Why I'm Worried About Apple Growth

| About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) has been hitting new highs this week, getting close to $500 a share (and already sporting a market cap north of $450 billion) on the strength of its insane blowout earnings report on January 24th.

To understand how crazy Apple's most recent earnings were, here are the revenues and gross earnings for this quarter and the 3 quarters before that (all figures in billions except EPS):

Revenue: $46.3 (current), $28.3, $28.6, $24.7
Gross earnings: $20.7 (current), $11.4, $11.9, $10.2
EPS: 13.87 (current), 7.05, 7.79, 6.40

(source: Google finance)

Earnings almost doubled from the previous quarter. So why didn't the stock double?

First of all, the January earnings report covers the holiday season coinciding with the newly-released iPhone 4S. Those figures will not be repeated in the following quarter. Going forward, Apple expects to earn $8.50 a share on $32.5 billion revenue in the second quarter.

Analysts here on SA, in the WSJ, and on CNBC rate the stock "cheap," since it trades at a trailing P/E of 14. The P/E falls to 11 if you subtract the $104 per share cash hoard. Analysts peg its "forward P/E" (a term which always raises my skeptic's radar) at 7 if you exclude cash value.

"7 P/E? For Apple?! Let's back up the truck!"

To which I say, not so fast. If Apple can sustain its current earnings momentum, then it would certainly deserve its $500/share price, and higher. However, I have serious doubt about the sustainability of its earnings momentum.

Here's why: Most of Apple's earnings come from 2 products: the iPhone and the iPad. I'm going to focus on the iPhone in this article, since it accounts for a higher proportion of earnings.

Concerns about the growth rate of iPhone earnings

Due to the enormous pressure Apple exerts on suppliers and carriers, Apple earns a staggering 80% of operating profit for the smartphone industry. It is literally sucking all the money out of the smartphone industry for itself.

True, Apple has no obligation to allow anyone else to make money, but at the very least Apple needs wireless carriers to provide service, since I'm not aware that Apple is getting into the wireless industry soon.

For the past quarter, the wireless carriers have been involved in a suicidal game of "discounting chicken," taking up-front losses in the billions of dollars on iPhone subsidies to users as a way to boost their subscriber numbers. During the holidays, both Verizon (NYSE:VZ) and AT&T (NYSE:T) gave $30 discounts for iPhones while Sprint (NYSE:S) opted to sit out that game. Radio Shack (NYSE:RSH) heavily discounted older iPhone models. All of this served to boost iPhone sales for this quarter.

As I've said before, I believe that the current iPhone sales momentum is unsustainable.

Let's look at how the last quarter's earnings have affected the major carriers that support the iPhone.


AT&T was the first wireless provider to offer iPhones, and 82% of customer purchases in the most recent quarter was an iPhone. It's been struggling to make iPhone sales profitable for years, because it subsidizes each of the 7.6 million iPhones it sells. Adding to the problem, customers often want to purchase another phone before their 2 years are up, and AT&T, for fear of losing that customer, is offering discounts for them to do so.

"The AT&T wireless model is broken," said Kevin Smithen, a wireless analyst at Macquarie Securities. "AT&T is basically subsidizing Apple's revenues and profit growth."

OK, so AT&T has to subsidize the iPhone when the customer first purchases it, but don't they make it back during the 2-year term of the contract? So far, that hasn't happened:

At AT&T, Nomura Securities analyst Michael McCormack says, the profit margins on wireless service haven't meaningfully improved since the company started carrying the iPhone in 2007.

"For the most part, it's really been a wealth transfer from AT&T shareholders to Apple shareholders," said Mr. McCormack.

AT&T stock has dropped 28% since they first started selling the iPhone.


The headline says it all: Sprint's First iPhone Sales Add to Wider Loss. Sprint has committed to buying $15.5 billion of iPhones through 2014 regardless of whether it can sell them. Over the last 2 years, Sprint has lost over $2 billion, and is taking increasingly desperate measures to survive. If Sprint goes bankrupt, the nullification of the $15.5 billion contract will hit Apple earnings.

Sprint stock has dropped 16% since it started selling the iPhone last year.


While Verizon added 1.2 million new subscribers as a result of adding the iPhone to its lineup this year, like everyone else its margins are getting squeezed.

... the [iPhone] activations cut into profit margins because of the upfront cost to bring in new contract customers who purchase smartphones ... at a discounted price in exchange for a two-year wireless contract.

The carrier reported its wireless operating margin narrowed to 23.7% from 30.1% a year earlier, which was before it began selling the iPhone or 4G devices.

Meanwhile, with so many smartphones out there, it looks like the carriers are just cannibalizing each other's sales:

While the use of smartphones and other wireless devices has flourished, there are fewer new customers up for grabs, leaving carriers to woo customers from their rivals.

Radio Shack

Radio Shack falls to single digits as it announces on January 31 that it will miss earnings estimates. The reason?

... a substantial chunk of Radio Shack's lower profit margin was because iPhones accounted for almost a third of its sales of mobile phones in the quarter. The profit for RadioShack on the Apple device is perhaps a fifth lower than it is on other phones.

They also blame significant declines and costs related to working with Sprint and Verizon. RSH shares plunged 27% in a single week after the profit warning.

T-Mobile, the holdout:

The only major carrier not carrying the iPhone is T-Mobile. In a blog post explaining why they don't carry the iPhone, in the first paragraph they note that there are 1 million unlocked iPhones on their network, then spend the rest of the post pushing their "wonderful" lineup of Android phones.

Conclusion: So what? Who cares about these other companies?

The iPhone needs a wireless carrier to make it an iPhone, otherwise it's just an iPod Touch. Each of the 3 major carriers offering the iPhone is struggling to make it pay off. So far, it hasn't been working, resulting in an erosion of shareholder value for those companies.

With the smartphone market reaching saturation, and Apple already grabbing 80% of the industry's operating profit, how much more can they grow the iPhone market?

With the wireless carriers already losing billions for the privilege of carrying the iPhone, how enthused are they about helping Apple expand iPhone use?

My uninformed opinion? They're not that happy about it.

At some point the carriers need to raise the iPhone prices, or they will go out of business. Either way, sales will slow. Apple will not see these price increases, since the price that carriers pay is already set.

Also, the iPhone is not the only smartphone in town.

A comparable Android phone costs the carriers about half the price of an iPhone. Carriers are already pushing the customers towards Android phones:

At a Verizon Wireless store in Los Angeles' Koreatown neighborhood, half a dozen wall-mounted displays feature fancy, back-lit red-and-silver graphics pitching the company's new line of next-generation 4G Android smartphones. The display for the iPhone is smaller and plain, its white motif clashing with the store's color scheme.

Look, people will always love and continue to buy iPhones. I myself own an iPhone, iPod Touch, an iPad, and several iPods. I'm not here to debate which is the better smartphone.

However, Android's market share is catching up quickly, and the wireless carriers are realizing how much money they're losing to Apple.

Given these factors, I believe that iPhone revenue is within a year of topping out if it hasn't already. At the very least, iPhone sales momentum will slow, not accelerate. If this happens, will Apple be able to replace that lost growth with its newer products and propel its stock price towards $1000?

And, given the very high expectations for Apple earnings growth, if they post numbers even slightly below that, what will happen to the share price?

Only time will tell.

Disclosure: I am long VXX. I am long out-of-the-money back-month AAPL puts, and have multiple SPY options that lean bearish. I am an active options trader. Please read my bio for full disclosure.

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