There seemed to be a bit of panic last week when Apple (AAPL) released its fiscal Q3 results, which were a replay of 2011's fiscal Q4. Consumers held back iPhone purchases as they wait for a new version to be released, so iPhone sales dropped 9 million units over the prior quarter. Apple also released a very late in the quarter Mac refresh, so Mac sales were sluggish as consumers waited for newer versions. Add in the fact that the iPad didn't go on sale in China until after the quarter ended, and you had the perfect storm for an earnings miss.
There's been a wide debate over what to make of these results. Is Apple struggling because the competition is catching up, or will the above mentioned issues sort themselves out over the next few quarters? I'm inclined to argue with the second of those two, but there are some concerning issues with Apple right now. Let's look at both sides of the argument.
Bear Case 1 - Average selling prices are down:
I've compiled Apple's average revenue per product in the table below, comparing the just released Q3 with last year's Q3 and this year's Q2. The quarter and year columns show the decrease in price versus the prior quarter and prior year periods. The figures below are the average selling price per unit sold, including accessories and other items. Apple has introduced a few lower priced versions of its products in recent years, but the selling price declines are starting to really increase.
|Selling Prices||Q3 2011||Q2 2012||Q3 2012||Quarter||Year|
This isn't just a one quarter issue. I've been detailing it over the last couple of months. It will be interesting to see if Mac prices rebound with the newer versions getting a full selling quarter in Q4. The iPhone numbers will be even more interesting if the waiting for 5 phenomenon continues as well. Apple has been averaging between $645 and $660 in revenue per iPhone sold, so this quarter's $624 seems like an aberration. There have also been rumors that Apple will eventually launch a mini-iPad, perhaps priced at $299 or lower. That will bring iPad selling prices down even more, and as we already know, iPad margins aren't the highest to begin with.
Bear Case 2 - Competition is Growing:
Whether you agree with each of these or not, you cannot ignore the fact that Apple does have more competition coming in the near term:
- Research in Motion (RIMM): The Blackberry 10 phones are expected to be released in early 2013, and if they do hit, RIMM could make a comeback. Whether you like it or not, expect the BB10 phones to make a splash. RIMM's future is at risk. Also, we've heard recent rumors of a new PlayBook launching soon. Research in Motion is not giving up, and management does not look like it will put the company up for sale. This company believes they are set up well for the future, and we will see in about 6 months if that is the case.
- Google (GOOG): The Nexus tablet is coming to market, and shipping delays are mounting as limited supplies have sold out already. We know that Google has a huge future in Android, and there are those willing to give Android a chance in the Nexus. Google has completed its purchase of Motorola Mobility, and will look to use that new segment to its advantage. Google must also respond to some "attacks" from Apple recently, including an Apple-Baidu (BIDU) mobile search deal for iOS 6, and Apple's decision to take Google Maps off the new operating system.
- Microsoft (MSFT): Windows 8 will be launching later this year, along with Microsoft's own tablet, Surface. We've also heard rumors that Microsoft will look to enter the phone business over the next year. Whether those are true or not, Microsoft will always be a competitor to Apple.
- Amazon (AMZN): Whether the Kindle Fire was a flop or not, Amazon still believes it can be competitive in this space. Amazon is trying to become more of a technology company and less of a retailer. The company could launch several new versions of the Kindle Fire tablet, and who knows what else they will do. Even if they don't profit from it, Amazon is constantly looking to increase revenues. What better way to do that then to take some away from Apple?
- Facebook (FB): On the conference call the other day, Facebook executives made it clear that the company is looking to heavily invest in mobile. While Facebook insists it is not looking to build an entire phone by itself, I'm betting that there are more than a few companies out there that would be willing to partner up. Maybe Facebook and Amazon partner up on a phone? Both seem like they want to enter the phone business, but neither seem to want to do it alone.
Those are just a few pieces of competition that could be coming, and I haven't even discussed already existing competitors, like Dell, in detail.
Now, I know that Apple supporters will come back at me, claiming that Research in Motion is dead (and it very well could be), or that this company or that company's tablet can't compete with the iPad. Yes, to an extent, certain products can and perhaps will complement existing Apple products. But it's not all about stealing away market share. It's more than just Apple losing unit sales. Yes, it may seem that if Apple loses 1 million iPad sales in 2013 to the competition, that it's only a drop on the bucket. But it's more than just that. With added competition, Apple may lose even more pricing power, and I've already detailed that they are. Losing 10,000 phone sales to RIMM, for instance, is not as harmful as losing $1 in average iPhone revenue per sale. Also, Apple may be forced to increase operating expenses, such as technology costs, to fight off this increase in competition. Marketing and other operating expenses could also increase, and if you laugh at that, that's the focus of my next section. But just to illustrate my point, Apple's operating expenses were 9.77% of revenues in the third quarter. In the year ago period, they were just 8.90%.
Bear Case 3 - Are margins peaking?
Generally speaking, everyone knows that Apple's margins fare better when iPhone revenues make up a larger percentage of Apple's total revenues. You can see that in the table below. The iPhone % number is the percentage of total revenues from iPhone and related sales.
|Margins||Q1 2011||Q2 2011||Q3 2011||Q4 2011||Q1 2012||Q2 2012||Q3 2012|
So when iPhone revenues aren't a huge portion of the total, like in the recent Q3, you can see how margins fall off. You can expect that Q4 will see a similar story if iPhone sales fall to that low 20 million area.
But it's not just about gross margins (even though Amazon will tell you it is!). Apple has made a lot of strides to improve gross margins, but even if they get to say 50%, or even 55%, you won't see that hit the bottom line. It's just a simple matter of math. Apple's operating expenses have been running at a rate of about 10% of revenues over the past few quarters, so Apple can't gain much there. Apple still has to invest in technology, and still has to pay its workers. Apple also has a tax rate around 25%, and I don't see that decreasing too much anytime soon, especially if they bring any foreign cash back into the US. Apple could improve gross margins by X percent going forward, but it won't see all of that translated to the bottom line.
We know that Apple's margins will probably be flat to down in fiscal Q4 as more iPhone sales are held back and other product lines take the spotlight. But we also expect a huge number in Q4 as Apple potentially sells 40, maybe even 50 million, iPhones. But it will be a test to see how Apple can keep costs under control, especially if prices continue their descent.
Now, it would be wrong if I didn't discuss some of the positives.
Bull Case 1 - Q3 examined again:
So, even with the iPad not available in China, a late quarter Mac refresh, and iPhone sales about 4 million below expectations, Apple still posted a 22.6% increase in revenues to $35 billion, which was a Q3 record. The company also posted a Q3 record net income of $8.82 billion, and that was considered "terrible". Oh, and despite a lesser percentage of iPhone sales (compared to total), the company improved gross margins by 108 basis points over the prior year period.
Bull Case 2 - Second half of 2011:
While analysts have taken down their fiscal Q4 numbers thanks to Apple's guidance, they have raised Apple's fiscal Q1 numbers (calendar Q4). Remember, Apple's fiscal year ends in September.
So for the second half of the calendar year 2012, current estimates call for about $90 billion in revenues, compared to $74 billion in the first half. Current estimates call for almost $55 billion in revenues for the holiday season fiscal Q1. Some estimates call for more than $60 billion.
But for now, I want to look at the current fiscal Q4, considered to be the "weak" quarter of the year. Apple still guided to $34 billion in revenues, which would still be more than 20% growth. Analysts are currently looking for $35.21 billion, or 24.6% growth.
But look at the product lines. Even with consumers holding back, iPhone sales are still expected to be around 20-22 million, up decently from last year's 17 million. Thanks to the late Q3 refresh, this could be Apple's first non-holiday quarter of 5 million plus Mac sales. Don't forget as well that China gets the iPad. Could they break fiscal Q3's record of 17 million iPads sold. It could happen.
Bull Case 3 - Does money grow on trees?
Okay, so money may not grow on trees, but it seems like it does for Apple. Apple's cash and investments pile is now up to $117 billion, up from $81 billion plus just nine months ago. Apple could easily pay off all of its $51 billion in liabilities and still have a ton of cash left over.
Now, we know that Apple is about to start paying a dividend and will buy back some shares to cover executive option dilution. Even with the expected $45 billion Apple will spend over three years, that cash pile will continue to grow. That means even more dividends, and eventually, probably buying back enough shares to reduce the count.
Conclusion - Legitimate fears, but not the death of Apple:
Yes, there are some issues Apple needs to deal with. Apple cannot have the average Mac price drop $25 each quarter going forward. Selling some of those MacBook Pros with Retina display should help there. To a point, a 10% decline in average prices can be overcome when you are growing unit sales at 50% or more. However, those high growth rates won't last forever. Apple also needs to keep selling those iPhones for at least $640 or $650. $5 here or there may not seem like much, but when you are selling over 100 million iPhones a year, it does add up. Apple needs to maintain its average selling prices, just in case margins do flatten out or start to decline. Also, don't forget about the competition. Some of Apple's competitors (RIMM is a good example) ignored Apple for a while, and it cost them. Apple does need to keep a watchful eye.
So what to do with Apple stock? Well, long-term investors should use any pullbacks in the stock to add to their positions. The post-earnings fall to $570 was a good chance, but I think they'll be more opportunities to pick up cheap shares. Global stock markets have had a few nice days, and if we come back down a little Apple will get hit like everything else. I wouldn't be surprised to see some negative analyst notes for this "weak" quarter, so we could see Apple trade back down to $550 or a little lower. But I don't see it going below $525 anytime soon, unless we get some real surprise.
Talk of an Apple downfall is just that, talk. But just like anyone who has ever driven a car knows, you can't just put cruise control on and close your eyes. You always have to be vigilant, and while there are some issues Apple may need to deal with, I think they are more than capable of handling them.