Beware Apple's Concentration And Margin Risk

| About: Apple Inc. (AAPL)
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The general consensus on Apple (AAPL) is that it's a "best of both worlds" stock for both "value" and "growth" investors. Despite consistently solid growth over the past few years, Apple's P/E has been solidly in the bargain basement.

AAPL PE Ratio Chart

AAPL PE Ratio data by YCharts

Although I'm bullish on Apple's prospects in the near term, I'm wary about Apple's future, because I believe a lot of their current popularity will evaporate.

One development that Apple investors should take note of is that they recently lost their patent battle against HTC:

HTC Corp. (2498), Asia's second-largest smartphone maker, won a London court ruling against Apple Inc. (AAPL) over patents for touchscreen technology used for its mobile devices, including Apple's slide-to-unlock feature.

HTC's devices don't infringe four Apple patents for the technology and three of those patents are invalid, Judge Christopher Floyd said today.

Apple has similar lawsuits against Samsung pending. So why is this important?

Apple's Concentration Risk

Reviewing data from Apple's Q2 2012 results, we can find the following:

  • Total revenue for the quarter is $39.2 billion
  • iPhone revenue for the quarter is $22.6 billion
  • iPad revenue for the quarter is $6.6 billion

So overall, the iPhone and iPad are together responsible for about 75% of Apple's total revenue. This is in line with Steve Jobs' philosophy about narrow product lines - when he returned to Apple, he famously cut Apple's product offerings by 70%.

Apple faces fierce competition in the smartphone market: currently, in the US, Apple has a 30% market share (vs Android's 50%). It's easy to see why Apple is trying to sue competitors out of the market - the competition's pretty fierce.

Heads You Lose, Tails You Lose Too

This product concentration opens Apple up to significant risks from competitors offering "similar enough" products at much lower prices - for example, the Google Nexus 7 tablet retails for $199. In response, Apple is said to be planning a 7-inch version of the iPad, which according to reports would be priced at $299.

But this won't help. Even if Google's Nexus 7 goes bust, Apple still loses money - because the strategy directly contradicts Apple's existing revenue-generating strategy. Here's why. It's unrealistic to expect the same consumer to purchase an iPad mini and a regular iPad. A lot of Apple customers may be irrational, but they're not that irrational. Therefore, each iPad mini sale means that one consumer who could've bought an iPad won't. If 20% of potential Apple customers chose the iPad mini over the iPad, Apple would lose significant revenue. For comparison, the base version of the new iPad starts at $499, and the tricked out 4G 64GB model retails for $829 - nearly 3x the cost of the proposed iPad mini.

Therefore, the fierce competition in the smartphone/tablet industry is bad for Apple - especially in developing/emerging markets where many phone-hungry consumers don't have bank accounts or credit cards (and consequently, likely not enough money for an expensive Apple product).

Apple products have long commanded a price premium, and Apple profits from selling products at huge margins. For example, the 16GB iPhone 4S, retailed for $649, costs Apple only $190. Thus, a lot of Apple's earnings power comes from these high margins, bringing up another "heads you lose tails you lose" scenario. If a competitor came out with a phone $100 cheaper, and consumers started switching to that phone, Apple would be forced to lower prices. Even if they managed to keep their market share, they've just been forced to shave of 25% of their margin on the iPhone 4S. This scenario takes a significant chunk out of Apple's currently stellar earnings, especially since as I established, the iPhone and iPad account for 75% of total revenue.

A Potential Explanation of Apple's P/E

For a company that's growing earnings at such a rapid clip, it's surprising to see such a low P/E ratio. Apple investors have long complained about the P/E multiple and predicted that it will eventually rise. But Apple's low P/E may be due to the factors I've just mentioned - earnings are very concentrated in products which are susceptible to having margin stolen by lower-priced competitors or lower-priced products Apple is forced to roll out to stay competitive on price.

These factors may be why Donald Yacktman, Morningstar Manager of the Decade and my personal favorite value investing guru, has avoided Apple despite their apparent "value" based on P/E and EPS growth. In an interview this May, Yacktman had this to say about Apple:

Apple has to spend incredible amounts of money on research and development to see the next mousetrap down the road, or settle for smaller market share. If another phone is close enough, for $100, and an iPhone is hundreds more, which will people buy? Look at what happened to Xerox (XRX). They didn't bring their prices down, and then competitors made things nearly as good and much cheaper. In the short term, Apple's stock does well. But the stock is dangerous. Ten years from now, Procter & Gamble (NYSE:PG) will sell you Tide, Clorox (CLX) will sell you bleach, but what will happen with the iPhone, iPad, and iPod?

In another interview, he said the following:

Apple is a company that has executed brilliantly and looks inexpensive if you believe its sales will continue to be robust and profit margins will stay at current levels. Is the business more durable than cyclical? We do not think that Apple will be able to sustain its profitability over time as the rate of product innovation slows and/or competition catches up. Consumer electronics, computers, and the cell phone markets all have had rapid boom/bust cycles previously. In addition to potential business challenges, at the current size, the high rate of growth is likely over.

These are important factors for Apple investors to consider, especially considering Apple's skewed insider trading statistics. According to available data from Nasdaq, no insider has bought Apple since it was trading at $374, but over the past few months, insiders have been unloading shares like crazy. This suggests that management may realize the same thing as Yacktman: Apple's strategy of profiting on high margins and diehard customer loyalty may not work forever.

One more point, bouncing off what Yacktman said: remember that at one time not too long ago, the Motorola RAZR was the most popular phone out there, doing for Motorola what the iPhone did for Apple. I owned a RAZR. It's currently sitting in the same cabinet that holds all my floppy disks. Why? Eventually, competitors came out with better products, and RAZR-mania ended, leaving Motorola in the dust behind Apple and Samsung and LG.

So be cautious about Apple's prospects in the future, keeping in mind that their phenomenal earnings are based on very high margins. Google has essentially started a price war with Amazon over ebooks, so it's not unrealistic to consider the prospects of a similar phone/tablet price war. Even if Apple's sales weren't impacted at all, as I've demonstrated, Apple's current high-margin-product-concentration strategy leaves it vulnerable to such a price war - being forced to reduce product prices would absolutely cripple Apple's earnings. (Again, using the example of the iPhone 4S, reducing the price by $100 would reduce gross margin by 25%, and after accounting for administrative/selling costs, earnings could be impacted by an even greater multiple.)

Unfortunately for Apple, they can't sue every competitor out of the market, as the recent HTC decision showed. Thus, as Yacktman says, they will be forced to continue innovating and lower prices. If they don't, they may end up just like Xerox and Motorola - left behind as newer companies take the spotlight.

Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources & management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.

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