Apple Earnings: Disappointment Across The Board

| About: Apple Inc. (AAPL)

Summary

Apple results were even worse than anticipated.

Gross margin contraction highlights poor sell-through across many product categories.

Dramatic sequential drops in Other category signals Watch sell-through deserved a repricing of the product.

It is an unfortunate situation that Apple (NASDAQ:AAPL) finds itself in after releasing its latest quarterly results. The stock is down more than 7% just after the open, after failing to meet analyst expectations.

Apple posted quarterly results that were quite the miss for a company that usually beats analyst estimates, especially estimates that had been lowered somewhat going into the quarter. Apple's quarterly profit fell 22.5% as revenue declined for the first time since 2003, and iPhone sales declined for the first time ever.

Investors might recall my reasoning to avoid AAPL shares in Can Apple Watch Compete With Fitbit Blaze? In the article I stated the following:

But timing is always relevant to investors and I don't believe Apple to be a strong investment presently. I would rather see AAPL shares priced below $100 before taking a position in the company. But that is very simply my strategy and may not be favorable to the masses. With the company reporting earnings this week, shares could surge or plunge depending on their quarterly results and forecast. With iPhone and iPad shipments expected to fall in 2016 a good portion of AAPL's share price appreciation may have to come from other products or business operations that may include increasing the dividend paid to shareholders.

Pretty much every reason I decided to avoid shares of AAPL is relevant to why the stock is selling off. This sell-off is coming in the face of an increased buyback plan alongside an increase of 10 percent to the firm's quarterly dividend. But I'm in no way interested in a dividend presently, and it doesn't appear many investors are at the moment. Based on the Q2 2016 results, the only thing that is plainly clear concerning Apple is that it has saturated the market with its legacy, hardware products and largely achieved its total addressable market (TAM). I will discuss this further after we take a look at sales for the company's individual product segments.

Apple said it sold 51.19 million iPhones, down 16.3% from the 61.17 million units it sold a year earlier. Keep in mind this depressed iPhone unit sales figure butts up against very tough YOY comparisons due to the launch of the iPhone 6 last year. The iPhone accounted for 65% of Apple's total revenue in the March quarter. While the total number of iPhones sold during the March quarter slightly beat analyst estimates, the average selling price (ASP) fell more than anticipated. During the March quarter, the average selling price fell to $641, below analysts' projections of $658 per unit. Another consideration for investors and the most recent results is that they exclude the iPhone SE, which began shipping on March 31st .

Naturally, investors had hoped that other product segments would help to offset the expected declines from the iPhone, but that did not come to fruition in the March quarter. Apple said iPad sales fell for a ninth-straight quarter. The company sold only 10.25mm iPads during the quarter, which was a decline of roughly 19 percent. In addition to iPad sales falling, Mac sales fell 9% YOY and 24% sequentially. If you were looking for a bright spot with contribution from the "Other" category, you received mixed results there. Other sales grew 30% YOY, but fell dramatically by 50% sequentially and contributed $2.2bn to net sales. The Apple Watch contributes significantly to the "Other" category, and with retailers not reordering the product at a meaningful rate due to poor sell-through results, the sequential declines become extremely magnified as they have in the currently reported quarter.

I had alerted investors about the Apple Watch sales impacting results leading up to this quarterly release. To be clear, when I say impacting results, I largely mean they did nothing to offset other impaired sales segments. Essentially the price reduction of the Watch did impact some of the overall company profitability, as the reorders for the Watch fell significantly post the Q1 2016 period. Apple's hand was forced by retailers that helped the company to launch the product last year. Despite strong sell-in to retail partners, the sell-through was quite poor as evidenced by one of Apple's largest North American retail partners, which is not permitted to be named. The screen shot below highlights one of Apple's larger market regions in North America and signals that the retailer had not a single Apple Watch Sport on order prior to the price reduction instituted by Apple.

Additionally, the rate of sale was less than 1 unit a week across this region. The sales data for the retailer is obtained nationwide by Capital Ladder Advisory Group. This sample set of data is actually higher than most regions and especially Apple's worst selling region of the United States for the Apple Watch, the Southwest.

In coining the Apple Watch a Lost Leader in a previous article, I did so with the understanding that investors largely consider the Apple company to be a leader. But in the case of the Apple Watch, the company is completely lost and found wanting for greater sales as the product has failed to generate sequential unit growth that will ultimately lead to YOY declines, as I previously forecasted. With Apple Watch sales declining sequentially thus far, this variable of the Apple business has taken on negative sentiment rather quickly.

Most every region around the globe witnessed sales declines for Apple products. All distribution regions exhibited double-digit sales declines during the Q2 period except for Japan, which grew roughly 24 percent.

Shares of AAPL have fallen significantly after hours and rightfully so. What Apple is faced with going forward is market saturation for its hardware products and a lack of innovation to offset this saturation of existing products. Apple Pay and its other services simply don't have the ability to offset legacy product declines with $100-$2,500 price points. Apple is up against the reality of its total addressable market and formulating a plan to combat the issue.

Apple is a hardware company in that some 90% of its sales are generated through legacy, hardware products. This is the major reason that AAPL shares by and large never seem to achieve the valuation investors desire it to achieve. Carl Icahn was extremely out of bounds when introducing the concept that AAPL shares should trade at $200 a share. His reasoning was absent the relevance of what hardware companies face during stalled innovation cycles and they are cash burn alongside earnings and sales declines. Let's touch on what led to this point in Apple's business cycle.

In the past, the only reason Apple has been able to grow both revenues and earnings is because of its innovation of "all things i" alongside limited distribution. As Apple grew into new products, it grew its distribution channels or networks. I desire to further explain to you this perspective using the original Apple iPhone and the newer Apple Watch. When the original iPhone launched, Apple had limited distribution for the product. As sales for the iPhone grew, so did distribution. So when the media has offered to interested parties that the Apple Watch sales nearly doubled that of the original iPhone, that should be the expectation with the understanding that Apple's distribution is far greater than it was during the days of the original iPhone. Unfortunately, the headline masks the relative value within the headline.

Apple has its limitations as the warning signs were well exampled by the Mac, iPad and iPod sales of yesteryear that reached their TAM potential somewhat quickly. The iPod was a game changer in that consumers could literally have thousands of songs in their pocket at the touch of a button.

The styling of Apple lent itself to mass appeal and adoption even as it was not the first MP3 player. But it only took about four years until the iPod found itself in the precarious situation of declining sales as the product was mass distributed and achieved mass adoption. Since 2009, iPod sales have declined each and every quarter. Besides market saturation, the iPhone had cannabalized the MP3 player as it replaced the former "iThing" that made Apple great, next to Steve Jobs of course. And this was the plan, which is why I stated previously that Apple has to have a plan for its current situation.

In June, 2009, Apple CFO Peter Oppenheimer admitted that cannibalizing the company's MP3 players was all part of the plan:

For traditional MP3 players, which includes Shuffle, Nano, and Classic, we saw a year-over-year decline which we internally had forecasted to occur. This is one of the original reasons we developed the iPhone and the iPod Touch. We expect our traditional MP3 players to decline over time as we cannibalize ourselves with the iPod Touch and the iPhone.[emphasis ours]

But what is the plan for addressing the problem that most every hardware product Apple sells is facing, the TAM crisis? Some were of the opinion that the Apple Watch was the next "iThing" for Apple. I was very skeptical about the Apple Watch being the next big and innovative product for Apple because the utility of the Watch was found wanting in so many ways. Besides the duplication of iPhone applications, the worst part about rationalizing the utility of the Watch is that it essentially renders the Apple Pay system negligent as well. Let me explain...

Some of the "Apple faithful" offer that one of the key advantages to the Apple Watch when compared to the iPhone is that you don't have to take the iPhone out of your pocket. But that same example voids the availability and utility of the Apple Pay system, which is housed... that's right, on the iPhone. The iPhone is still the primary hardware communication device for Apple users and in that there is no desirable behavioral change necessary for consumers.

The paradox noted is pretty clear and presented with danger from a logistical standpoint as Apple Pay is only so new to the Apple user base and so is the Apple Watch. With newness comes the challenge of inviting consumers to change their behaviors. That is essentially what the Apple Watch and Apple Pay do, ask consumers to change the way they pay for items and utilize communication systems. So if the Apple Watch was supposed to be the next iThing of greatness, it would have to come with a quick behavioral change request on the part of the consumer from the iPhone to the Apple Watch and Apple Pay systems. So who wants to take on that task of developing two entirely new behaviors simultaneously, utilizing the Apple Pay and Apple Watch systems?

Where the iPod was overtaken by the iPhone, a market was already well established for which Apple could slide the utility of the iPod into the iPhone. Cell phones and smartphones were massively being adopted during the iPod/iPhone days due to the many predecessor products from Blackberry (NASDAQ:BBRY) and others. That same situation doesn't exist here and yet for the Apple Pay to slide into the Apple Watch without real pain points being felt. That pain would likely come at the expense of the shareholder by the way.

Every headline coming out of Apple's quarterly results has highlighted Apple's main problem going forward... saturation. The Apple Watch is not the next big iThing for Apple as logic dictates and thus the Apple Watch cannot address Apple's TAM issues. The screen size of the Watch is far too small for navigation and touch-implementation by the consumer. Engineering costs are increasingly higher when miniaturizing devices and the cost impediments aligned with this process become impediments to product adoption at retail. The Apple Watch is a communications device in search of a problem to solve where likely no problem exists. Taking a phone out of one's pocket is hardly an addressable problem. But even within that understanding or perspective, Apple well understood its brand reach and sold billions of dollars worth of Apple Watches to retailers. Unfortunately, the retailers have struggled mightily with selling those Apple Watches to consumers. No specific sales numbers were offered by Tim Cook during the latest conference call concerning the Watch, although shipments for the Q4 period are expected to decline some 40% due to current inventory overhang.

Apple is still a great company and I had previously offered waiting to acquire shares of AAPL below the $100 price point. Investors and readers would have benefited from heeding the offering earlier this year. Having said that, I don't believe Apple's Q2 2016 results will be remedied in 90 days. Simply put, if the Watch was the plan, sales for the Watch suggest that Apple needs a new plan. Secondly, the iPhone 7 which is expected this fall will not be the answer either. It should be more closely recognized as the "have to" product in that Apple has to continuously introduce iterations of the iPhone to stay relevant in the smartphone category. Where the iPhone 6 and SE have failed to produce earnings and revenue growth upon the anniversary of the introduced product (for the iPhone 6 specifically), the iPhone 7 is less likely to produce sequential growth. The addressable market is simply not there for Apple to benefit from like product iterations going forward. I've seen hardware companies, consumer goods companies facing the same problem Apple is presently facing, and they generally aren't able to return to growth within 12 months. It takes that next big product cycle or innovative thing to really move the needle. Everything that Apple has added to the ecosystem in the last 12 months has failed to generate YOY sales growth in total. This new reality and what appears to be a lack of foresight, might force the price of AAPL shares lower over the next 90-day period for which investors may be able to acquire shares below $90 a share. Presently, I am waiting for lower AAPL trading prices and a resetting of YOY expectations as analysts will likely have a great deal to offer in the coming days that could serve to create additional volatility in shares of AAPL.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Personal Computers, Earnings
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