Many investors scream as a result of logical, unbiased (I don’t even have a position in Apple (NASDAQ:AAPL)… yet) analysis and off-the-wall thinking that is just so different from what the retail is used to getting from the sell side shops that routinely rip them off. And then there's the institutions that pay 2 and 20 for leveraged beta rides that often do little else than follow the crowd.
I’ve decided to throw some more fuel on the fire to see if I can make some baked Apples. Bloomberg did an article on a survery of 2500 analysts, and the number one ranked analyst since Jan. 2008 only racked up 38% in correct calls. I am not trying to impinge upon the sell side guys that give it their honest all, for I know there are a lot that work hard under very political conditions, but the investing public should know better by now.
You see, I thought it was rather prescient to call margin compression, live on CNBC (3:40 into the video), just hours before Apple announced… Margin Compression… At a time when just about everyone who could spell Apple shouted Buy! Buy! Buy! Buy! Buy!!! It’s not as if the stock didn’t tank. It’s not as if I didn’t tell you so. I actually like Apple as a company. It’s quite successful and a whiz at marketing and product design. What I don’t like is how everyone decides to shut their brain off and let their hearts do the talking (and investing) when it comes to Apple. And, they do so with passion if not downright blind idolism at that. Because of this “social phenomenon” that used to be research and analysis, I’m giving it raw, straight up and uncut.
Many have emailed me and said the margin compression was due to the inability to source components, not competition. Well, my dear future and potential BoomBustBloggers – that makes no sense. Competition will always challenge margins, and competition on the scale that Apple is going to encounter will do so even more. You cannot separate component sourcing from competition. In the case of Apple, the two are literally joined at the hip-- to Apple’s disadvantage as I will illustrate in graphic detail below.
So, following up on the piece that I did just a few hours ago – Reggie Middleton Wasn’t the ONLY Openly Apple Bear in the Blogoshpere, Was He? along with this cute chart…
Click to enlarge:
I wanted to excerpt a few snippets from this Bloomberg piece, which actually had money managers thinking realistically on Apple as well as a few comments by Steve Jobs, in order for me to set the stage for illustrating how we at the BoomBust attempt to model reality. First, we start off with a realistic way of thing…
“The rising popularity of devices using Google’s (NASDAQ:GOOG) Android software may hurt Apple in the long term, said Michael Obuchowski, chief investment officer of First Empire Asset Management, which holds Apple shares. “Everyone is closing in and it’s a huge question of how they are going to respond,” said Obuchowski, whose firm oversees $4 billion. “I’m really worried about Apple; I’m not convinced that I’m going to hold Apple two years from now.”"
Jobs dismissed the threat of rivals. Apple’s approach of designing the software and hardware for its devices results in a better user experience, he said. By contrast, Google gives Android free to handset makers including Motorola (MOT) Inc. and HTC Corp. (OTC:HTCCF), creating a “commodity” experience, he said. “We are very committed to the integrated approach, no matter how many times Google tries to characterize it as closed,” Jobs said. He said Apple is outselling BlackBerry-maker RIM (RIMM) and he doesn’t “see them catching up with us in the foreseeable future.”"
Notice how he failed to say Apple was outselling Android. This is material, because they were materially outselling Android 2 and 3 quarters ago. Androids growth rate is simply phenomenal, and its business model may prove unassailable unless Apple makes some drastic changes (ex. allowing cloning). These are changes that I doubt management will be willing to make. Jobs also (understandably) failed to mention that the “commodity’ Androids materially outperform the iOS products in terms of features and functionality. This is pretty much in direct contravention to the concept of the term “commodity”, isn’t it? I don’t think many Samsung (OTC:SSNLF) Galaxy S, Droid X or HTC (OTC:HTCCF) Evo owners will characterize their devices as “commodities”.
“Munster, who estimated Apple would sell 11 million iPhones, said last week that supply shortages likely held back sales of both the smartphone and iPad. The cost of making the iPhone may be increasing, said Andy Hargreaves, an analyst at Pacific Crest Securities in Portland, Oregon. The device accounts for 43 percent of Apple’s revenue [and much more of their profit!!!]. ‘‘We saw what we think is a pretty remarkable increase in iPhone costs,” and that’s fueled concern over margins, Hargreaves said in an interview with Bloomberg Television.”
Good to know he’s been reading BoomBustBlog. Remember, supply shortages can very well stem from competition for suppliers and supplier’s attention. Is it Android again? Here’s a hint: Does the sole patent holder and sole manufacturer of Apple’s branded IPS Retina Screen plan to become one of the most prolific Android phone vendor’s in the world? If so, where does that leave Apple? Margin compression!!! Or worse. Read up:
Verizon Phone – Even so, competition is increasing. The Android operating system was the most popular smartphone software in the U.S. in the second quarter, according to Gartner Inc. Samsung (OTC:SSNLF), HTC, Motorola and Dell Inc. (NASDAQ:DELL) are among the companies using Android in tablet computers to rival the iPad. Hewlett-Packard Co. (NYSE:HPQ), the largest computer maker, is developing a tablet computer.
Apple may get a sales boost by expanding the availability of the iPhone in the U.S. Verizon Wireless may begin selling it in January, two people familiar with the matter said in June.
You can bet that the deal Verizon (NYSE:VZ) cut is nowhere near as sweet as the one AT&T (NYSE:T) gave Apple. What does this spell? Margin compression in the quest for wider distribution to prevent Android (to late) from gaining critical mass and taking over.
Jobs also said he’s been surprised by iPad purchases by business customers. “We haven’t pushed it real hard in business and it’s being grabbed out of our hands,” Jobs said. “The more time that passes, the more I am convinced that we’ve got a tiger by the tail."
I agree that the business adoption for the iPad is cool and big positive development. I don’t see why Jobs would be shocked, for simple consumption the iPad is truly a marvel. But, the caveat still remains: Will Android devices outperform at the same or lower price points? Probably. Will Android proliferation drive up costs and drive down margin? Most definitely, and in ways that most retail and many institutional investors don’t realize!
Higher production costs for the iPhone 4 are all but guaranteed! The most critical parts of the device are sourced from the biggest vendors of Android devices in the world! For these vendors, Android is one of their (if not the) most lucrative revenue drivers. Where do you think their loyalties lay?
The margin-destructive risks and higher costs of the iPhone 4 are due to two specific parts which are unique to this iteration of the iPhone – the sharp display and the very snappy CPU. The “retina display,” which Steve Jobs himself has admitted is “the most important component of the entire phone”, is also the most expensive. iSuppli states that each display, built by a subsidiary of LG Electronics of Korea (OTC:LGERF), costs $28.50. I quote Steve Jobs, via CNET:
We think this will set the standard for displays for the next several years.” | “Display is the most important component of the entire phone, he says.
Here’s a newsflash. LG Electronics is vying to become the largest vendor of Android phones in the world and they own the IPS Retina Technology, as well as being the sole manufacturer of the screens. My readers are smart enough to connect the .dot(s) themselves. Spell it out again – margin compression!
This is an excerpt of the note that I sent over to my analysts on 8/25, insisting that they rehash the freshly built Apple model. Yes, even they were Apple bugs, so eventually I sat down with them and we did it together. This is why the Apple forensic analysis is not ready, it (as well as the Google report) had to be done over (twice!) in order to remove bias and perform a more granular analysis and achieve a more realistic result. I actually bounced the project from one team to another and participated significantly in the model theory, structure and fine tuning process; I rarely participate in the structuring process anymore. I usually create the theory and then fine tune the end product. Here’s an excerpt of my note sent to the original crew:
1) …It is unlikely that Apple will be able to replicate the sweetheart deal it cut with AT&T, particularly after several telcos worldwide have actually taken losses selling iPhones despite the fact that unit sales were brisk. This, in combination with the threat of Android is bound to bring ASP down, and probably more than 1%. I see there is a differentiation between iPhone 4 and older models in the revenue cells, this needs to be trended. I believe cost to the consumer may be fairly static for the time being due to telco subsidies, but telcos will definitely be more hardnosed than AT&T has been due to the benefit of hindsight and the availability of other popular options in the Android lines, plus the ability to customize Android to their liking. The customization is a strong selling point for Android to telcos, thus although more (possibly many more) units will be sold, ASP will probably drop as well as development and costs increasing. There may be component sourcing conflict as well as Apple competes with its own suppliers in smart phone sales, ex. LG Group who controls LG Display who sells the technology behind the IPS screen also makes a direct iPhone competitor, the LG series phones running Android.
See this quip from Wikipedia:
LG Electronics (Korean: LG전자, KRX: 066570, LSE: LGLD) is the world’s second-largest manufacturer of Television sets and third-largest producer of mobile phones.With its headquarters in the LG Twin Towers in Yeouido, Seoul, South Korea, LG Electronics is the flagship company of LG Group, one of the world’s largest electronic conglomerates. The company has 75 subsidiaries worldwide that design and manufacture televisions, home appliances, and telecommunications devices. LG Electronics owns Zenith Electronics and controls 37.91 percent of LG Display.
2) LG Display is the exclusive maker of the IPS Retina screen, the iPhone’s single most expensive component (about $28, and its most differentiating attribute, by far), and is literally controlled by a direct competitor, LG electronics, all under the LG Group of companies. LG Electronics has put substantial resources behind the Android effort, the single biggest threat to Apple’s dominance in Smart phone margins, profit and revenue growth, mindshare/market share growth. More on LG Electronics Mobile aspirations: LG Electronics (Korean: LG전자, KRX: 066570, LSE: LGLD) is the world’s second-largest manufacturer of Television sets and third-largest producer of mobile phones.
3) LG Electronics is bound to crowd out Apple for competition of the limited production capacity IPS retina screens. See the following article for a backgrounder., and keep in mind that with this level of competition, the better case scenario is that prices go up – the more likely scenario is that Apple may not be able to secure the parts and may have to switch technology and supplies since the supplier of its most expensive, most mandatory and most differentiating component is owned by a direct competitor using the OS that is the biggest threat that the iPhone franchise has ever faced.
a. Even if it wasn’t on the top of choices with its Android phones, LG is now bringing on the market two smartphones from its Optimus Series with Android 2.2 on board. While other owners of Android phones are still waiting for an official update, LG doesn’t waste time and announces the Optimus One and Chic.
LG has only one phone running Android OS so far, LG Ally from Verizon, but things will change, because the company is determined to introduce around ten new smart devices “in the second half of this year under the LG Optimus label” as well as Android Tablet PCs.
But the launch of more Android devices depends of the impact of Optimus One and Chic over in the UK. Both models, the Optimus One with Google and LG Optimus Chic has incorporated the speedy Android Platform 2.2. No other specs for the phones have been revealed at this point.
|The LG Android phone series|
The iPhone 4’s second most differentiating component is the snappy processor. It is the Samsung-powered A4 chip, designed in-house by Apple.
You should be saying to yourself, “Hey, wait a minute. Doesn’t Samsung make those Snazzy Galaxy Android phones and that new Android tablet???” There ya go!
|Samsung Galaxy S Android Phone Series||The Samsung Tab Android tablet|
Samsung (the 2nd most prolific Android vendor, behind HTC), makes the A4 chip that costs Apple $10.75 each, and is probably the second most expensive (and critically differentiating) component in the iPhone!!!
Samsung and LG, literally two of Apple’s staunchest competitors in the space where they derive a whopping 70% of their profits, has the company at a disadvantage in regards to sourcing of the most important, most differentiating, and most expensive components in the company’s most important, proftable and strategic product - (Steve Jobs admitted). That is a most compelling argument to make a mostly assured case for (I can’t practically fit “most” in here again, but I’m going to give it a shot anyway) a most material increase in margin compression!!! Ha, I dd it – so there.
More on the Creatively Destructive Pace of Technology Innovation and the Paradigm Shift known as the Mobile Computing Wars!
This article should drive the point home: An iPhone 4 Recall Will Hurt Apple More By Opening
Disclosure: No positions in Apple, yet - Long Google