So far, Investors have easily digested Apple's (AAPL) transition from the Steve Jobs to the Tim Cook era. Steve Jobs sowed the seeds of the current Apple success through innovative software design. Under Steve, Tim Cook excelled as an operational guru. He built the supply chain that can deliver 5 million new iPhones overnight. A hot design coupled with an efficient supply chain has pushed operating profit margins from 21% in 2009 to 35%.
The market is too complacent about the sustainability of the margin. With the success of the iPad and the latest iPhone 5, the company is putting more emphasis on the hardware performance instead of introducing more software design innovations. This trend will not necessarily reverse the growth, but will automatically pressure the high margins. Eventually, this will result in a stock price correction as sales growth does not translate into the expected profit growth.
PE valuation is misleading
Apple is currently benefiting from a positive spiral of price momentum and higher earnings expectations. Analysts take the short-term outlook and multiply that with the price / earnings of the share. The PE ratio seems cheap because it is 'only' 14x expected earnings. This naive valuation technique can be wrong on two counts. The profit expectations can disappoint. Secondly, the multiple of 14x might not be cheap at all as the market realizes profit margins have peaked. The market now discounts the exponential sales growth of the iPad, but underestimates the negative mix impact on the profit margin. Apple reports along geographic lines instead of product lines, which does not help either. Message boards are swamped with short term noise instead of focusing on the long term technology cycle. A longer horizon technique (DCF) is more suited to show the margin impact on the valuation.
Margin impact of software design vs. hardware
The recent success of Apple is based on a fantastic software innovation rather than fast processors or connection speeds. The iPhone became an instant success due to the user friendliness of its OS that glued its users to Apple. The wealth of free apps boosted the adoption of the iPhone considerably. Apple now makes much more profit than all competitors, suppliers and distributors combined. Nokia made the mistake to focus too much on the hardware and missed the App revolution completely. The graph below should remind investors about the devastating effect on profit margins of missing a trend change. The risk to the Apple margin is equally high if its software lead decreases.
With the success of the iPad, Apple has created a new iPhone competitor of its own with a lower margin profile. Analysts now count the iPhone and iPad volumes together on similar margins. The problem is that the iPad competes in the tablet market which is driven by hardware specifications like the notebook and PC market. According to iSupply, the iPad2 16G costs $245 in components and sells for $399. This generates a gross margin of 39%. The same study puts the bill of materials of the new iPad at $316. With a retail price of $499, this generates a gross margin of only 36%. The iPad mini will not bring much good news on this front as it will compete with the Kindle models. Amazon (AMZN) competes below cost as it generates its profits on the expected e-commerce. On the other hand, iSupply calculates the BOM of the iPhone 5 at only $207 for a retail price of $649. The gross margin of the iPhone is 68%, almost double the iPad margin. The iPad success automatically depresses the average Apple margin as it takes share in the consumer wallet. In the mature notebook market, the gross margin is as low as 20-25%. The iPad will also eventually end up in this range as the product matures.
Gross Margin suffers impact of iPad as it rises in the sales mix:
Because Apple does not produce anything itself, it does not control the hardware value chain. There are ample suppliers of memory and communication chips. The supply of high end processors and touch screens is becoming more difficult. This is exactly the area where the new iPad is competing. Tim Cook has not opted for a radical new software design, but rather a better screen and a faster processor. His attempt to replace Google maps has backfired painfully. Samsung has a lot of capital invested in the next generation of Amoled screens. Apple is avoiding the Amoled technology and puts its faith in weaker suppliers like LG and troubled Sharp (source: Techradar). Hardware provider Samsung (SSNLF.PK) will gradually claim part of Apple's margins either as a supplier or competitor.
Competition is not dead
In the heyday of the technology sector, the Gorilla Game theory was popular (G.Moore, 1999). The "gorilla" reigned over its space and enjoyed high margins and R&D advantages in order to extend its lead. Only one or two players," the chimps", survived on much lower margins. The rest of the competition just disappeared overnight.
Now things are different. Apple is now clearly the gorilla in the smartphone market, but there are too many chimps left. Nokia (NOK) has generated enough cash in the previous tech cycle to afford itself a huge mistake. Nokia is now supported by Microsoft (MSFT) and still has $4 billion to burn. The BlackBerry (RIMM) is losing ground fast, but refuses to lie down. Recently, Motorola was saved by Google (GOOG). Its Android operating system is freely available to the other competitors that don't need to invest in software design. Samsung (5930 KS) developed Android into a commercial success with the Galaxy, which is now racing with Apple for market share. The real patent discussion should in fact pitch iPhone iOS against Android.
In the '90s, Apple OS was copied by Microsoft (MSFT) windows and nearly bankrupted Apple. It is clearly tougher to defend intellectual property against a fellow US technology company. The patent case win against Samsung in the US is irrelevant as it does not settle the Operating System battle. The Apple software design advantage will evaporate over time. The App designers will also become platform independent like Facebook (FB) and Twitter already are. It will neither matter whether Apple has 5 million Apps, while Windows 8 only has 50,000. The Apple margins will not turn into HP margins overnight, but the trend will become clearer over the next couple of quarters. Apple's dodgy geographical segment reporting will not be able to hide this margin evolution.
If a correction comes, it will be a serious correction at once. An investment fund that follows the MSCI world index has 2.5% of its portfolio invested in Apple in order to maintain a neutral weight. A change in sentiment will generate a large flow of stock. The market is obsessed with the next two quarters and takes little consideration of what the company will be like in 3 years. Five years ago, Nokia was the undisputed handset leader and is now priced for bankruptcy. I model the Apple growth, margin and capital investments over a longer period in a DCF. This generates a target of $500. In the unlikely case that Apple misses the next trend completely over the next 5 years, the target easily halves. As Apple has a tangible capital base of $130bln, there is little support.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AAPL over the next 72 hours.