First, let me explain why I am calling this Mea Culpa. I used to be a huge fan of Apple (AAPL), not initially as a stock but as a hip, counter-culture company that makes amazing, drool-worthy products whose mere purchase conferred on the buyers a halo of 'coolness' . You instantly became a 'player' when people saw you with an iPod, iPad, MacBook Air, and specifically, the iPhone. I seriously started dating Apple's stock when I first saw iPhone 4; not that the earlier versions were bad, but somehow I liked the iPhone 4 the best.
With all iPhones, 'pinch to zoom' was a beautiful experience to be cherished, and the phrase had not yet entered any bitter court arguments in U.S. Using a lull period in the markets in 2011, I entered the AAPL journey at $370 a share, though my Apple journey (as a customer and aspirant) pre-dates that by a good 10 years. From the day I bought the stock, I was not only an admirer but an evangelist of both Apple and AAPL. Therefore, it is with considerable admission of guilt that I admit I recently sold Apple in the $600's range. My love affair is over, regrettably.
Of all companies, I thought Apple knew that success attracts competition and their resounding success would, of course, attract heavyweight competitors. Instead of focusing on winning the hearts of consumers in the marketplace to overwhelm competition, it focused its efforts to win in the courtroom. To its credit, Apple managed to convince a California court of its dominion over smoothed rectangles and aspect ratios of its products - normally not what one would consider as a defensible IP. (If you ever get into an IP case, consider hiring Apple's legal team). However, this is not the main point. Of course, every company has the right to pursue remedies in court if they feel their IP is violated.
The bigger point is that the 'edge' of Apple's products is now almost gone. Even its ads now seem to have lost their edginess. Remember the famous ads of Apple's 'cool dudes' against IBM's 'suits' in the yesteryears? The iPhone 5, with obviously planned obsolescence, needless changes to hassle the customers ('lightning' adaptor, anyone?) and attempt to monopolize a critical app when the best-in-class is already out there (Google Maps), has not endeared me to them anymore. Having worked in the consumer products industry, I can tell when the developers are getting trumped by overreaching businessmen and lawyers, and the end product reflects the compromise reached. In some cases, the compromise can be worth it but in others (like iPhone 5), it turns counterproductive.
Especially if you want to retain an iconic status, it is imperative that design and 'wow' factors overwhelm near-term business considerations like obscolesence and restrictive uses - here, Apple is starting to tilt towards the latter. As a customer, I did the unthinkable - give up on iPhone - and moved to Samsung SIII. Not because I hankered for a Samsung, but because my love for Apple's latest iPhone had diminished to the point of indifference. Samsung SIII was just an acceptable, rational choice to me.
Don't get me wrong - Apple is still an excellent company, an amazing executor of new products and it makes tons of money. But if we are judging ownership of a stock based on its future potential, recent events did not convince me of a valuation >$650 until some new game-changer occurred. Of course, after I sold, the stock went up higher than this threshold to reach $700 briefly, but has since come down and closed at $576.80 on Nov. 2. Consider this (data from recent financial statements dated Sept. 29, 2012):
Going strictly by its balance sheet figures, its book value of $118.2 billion gives an estimated value per share of $125. Note that this assumes all the assets and liabilities on the balance sheet are valued at market as stated. This works to about 22% of the share price. That leaves about 78% of the share price attributable to market expectations of growth, and of course, the strong brand goodwill. Valuations in the consumer products industry is different from the technology industry, but this is a lot of value tied to its future growth.
This is not surprising for companies like Apple that have a strong brand value. What is implied here is that the business franchise will turn out blockbuster products in the future at substantially growing profits. So, if there is even a slightest bit of margin compression, this valuation will take a serious hit among investors.
Let's look at the factors that allow margin compression to happen. Samsung (GM:SSNLF), like a hurt tiger, is looking for opportunities to pounce. And it already made a dent with its impressive SIII phone, which many are rating better than the iPhone 5, and is priced lower. Google's (GOOG) Android is getting stronger with Jelly Bean and will likely give iOS a run for its money. Music lovers, long a customer domain of Apple since the start of its brilliant iTunes with iPod franchise, are now (slowly) getting converted to Android-based platforms.
Windows 8, even if it is not all that it's cracked up to be, appears to make some inroads into mobile and touch interfaces. With the iPhone 4, over 65% of the value in the supply chain was captured by Apple (while the actual iPhone 4 cost only $178 including margins for all its suppliers, Apple sold it at $560).
See excellent graphic below from The Economist.
With about 25% of iPhone components (by cost) supplied by Samsung, who is also the IP owner of those assets, the bitter animosity caused by recent legal battles will likely make Samsung push for more value-based pricing in the future. In addition to this, the intense competition (and increasing 'sameness' of features across high-end smartphones) will, at some point, force Apple to answer a difficult question about chasing market share versus increasing profit share. For much of the last 3 years, Apple was able to successfully achieve both (market share while retaining high profit margins), and I now doubt that will be the case for the next 3 years.
The underlying reasons for margin compression (while trying to hold onto market share) for any market leader is not new because that's how many successful innovators 'normalized' to maturing competition and evolving market conditions. The Apple business franchise will continue to be very profitable, but imagine what even a 1% margin reduction would do its stock price. Based on what we have seen in the recent past and the above factors, is it unreasonable to expect a scenario of modest margin squeeze at Apple?
While my heart still longs for Apple, my head wants to stay clear of AAPL till the valuation becomes attractive or the business scenario changes for the better.