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Demographics

The world has a population of 7.1 billion people, more or less. Of those, 1.2 billion are under the age of 10.

That leaves 5.9 billion people old enough to contemplate owning a smartphone. UNICEF estimates that 40% of the world's population earns less than $2.00 a day in constant 2005 dollars.

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I am going to go out on a limb and suggest that people under nine and those earning less than $2 a day are unlikely buyers of smartphones in general and iPhones in particular. Another 20% earn between $2 a day and $10 day and are no more likely to buy any devices. If that is the case, the number of people worldwide with the means to buy a smartphone is no more than 40% of 5.9 billion or roughly 2.4 billion.

This market is today pretty well saturated.

Smartphone market saturation

(billions)

Demographic analysis

World population

7.1

Less: Those 9 and under

1.2

5.9

Less: Those earning less than $10 per day

3.5

Potential smartphone customers

2.4

Smartphones sold in 2011-2013

2.4

Saturation level

100%

Of course, the population of potential smartphone owners will grow with population growth and an expanding middle class worldwide. The question is by how much?

"Middle Class" is defined by the United Nations and the Organisation for Economic Co-operation and Development (OECD) as someone who earns or spends $10 to $100 per day.

As you might expect, most of the middle class so defined are in the lower end of that range and the total range encompasses people whose maximum income is $36,500 a year.

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By Interpolating the Brookings data to 2013, I estimate that the "middle class" worldwide amounts to about 2.5 billion persons today. Another 2.8 billion are impoverished leaving 1.8 billion as the "upper class" of which some 300 million are below the age of 10. The total smartphone market of 2.4 billion must therefore include 1.5 billion of the "upper class" and 900 million of the middle class. The growth of the middle class is nonetheless important. About 1.4 billion new members of the "middle class" are expected to enter the middle class between 2009 and 2020. Of course we are about halfway there already as we enter 2014, and that growth is already in the 2.4 billion I mentioned earlier. In any event, adding 130 to 140 million people annually to a base of 2.4 billion is growth of about 5 to 6%, a far cry from the blistering growth of the past few years.

Market Implications

It is important to understand that in smartphones as in any new market place, the market created by initial demand will not only be larger than the market created by replacement demand but also will grow more quickly. If there were 2 billion who had the potential to buy a smartphone when the iPhone was first introduced, the market could grow to a cumulative 2 billion units with no replacement demand at all. But when everyone owns a smartphone, demand from that point forward is going to be a combination of new entrants into the customer pool from growth in the upper "middle class" and replacement demand from existing users.

Qualcomm provided the best data on replacement demand that I have seen, reporting that replacement rates in developed markets were about 40% meaning users on average replaced their smartphone every two and one half years and about 25% in emerging markets where users replace their phones on average every four years.

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For the purpose of this article, I am going to assume that replacement demand from the existing user base is 33%, that is, the average user upgrades their smartphone every 3 years. If the market were saturated today, total replacement demand for smartphones would run about 800 million units. With demand from growth in the customer population as more people enter the middle class adding another 130 to 140 million the 2014 smartphone market should be about 930 to 940 million units. This is less than IDC or Gartner forecasts.

Current Market

IDC estimates over 1 billion smartphones will be shipped in 2013, up from about 800 million in 2012. That market must include both first time smartphone owners and replacement demand, with growth in the first time owner category rapidly falling off and overall market growth slowing as a result.

Data from Samsung (see chart below) support this point of view. Samsung sees the smartphone market at 1.2 billion units in 2014, a 20% growth rate from 2013, and 1.3 billion in 2015, which is barely an 8% growth rate over 2014. While Samsung does see slowing growth, I believe the Samsung forecast, like the IDC and Gartner forecasts, are ambitious given pretty solid data that the market is saturated today.

Premium Segment

The "premium" segment of this market, defined as smartphones priced at $400 U.S. or more, should be about half of the total according to data from Samsung.

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Samsung puts the premium segment at 600 million in 2014 and 700 million units in 2015. Following 2015, the premium segment should fall to about 460 to 470 million units for the reasons set out earlier assuming the premium segment remains at half the market and my demographic analysis holds water.

Competition in the Premium Segment

Apple (NASDAQ:AAPL) is the largest player in the premium segment and all of its iPhones are "premium" priced.

Apple had a commanding 73% of the premium market in 2012 but its share fell to 38% by May 2013 when new premium offerings from Samsung and others entered the market.

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Samsung's introduction of the Galaxy S3 and S4 smartphones took the largest bite out of Apple's dominance, capturing 47% of the segment by May 2013. Other entrants such as LG, HTC, Sony and Motorola also gained ground with their share rising to 15% from 7% of the premium space.

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Apple Response

Apple has no doubt reversed a lot of the damage with its late 2013 introduction of its superb iPhone 5S with its 64-bit A7 processor and fingerprint scanner. The new device has been pretty well sold out since it was launched with Apple having to raise production rates at Foxconn, its supplier, to 500,000 units a day according to internet reports.

Apple's response has been brilliant. Rather than attempting to meet competitors on price in the lower end of the $400 plus smartphone market it has introduced new features and processing power to command an even higher price while pushing back inroads to its market share. Those efforts have been particularly successful in Japan where in October Apple iPhones represented 76% of all smartphones shipments and in the United States where Apple's share of market rose quickly with the launch of the new device.

Going forward, you can expect more of the same from Apple. It will continue to innovate, providing enhancements to user experience, processing power and functionality ahead of its key competitors and taking the high ground in this battle.

iPhone Market Outlook

Sales of 160 million iPhones at about $600 comprise $96 billion of revenue and with a bill of materials per iPhone of $240 more or less iPhone sales contributed value before fixed costs is close to $58 billion.

Even with a 40% share of this premium market Apple iPhone sales will stagnate at between 180 and 190 million units per year. That is not a great deal more than the current sales rate of about 160 million units of iPhones. And, there is a significant risk in the 40% share assumption with strong competitors offering very good designs that compare well to the iPhone on virtually every metric in addition to competition from resale of Apple's own iPhones by those who upgrade.

A substantial part of the premium segment is today represented by "phablets," a category where Apple is not yet represented. IDC puts the Q3 2013 share of "Phablets" at 21% of the smartphone market at an average selling price of $443.

The "phablet" share of the purely premium segment is obviously greater than 21% representing about 42% of that segment if the premium segment holds a 50% share of the total smartphone market. To hold a 40% market share, Apple has to get almost 70% of the available demand for premium smartphones that are not "phablets" in all world markets. Apple may launch its own "phablet" to protect share but this will not improve earnings as I argued in a previous article.

At the same time, average selling prices are likely to fall over time. Electronics of all types tend to fall in price with time, a product of cheaper components and increased competitions. I paid over $10,000 for a Micron laptop in 1995. Today I can get a laptop with 500 times the computing power and 1000 times the storage for less than $500. I see no reason why smartphones will not follow a similar curve.

At 180 million iPhones and a drop in ASP to $575 a unit, iPhone contributed value would be $60 billion versus $58 billion today. If the market saturation has already been reached, the unit sales will be much lower.

Apple's other products

Non-iPhone revenues are about $65 billion and are lower margin than iPhones. The revenue sources comprise iPads, iPods and software and services.

iPads

Analysis by Tech Thoughts puts iPad margins in the 40% range before certain costs.

The Tech Thoughts estimates exclude software, intellectual property royalties, and packaging so actual margins are less.

iPad mini margins and contribution were tested by Monte Carlo simulation by Rags Srinivasan of Iterative Path and his conclusion was that despite high volumes the iPad mini would add very little to Apple profits.

On the other hand, the new iPad Air is definitely in the high margin category with estimates placing its margin in the 45 to 61% range.

It is not unreasonable to attribute a margin rate of 35% to the iPad group as a whole once all costs above the margin line are considered. This is consistent with Apple's total gross margins being sub-40% despite iPhone margins being much higher. If you assume Apple can sell 75 million iPads at $425 ASP and 35% margin you have a $33 billion product line generating about $12 billion in margin.

iPods

iPods remain reasonably profitable with margins in the 40 to 60% range according to Tech Thoughts. iPods thus represent a $4 billion business for Apple with a margin contribution of about $2 billion.

Mac Computers and MacBooks

MacBooks' revenues have been declining for some time in a declining PC market. In total, the computer segment represents at best a $22 billion revenue line with contribution margins very likely about 25% to 30%. Horace Dediu's analysis of Apple's computer margins in late 2012 is a useful benchmark.

Margin from Mac computers of about $6 billion for 2014 and future years is a decent estimate of the high end of its potential.

Software, Services and Accessories

Apple sells about $22 billion annually of software, services and accessories, contributing about $12 billion to margin at a 60% margin rate. This segment is growing but Apple's decision to provide OS upgrades and programs like iLife and iWork for free will limit growth somewhat.

Conclusion

Looking ahead the Apple income statement can be inferred from the foregoing segments.

Revenues should plateau at about $182 billion comprising:

  1. iPhone revenues of $104 billion (180 million iPhones at $575 ASP)
  2. iPad revenues of $32 billion (75 million at $425 ASP)
  3. iPod revenues of $4 billion
  4. Mac revenues of $22 billion (16 million Macs at $1,350 ASP)
  5. Software, services and accessories revenues of $20 billion

At a 38% margin for the total company, this would produce $69 billion of gross margin. Subtract $17 billion for research and development and general and administrative charges, add $1 billion of "Other Income" and subtract taxes of $15 billion at a 26% tax rate and you have net income of $38 billion or roughly $41 per share in 2014, with declines likely in 2015 and following.

This analysis is based on substantially every person on earth who can afford a smartphone buying one; on Apple taking 40% of the over $400 price segment; and, on everyone who owns a smartphone replacing it on average every 3 years. Those are very aggressive assumptions in the direction of giving Apple the benefit of any doubt. Actual results are likely to be somewhat less.

More realistically, not everyone who can afford a smartphone will buy one. Some people just don't want one, a group that includes pretty well all my aunts and uncles in their 90s. Some are completely happy with a feature phone. Some still have landlines that meet all their needs. There are a lot of people who don't need to log onto Facebook first thing in the morning, watch a YouTube video or read Tweets on Twitter.

Some data suggests 15% of Americans don't even use the Internet.

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If 15% of Americans are not online, you can bet that number is greater in other countries. People who don't use the internet have no use for a smartphone.

The data suggest that once the worldwide smartphone market reaches saturation and demand is primarily replacement demand with very few new users, the volume of smartphone sales will fall off a cliff. Apple is particularly exposed because of its concentration is the most saturated group of all, the premium user. Saturation in the premium priced segment is probably occurring right now. For that reason, I am bearish on the outlook for Apple notwithstanding its current surge in price and obvious momentum.

Is this thesis sensible?

I don't think there is a lot of debate about the population demographics so the skeptics will very likely argue that Apple can command a higher than 40% market share or that the premium market as a percentage of the total market is larger than my estimates. Fortunately, for those people, I have provided transparent data and they can do their own arithmetic and draw their own conclusions. Far be it from me to suggest I have a monopoly on arithmetic or common sense.

The important points of this article are not the precise number of people in the segments or the precise market share estimates, they are the common sense points:

  1. The initial growth of the market until everyone owned a smartphone has almost run its course
  2. The premium end of the market comprises somewhere around 450 to 500 million units a year
  3. Apple competes solely in the premium end selling all its phones above the $400 price level
  4. There are real competitors in this space who have taken and will continue to take some share
  5. As an inescapable result, it is very likely Apple will sell the same or fewer iPhones in the future than it is selling today and it will sell them at lower average selling prices.
  6. Sales of fewer iPhones at lower prices will result in lower sales and profits and may be followed by a lower share price.

This article was not an analysis of the North American market or the Latin American market or the China Mobile market or the India market. It was an analysis of the entire population of the world. The data on population and income are not my estimates, they are census and United Nations estimates. The market segmentation data are from Samsung, who knows something about the market. I did not create them.

You can do your own analysis of the same data and draw your own conclusions. And you should if you are betting more than you can afford to lose on the theory that Apple is going to sell millions more iPhones than there are possible customers in the price segment where they operate. You will simply have a bad experience.

Apple may have new products on the horizon, which will more than offset the maturing smartphone market. So may Apple's competitors. Investors who choose to bet on possible innovations that no one knows about will have some successes and some failures. But based on the product portfolio it has today, Apple has about run its course in terms of profit growth and there is more downside risk than there is upside potential.

I have taken a lot of flak on this site from people bullish on Apple. They love Apple and they love the Apple products they own. Their comments are not always polite, sometimes based more on emotion than reason, and frequently become personal attacks on me. That does not reflect well on them neither as people or investors. They still have value. The hysteria in the comments makes me even more convinced there is money to be made on the short side of this trade.

I first considered short selling when I had just been appointed a Vice President of Canada General Electric and as I drove to my new office in downtown Toronto for the first time I passed a shop called Charlton Numismatics and there were literally hundreds of people lined up outside to buy gold, which had passed $1,000 an ounce. When cab drivers and school teachers are lining up in the cold to buy a commodity, which is at or near an all time high, the market is close to a top. That is time to short.

I have the same sense when I see sane and rational people lined up overnight to buy an iPhone, not because they could not get one from the convenience of their home by ordering it online a few days later but because it was not only important to get one but also essential that they get one first.

If my children were among them I would have to give them some advice. Slow down a bit. Back off the caffeine. Think before you act. There is more to life than the phone you own at some point in time. For you readers over 30, can you remember the brand of telephone your grandparents owned? I doubt it. And if you can, I am fairly confident it did not matter to you then or now.

My articles on this site are not to give advice but to share ideas. The value is in the dialogue and it only has value if it includes facts, logic and common sense.

Thanks for reading. I currently hold Apple puts on 1,000 shares at a $485 strike with April 2014 expiry. I expect them to expire worthless but I hold them in the event the market replaces euphoria with reason and the stock corrects. I will add to this short position in size when I think the current "Bull Run" approaches exhaustion.

Good luck with your investments. And don't make any investments based on anything I have written. Make up your own mind and get professional advice.

Source: Demographics, Manias And The Short Case For Apple Explained

Additional disclosure: I hold puts on 1,000 share of Apple at $485 strike for April 2014 expiry