wonder why I'm still an Apple investor. The answer is simple. I see tremendous untapped potential in Apple. I see a wealth of new products, if Apple's management would stop sitting on them. I see a superior mobile OS that could enjoy a renaissance of growth if only it was more affordable. I see $130 billion in cash that could be used to make Apple competitively invulnerable.

Most of all I see a management that's drinking its own bath water by making claims that a particular approach or product is the "best", then being unwilling to deviate from what is "best". Thus, after claiming that the screen size of the iPhone 5 was the best size, Apple has been unwilling to build a larger screen, even though the whole universe of smart phones has moved on. Thus, after claiming that notebooks and desktops with touch screens were unnecessary, Apple is about to be left behind by the personal computer industry which is embracing ubiquitous touch screens. This is especially ironic given that Apple pioneered touch screen computing with the iPad.

Being unwilling to embrace change, while claiming to be a technology innovator, is a contradiction that cannot long continue.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.