- Apple's lack of catalysts means the share price will likely trend lower throughout 2014.
- iPad upgrade cycles mean lower device turnover than with iPhone.
- Apple TV won't be more than a small incremental increase in revenue if it actually occurs.
Over the past couple of years I have gone from Apple (NASDAQ:AAPL) bull, owning shares in the tech giant, to a disconcerted shareholder, to where I am now, unsure of why anyone would actually want to own this company. The transition was simple; I believed Apple's growth prospects touted by analysts and that its days of growth weren't over. In fact, analysts (and I) were wrong and Apple's days of anything more than incremental growth are over and the stock now is priced exactly where it should be, or perhaps even a bit too high. In this article, I'll take a look at why I think Apple shareholders are desperately clinging to hope that the company will return to growth and why I think that isn't going to happen.
A gripe that I've had in the past is that Apple stubbornly clings to its tiny, outdated design for its biggest seller, the iPhone. While the iPhone was a groundbreaking product at its launch, it has become stale in the years since. It is still a great seller but it is ceding share to Android alternatives such as the Galaxy offering from Samsung (OTC:SSNGY), in particular. Apple has obstinately repelled obvious consumer taste shifts towards larger phones because it thinks people will buy what it tells them to buy. Unlike most companies, Apple isn't interested in what consumers want; it will make something and then assume people will buy it. That worked for a very long time but the last few quarters have proven that it doesn't work anymore; competition is simply too stiff and Apple has failed to adapt.
Here We Go Again
At various times in the past Apple has speculated to have been working on larger iPhones to address the very concern I just raised. However, those speculations have thus far proved groundless. Once again, Apple is reportedly working on a larger iPhone in order to compete with offerings from Android OEMs that are eating Apple's lunch in terms of smartphone market share. Color me skeptical as I'll believe it when I see it but let's assume for a minute that this report, unlike all the others in the past, is actually true. Why has it taken Apple so long to get off of its mindless support for a tiny phone that people have clearly been moving away from for a least a couple of years now? This move smells of desperation to me as Apple knows it is ceding market share and must try to do something, anything, to stop the bleeding.
I know the first thing defenders will say is that Apple is still selling tens of millions of iPhones each quarter and that is true. However, I would suggest that even selling 40 million iPhone per quarter, which Apple isn't close to doing right now, likely isn't enough to justify its nearly $500 billion valuation. Let's face it: Apple is a smartphone seller (56% of last quarter's revenues) with a couple of side businesses including computers and tablets. That means that the most important thing to watch in terms of valuing Apple is its share in the phone market and the margins and pricing power it enjoys therein. With margins and pricing power eroding for several quarters now and market share continuously relinquished to Samsung and others, what is left to like here? You've got a gigantic, stubborn, slow-to-react phone seller that has declining pricing power, margins and market share. Making a larger iPhone, if it actually happens this time, is a move of desperation and one that is at least two years too late. Apple's competitive advantage it used to enjoy is gone and simply making the phone bigger at this point is likely not going to make a material difference to consumers when there are so many other choices in the marketplace now. Apple took its sweet time adapting and it is paying the price for that complacency.
Barron's Is Delusional
In a move that reminds me of the $1,000+ price target days of Apple, Barron's has published a pie-in-the-sky piece on how Apple is going to $635 on a "second-half sales bonanza" that is fueled by upgrades based upon the iPhone 6 and its allegedly larger screens. Barron's reasons that the percentage of installed base users that upgrade to the 6 will jump from the recent trend of 9% or so to 12% to 14%. Consider that for a moment; Apple's installed user base is roughly 260 million so an incremental upgrade conversion of 3% to 5% is an additional 7.8 to 13 million phones that must be sold for Barron's scenario to play out. And that doesn't even include the 23+ million phones that must be sold in order to simply maintain the 9% upgrade cycle norm. Will 30 to 40 million current iPhone users want to upgrade to the 6 when it comes out? I seriously doubt it as history suggests those numbers are far, far too high to be realistic. I think something like 25 million is more likely and when that happens, the stock will trade down again, just like it has with the last few earnings misses.
iPads/Apple TV Will Not Save Apple From Stale Phones
Then there's the upgrade cycle for things that aren't phones: iPads, Macs and (gasp!) TVs. Apple enjoys an enormous portion of its revenue from phones that are upgraded every two years in the US. This means that phones are often replaced whether they need to be or not because carriers offer such attractive subsidies on these phones. This means that Apple's user base, assuming they don't leave for Samsung and the like, pretty reliably provides Apple with more revenue every two years. On a rolling basis, this makes up much of Apple's total revenue. However, with the stale iPhone losing share it has become more important than ever for Apple to diversify its revenue streams.
The iPad has done this to an extent but with its refresh cycle at 2-4 years the installed user base is far less profitable than with the iPhone. In addition, this study cites evidence that 78% of iPad buyers were purchasing one for the first time. This implies that, to Apple's dismay, the installed user base is not providing the kind of refresh revenue that can be counted on for phones. In other words, the lack of a refresh cycle for iPads is a serious detriment to Apple's revenue prospects because it must continue to attract new customers to the line, a feat which can only be accomplished so many times before everyone who wants and iPad has one.
Further, the study cites catalysts for upgrades are obsolescence or significant feature upgrades. Since Apple is famous for incremental upgrades and simply slapping a new number on the end of the product name, that implies to me that upgrades are unlikely to occur with any kind of frequency unless an owner's unit breaks or is otherwise unusable. Finally, the study says that iPad users are likely to give their old units to a friend or family member when they upgrade, instantly removing yet another potential customer from the fold.
TV is even worse which is why Jobs refused to get into that business. Assuming Apple TV actually shows up at some point - again, I'll believe it when I see it - it will be incremental at best. With an upgrade cycle of 5 to 10 years and terrible margins, I have no idea why Apple would want to be in this business. But assuming it does, it will not be the saving grace Apple needs and if other TV makers are a guide, profitability will likely suffer the second Apple begins selling TVs. The lack of an upgrade cycle will only hurt the business further as the TV business has the magic formula of terrible margins and a slow upgrade cycle. In my view, any kind of TV business will likely only account for a few hundred basis points of total revenue, at best.
Given all of this I think Apple shares are still overvalued at $539. I think we'll see Apple miss earnings and sales estimates once again throughout the year, as has become custom since Mr. Cook took the reins, and we'll see shares stagnate and trade down. The $635 price target from Barron's is ridiculous as there are zero catalysts for that kind of move. A company with declining margins and an increasingly obsolete product line is not one that moves up 20% after already sitting at a nearly $500 billion valuation. If you are long Apple you'd better ask yourself why because I think you're going to be disappointed in 2014. Analysts throwing out huge price targets and iPhone sales numbers based on conjecture aren't going to help matters as it simply sets Apple up for more earnings misses.