Apple: A Reversal Of Fortune Seems Inevitable

| About: Apple Inc. (AAPL)


Market share declines taking a toll.

Losing ground in China to Xiaomi.

Dependent primarily on replacement demand.

There are three keys to long term success in maturing markets. Market share, market share and market share. This axiom is as old as the study of economics. Sidney Shoeffler at General Electric kicked of the Profit Impact of Marketing Strategy (PIMS) studies in the 1960's, subject of very good read by Tom Peters and Nancy Austin. The extensive study was carried out through 1983, the year I was made a Vice President of GE, and had a profound impact on the strategic thinking of that company and its enormous success under newly elected CEO Jack Welch, one the great industrial leaders of the past century in my opinion.

While the study identified many variables as contributing to success, the key variable was a strong market position in most cases. High market share had benefits in brand strength; economies of scale in manufacturing; efficient distribution; greater capital efficiencies and the ability to put a lot of resource behind a critical factor - product quality.

A typical mature market often shakes out with a strong leader enjoying 30 to 40% market share; a viable number two with 20 to 25%; and, a pile of marginally profitable or money losing others struggling to eke out an existence by finding a niche or a local advantage, usually without a lot of success.

Jack Welch simplified strategy in GE by deciding to exit businesses where GE could not be either number one or number two in the industry. He realized that success in the lower tiers was difficult if at all possible.

Changes in outsourcing of assembly and components have altered the landscape a lot since the 1980's so that economies of scale in manufacturing may lie with suppliers rather than with OEMs. The car industry is a great example where a robust parts and support industry make it quite efficient to assemble a car and keep the costs extraordinarily low. At the same time, the industry as a whole has large cycles which range from steep losses in downturns to just acceptable profits in the good times, and no one has a record of making great returns year in and year out. With efficient manufacturing available to all players by outsourcing, the real advantage of scale is marketing and distribution.

We are witnessing the maturing of the smartphone industry. The days of blistering growth are gone and year over year growth has fallen to below 25% from a few years of dramatically higher rates of expansion. I expect that rate of growth to continue to abate over the coming years.

Samsung (OTC:SSNLF) emerged as the leader but is now experiencing market share declines that must be worrisome for its board of directors. Year over year sales were down 4% in a market that grew 23%. But rival Apple (NASDAQ:AAPL) was not the cause. Apple continued its trend of dropping market share in return for higher margins and showed 12% growth, about half the growth of the market as a whole.

The emerging winners are Asian. Huawei turned in a 95% year over year jump in units shipped. Lenovo continues to take ground with a 39% rise. And, not yet on the top five list, upstart Xiaomi is advancing quickly to become one of the major suppliers in China.

I take a lot of flak for being short Apple which has enjoyed a remarkable run, but the comments are less painful than the financial hit. Sure, I have mitigated the damage somewhat through hedging but so far I have taken a bath on the position. Am I worried? Not yet.

As the data come in they reinforce the trend. In the case of Apple, its market share losses came despite some price cutting somewhere since its average selling price has dropped to $561 from well over $600 in recent quarters. Margin rates were up in Q3 but Apple executives forecast them to come right back down again in Q4, an indication that the gains were more likely accounting based than any material change in costs.

It was only a few years ago that BlackBerry (NASDAQ:BBRY) started paying more attention to profits than to competition and saw its market share tank. It was only three years ago, in 2011, that BlackBerry's market share fell below 13%, about where Apple is today.

BlackBerry profits were still rising as its market fell through the spring of 2011 as sales of the iPhone eclipsed those of the venerable BlackBerry.

Source: The Guardian

Despite its share losses, BlackBerry profits rose about 40% in 2011 and investors took heart that its "share of profits" was still robust. Regrettably for BlackBerry investors, BlackBerry's hubris was soon apparent, as its profits took a sharp downward trend in early 2012 followed by major losses in 2013 and 2014.

Does a similar fate await Apple? Most say not but the possibility is ever present.

As I see it, Apple today is more or less where BlackBerry was in 2011. It is still growing and is very profitable; it has new products on the horizon with high expectations for their popularity; and, it seems oblivious to the rapid rise and increasing popularity of Asian competitors who are selling extremely capable devices backed by a fully competitive ecosystem at half the price of an iPhone or less.

The parallels are hard to ignore. In the key China market, reports of Apple's iPhone market share range from 7% (based on units) to 16% (based on revenues). The data are sparse and in some cases unreliable but a bit of cross checking can put some of the corners on the possibilities.

The most recent report of China smartphone sales dollars that I have seen puts Samsung in first place followed by Xiaomi and then Apple, with fast growing Huawei, Lenovo and LG not that far behind.


Given that Xiaomi sells its smartphones at prices about half of those charged by Apple for its iPhone, you can see that Xiaomi sold twice as many smartphone units as Apple in China in the 5 months through May.

Looking at global unit sales, IDC reports that in the June quarter Samsung sold 74 million units; Apple 35 million; Huawei 20 million; Lenovo 16 million; and, LG 15 million. Not on the top five list but close behind is Xiaomi which sold 26.1 million smartphones in the first half, triple its 2013 sales volume. Xiaomi seems certain to eclipse LG and Lenovo to take a third position worldwide this year despite confining its sales to China originally and more recently to other parts of Asia. If in fact the Xiaomi sales figure was twice as many as iPhone unit sales in China, it seems likely that iPhone sales in that country are running at about 2 million units a month. Adjust for seasonality and the lack of an iPhablet to late September at the earliest, and Apple might be expected to sell 25 to 30 million units of its iPhone into China in the current fiscal year. That is a solid performance but a far cry from the dramatic growth many predicted when Tim Cook announced the China Mobile (NYSE:CHL) deal in early 2014.

Tim Cook's enthusiasm for the forthcoming iPhone 6 is genuine and infectious. I almost wanted to buy one. Almost but not quite. It is simply a larger screen version of an existing device no doubt with a few tweaks.

I am reminded of Thorsten Heins' ebullience as he paraded the new Z10 and Q10 on stage saying BlackBerry would sell tens of millions of them. I think he meant that year rather than through the next decade. Heins is gone and the BB10 devices have a niche market for antiquarians like me who still care about personal security. I am comforted to see Angela Merkel still relies on a BlackBerry. But regardless of its niche, it is no longer a force in smartphones while only a few years ago it reigned supreme.

For Apple, I fear the same fate awaits. Short term profits and fat margins at the expense of market share is a fool's game. The number of companies who have been damaged by that strategy is legion. We don't hear much of Packard; Hudson; or Cord in the automobile market any more. Xerox was eaten alive in copiers by Canon and in printers by Hewlett-Packard (NYSE:HPQ) who offered outstanding devices at much lower prices while Xerox tried to hang on to margins. Even in retail, market share is seen as a key determinant of success.

So far, the Apple bulls have won the day with their oft repeated "it is share of profit that matters" for there is no disputing that Apple has the lion's share of profits in the smartphone world. But Apple's relentless loss of share seems to be a pervasive trend. I wonder if the Apple fan club will start to notice the shift if Huawei passes Apple in market share in the next twelve months? It just needs to repeat the progress it made in the past year to do so.

Interestingly, Samsung has found itself facing the same competitive forces that I see as persistently dogging Apple with the loss of a massive chunk of its own market share in the June quarter. Unlike Apple, I expect Samsung to come out swinging to defend its turf.

With China making up one third of the global market and India likely to move into second place sometime in the next several years as I see it, success in these two markets will determine the winners and losers in the smartphone wars over the coming few years.

In China, the most recent data suggest that Xiaomi is emerging as the leader while the iPhone is nowhere to be found in the top five.

The folklore is that Xiaomi is not a direct competitor to Apple since it sells at a much lower price point. The critics just miss the boat. Xiaomi sells very good devices at very low prices and its target customers are not the lower end of the market where price is the key to sales but the young professionals who have money but want value for what they spend, illustrated by these survey results from Flurry Analytics.

Source: Tech-Thoughts

Using the iPhone as a reference point, Flurry found "user engagement" on Xiaomi devices rivaled that of the iPhone, laying to rest the idea that serious users preferred iOS.

Analysts are projecting robust demand for the forthcoming iPhone 6. Samir Singh on Tech-Thoughts has done some excellent analysis of the consensus forecasts and seems to debunk their foundation using forecasts by Canaccord Genuity as a proxy for the group.

The Canaccord forecast data show very high replacement demand for the new device, an acceleration in the replacement rate that seems without much support except for the hype.

It is hard to see why twice as many iPhone users would upgrade to the iPhone 6 at a faster clip than they have to earlier versions given the new iPhone simply offers a larger screen, a potentially faster processor and very little else. While the larger screen will be welcomed by many, there have been a lot of larger screen devices in the market for several years and if the screen size was the key determinant, those users would have switched devices long ago but for the ones that cannot imagine using anything but an iPhone. As far as the processor goes, Apple's move to 64-bit computing generated a lot of buzz but did very little to improve the performance of its iPhones in the everyday use by typical users, hamstrung but having only 1GB of DRAM and lacking applications specifically built for 64-bit computing. If there is a performance uptick by a faster processor, it is more likely incremental than revolutionary.

Carving up the Canaccord forecast on the flip side, Singh showed very few net user additions were implicit in the forecast.

My conclusion is that if Canaccord is right in its forecast it is the result of Apple fans circling the wagons and then shooting inwards with the Apple fan club members falling all over one another to get the latest device while the rest of the world shows a lack of interest in joining the fraternity.

I have no doubt that Apple will have a solid quarter this Christmas. Whether it will be enough to demonstrate that Apple will stop shedding market share and stem the accelerating decline in average selling prices that will ultimately squeeze margins remains to be seen. What I foresee is more of the same - growth in units at a rate less than market; growth in profits at a rate less than growth in units; and, a quite dramatic reversal of fortune when growth in the market stops and the results reflect the vicious combination of lower volume, lower prices and lower margins all taking place concurrently.

For the Apple bulls who bet their life savings on "profit share" and who have done so well on their investment in the past year, almost recouping their investment if they bought at the 2012 top, I wish you well and sincerely hope you all make a ton of money. I will sit on the sidelines with my short position, adding a few long dated puts each time the stock adds $5 or $10 a share, and be quite content to lose my investment if Apple succeeds where others have failed. The stock market is a cold hearted lover that cares little who wins or who loses. We place our bets and await the outcome.

Best wishes. I am short the name through long-dated puts.

Disclosure: The author is short AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.