Apple Earnings: Getting Past The Dip

Jan.28.14 | About: Apple Inc. (AAPL)

In my Apple (NASDAQ:AAPL) earnings preview article I had predicted a post-report sell-off, to the tune of a 5% drop, and what we got was 7.5%. Not that predicting the sell-off was any great accomplishment: such sell-offs have become entirely predictable. Is this the prelude to another long Apple slide? Not this time.

Before I go into why this year will be different, let me first get my prediction mea culpas out of the way. In terms of overall financial performance, I didn't do too badly, missing slightly to the low side:

I had predicted modest revenue growth and flat operating income compared to the year ago quarter, and that's basically what we got.

One comment I received pointed out that my operating income assumed operating expenses of $4.12 billion, below Apple's guidance of $4.4 billion as of the calendar Q3 earnings report. I replied that I expected Apple to have a hard time spending that much money, and in fact Apple did come in slightly below guidance at $4.38 billion. R&D spending saw a commendably large boost of almost 14% sequentially. I've been advocating increasing R&D spending since my article of May of last year, so I was happy to be wrong about operating expenses.

Where I really went wrong was on my iPhone unit sales prediction:

The fact that most other analysts erred on iPhone sales is only a partial consolation. Where did I go wrong? I don't think the problem was really inability to meet demand. On the conference call, Peter Oppenheimer repeatedly stated that Apple achieved iPhone supply-demand balance by the end of the quarter. Although consumers had to wait as much as two weeks to get an iPhone 5s, basically everyone who wanted one got theirs by the end of the quarter. Lack of immediate fulfillment probably cost Apple some iPhone sales, but not 7 million.

The 5c Failure

I think the basic problem was that the iPhone 5c was a sales no-show. From the very start, it was never sold out, indicating that demand was weak. In the conference call, Apple acknowledged that it had to shift production away from the 5c to the 5s in order to meet demand, resulting in a higher than expected gross margin. Given the reason, this was not good news.

Also since May 2013 I've been advocating product diversification of the iPhone. This meant not merely offering discounted older models, but all-new models engineered from the ground up for a variety of form factors and price points. Apple provides such diversity for all of its other product lines. In hindsight, the 5c appears a very half-hearted attempt at this. A plastic case? What other Apple product has a plastic case? Not any Mac Book. Not any Mac. Not any iPod. Not any iPad. Not any other iPhone. The plastic case just telegraphed cheapness, without really being cheap.

According to IHS/iSupply, the cost of the 5c case was just $13 lower than the cost of the original iPhone 5 aluminum case. The innards of the 5c were the same as the 5, so costs for a 5 and 5c, if manufactured at the same time using the same parts would be about the same except for the case. This is the fundamental reason the 5c couldn't be as inexpensive as many were expecting.

It could be argued that Apple would have done better selling a discounted iPhone 5, as it has in the past, rather than the 5c. But this would be the wrong lesson to learn. The problem here is that Apple didn't really engineer a different and lower cost phone, but merely repackaged the 5, and the packaging was less attractive than the original.

For the past several conference calls, Apple management have been asked about truly diversifying the iPhone product line, and this latest call was no exception. The analyst prefaced the question by pointing out that even as Apple wants to make the best personal computer, it offers the Mac in a variety of form factors and price points. And this quarter, the analyst pointed out, the Mac gained market share relative to the PC industry. Why not do this with the iPhone? And as usual, the analyst didn't get a very good answer, with Tim Cook simply pointing out that Apple had just started to offer for the first time two new iPhone models, the 5s and 5c.

As if the 5c were really a new phone. In the 5c Apple succumbed to an uncharacteristic moment of weakness, resorting to a cheap rebadging of the iPhone 5. During the conference call, it became clear that Apple is re-thinking this strategy, as well they should.

Looking Forward

During the conference call, Tim Cook confirmed that 2014 will indeed be the year of new Apple product categories, not just newly upgraded products, although he wouldn't go into details. The new categories, combined with more judicious diversification of iPhone should restore Apple to revenue growth in the 10-15% range. I'll have more analysis of the financial impact of these products in forthcoming articles, but let me just highlight the products.

1) Finally, larger screen iPhones and iPads. With the A7 processor, the iPhone 5s is capable of supporting the larger screen resolution of the iPad, and with everyone clamoring for a large screen, a roughly 5 inch screen is a slam dunk for iPhone 6. A larger screen iPad "Pro" has been rumored for a while, and I think this would have strong appeal and serve to counter touch screen enabled Windows 8 all-in-ones.

Will the iPhone 6 screen use sapphire, as Seeking Alpha contributor Matt Margolis has suggested? Probably not. Margolis expects the fabrication cost for sapphire to become comparable to glass. I don't. The very properties that make sapphire desirable as a screen material (its hardness) also make it much more expensive to produce than glass.

Sapphire screens for smart phones also seem a solution in search of a problem. Most of the time, our phones are tucked away in a pocket or purse where they're protected from scratches (with a little care). The killer app for sapphire is. . .

2) iWatch. Sapphire crystals are pretty common on watches, because they're much more exposed and prone to scratches. Apple has correctly discerned that it's needed to make the iWatch practical. Apple's purchase of the sapphire fabrication plant in Mesa, AZ, from GT Advanced Technologies is the best indicator I can think of that the iWatch is really on its way to consumers.

As to what the iWatch consists of, basically it's an iPod Nano with Bluetooth connection capability so that it can connect to an iPhone to make and receive calls, check messages and emails.

3) iTV. Many of us noticed that with the introduction of the new Mac Pro, Apple didn't provide an updated Thunderbolt display to go with it. Instead, Apple offers a third party Ultra HD display with 3840x2160 pixels. Probably an updated Thunderbolt display with UHD capability is in the works, but perhaps Apple wanted to avoid a conflict with a UHD capable iTV.

It's clear that UHD is where video production has gone, but it's not clear to some that it will gain broad consumer acceptance in the home. I disagree. I believe it will be the next wave of consumer TVs, and Apple can offer the best solution for content distribution, which is a real stumbling block for consumer acceptance. UHD content can't currently be distributed over conventional broadcast TV or cable, and manufacturers such as Sony have resorted to download over the Internet using a separate media server.

iTV will integrate the media server into the television, and use iTunes as the user interface. Think of iTV as a TV with a very large hard drive, able to download content over the Internet in the background, unattended.

iTV will be part of a larger push by Apple into the living room, to counter Microsoft's (NASDAQ:MSFT) Xbox One. iTV will be iOS game and App capable, and provide audio connectivity to remote wireless speakers. Here, Apple will be trying for the beautifully integrated and simplified experience that has become its hallmark.

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.