The Repricing Of Apple Shares Should Be Nearly Over

| About: Apple Inc. (AAPL)
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The seemingly inexorable march forward by Apple (NASDAQ:AAPL) has come to a sudden halt. After peaking above $700 a share, these shares have fallen back to well below $600 in short order. The question is whether this is merely a blip and a good buying opportunity (like in the past), or whether there is something more structural at work.

iPad Mini
We fear that it might well be the latter. Some of the magic of Apple seems to be ebbing away. While Steve Jobs was rather disdainful of the concept of smaller tablets, Apple went on and made one anyway. The result, while beautiful, was also a little underwhelming (no retina display, for instance) and rather expensive. The 16GB model is selling for $319, which is quite a bit more than rival tablets of similar size, most notably the $199 Google Nexus 7. That's a huge $120 (60%) premium for the iPad Mini..

More worryingly, by Apple standards, the price (and hence margins) is already lower than usual:

Research firm IHS, previously known as Isuppli, has taken the Ipad Mini to bits, revealing that the 16GB model costs Apple roughly $188 to build, which it then goes on to sell for $319 -- not much of a profit by Apple's standards. The Ipad Mini 32GB and 64GB models cost around $31 and $62 more to make, IHS added. [The Inquirer]

Sales were still brisk though, selling 3 million units in the first weekend. But for how long can this Apple magic work? Apple's lead in tablets is eroding:

New data from IDC suggest that Apple's dominance of the global tablet computer market may be giving way. Competing tablet makers, led by Samsung, gained substantial ground during the third quarter of 2012. Apple's market share dropped from 65 percent in the second quarter to just over 50 percent in the third quarter. Meanwhile, Samsung's share doubled to 18 percent [MIT Technology Review]

It's a little early to jump to conclusions, as this is only one quarter. A quarter in which sales of the iPad could have been dented by the rumors of the upcoming iPad Mini. However, it seems that Apple is slowly losing its edge in the "spec" department -- that is, the hardware specifications that were one factor in giving it a lead.

It's not only the iPad Mini screen, but the new Google Nexus 10 tablet is trumping the iPad's retina display with a whopping 2560x1600 resolution (versus the iPad's 2048x1536) while being significantly cheaper ($399 for the 16GB version, $499 for the 32 GB version -- $100 cheaper than comparable iPads). There aren't yet 3G (let alone 4G) versions, but few people actually use these networks on their tablets anyway.

While that superior screen resolution isn't going to make much of a difference in practice, from a marketing perspective, it could be another matter. Apple's products command serious price premiums over the competition -- it has to be seen as offering frontier specification. Apple diehards will claim that the software running Apple's products is still superior to the competition, and they do have a point. But the competition isn't sitting still.

The 7 inch tablet space could easily get more crowded still, with Microsoft (NASDAQ:MSFT) rumored to introduce a 7 inch gaming tablet, the Xbox Surface:

Although full details on the gaming tablet are not yet available, it's likely that the Xbox Surface will feature a custom ARM processor and RAM combo designed specifically for gaming purposes. [Trustedreviews]

While we were rather hesitant about the WindowsRT tablets, a smaller gaming tablet could be quite a different story.

What's also not entirely reassuring is that Apple depends on Samsung, its main rival, for many of the iPad Mini's parts:

Ifixit tore down Apple's Ipad Mini to find that the device's screen, display driver and of course the A5 system-on-chip (SoC) are all made by Samsung. [The Inquirer]

Here is what John Lagerling, director of business development for Android, had to say:

We did really well with the Nexus 7, I feel, because nobody really pushed the envelope with seven-inch in terms of price and performance. It really proved that category. We felt the 10-inch category was overpriced and underpowered, and we wanted to see what we could do for that from our perspective. [The New York Times]

Indeed. And Google (NASDAQ:GOOG) isn't going to stop here, either.

We see similar movements in the mobile space -- Apple coming out with an iconic product (the iPhone), only for the competition to more or less copy the product and offer it often at cheaper prices. The iPhone is more important for Apple than the iPads. According to Travis, more than half the share price is based on the iPhone:

(click images to enlarge)

So competition in this space is more serious for Apple's bottom line. While Apple has an advantage in integrating hardware and software, the software platform Android offers provides way more choice in hardware, with many OEMs like Samsung offering products. Samsung, especially, is getting very successful. Its latest top end mobile phone, the Galaxy S3, has already sold more than 30 million units in the first five months. What's more worrying for Apple is that Samsung's momentum seems to be increasing:

The South Korean firm said the S III is selling at a much faster rate than its predecessor announced a year ago, the Galaxy S II. The S II took 14 months to hit 30 million sales. Sales of the Galaxy Note II, which fills a market niche between smartphones and tablets, surpassed 3 million in 37 days, Samsung said last week. [Huffingtonpost]

Samsung is already outselling Apple's mobile phones by quite some margin:

Research firm IDC ranks the South Korean firm as the world's top smartphone seller in the last three quarters. In the latest July-September period, Samsung sold 56.3 million smartphones versus Apple's 26.9 million, IDC said. [Huffingtonpost]

However, an even bigger threat could well hit Apple soon in the form of Google's Nexus 4 phone, produced by LG of Korea. In essence, it's a mid-priced smartphone with high-end specifications (bar LTE or upgradeable memory):

the LG Nexus 4 has an impressive set of specifications, including a 1.5GHz quad-core Qualcomm Snapdragon S4 processor, a 4.7in 768x1280 HD touchscreen, 2GB of RAM, a swish 8MP rear-facing camera and the latest version of Google's mobile operating system ahead of other Android smartphones on the market. [The Inquirer]

The price, at 239 pounds sterling in the UK, is less than half what a SIM free iPhone (529 pounds) or the Samsung Galaxy S3 (550 pounds) costs. That is rather spectacular. How is that even possible, one wonders? Well,

Google appears to be subsidizing the price of the Google Nexus 4 smartphone by around £240 in an attempt to grab more of a market share for its Android OS. [Trustedreviews]

This will only be at the Google Play store. Non-Google retailers can't compete with this at all, so they won't sell it at all, or not SIM free anyway. A problem could be that the Nexus 4 only has the support of T-Mobile. But whether that is a major problem, or one that cannot be addressed, remains very much to be seen.

Microsoft's introduction of Windows 8 and Windows 8 Mobile will further crowd the mobile and perhaps more, the tablet space. In the tablet space especially, Microsoft can still leverage its legacy Windows users. There is also Research In Motion's (RIMM) Blackberry 10 coming around the corner, although how much of an impact that can have on the mobile market is difficult to assess.

In Apple's defense, it has to be noted that users are extremely happy with their Apple products:

it ranks top in the reputable JD Power smartphone satisfaction survey as it has done consistently eight times in a row.

The iPhone excelled in every category, but scored particularly highly for design and overall ease of use. On a 1,000 point-scale the iPhone ranked at 848, way above closest competitor, HTC (790-points). [Computerworld]

A loyal base is a powerful weapon in these increasingly competitive markets.

Apple Magic
There is no doubt that the company has been on a roll, probably one of the best in history. There is no saying whether this roll will continue, although with Steve Jobs gone, this seems a bit more difficult. Can Apple yet again come up with another category-defying product that creates new markets?

Apple TV is a much rumored candidate, especially since Steve Jobs argued that he had "finally cracked it." Additionally, there doesn't seem to be a lack of demand for this mythical product:

Piper Jaffray's Gene Munster recently said almost 49 percent of Americans would be willing to purchase an Apple television when it eventually ships. (Expected this year the product now seems set to appear in 2013). A May Strategy Analytics survey results claimed nearly half of iPhone users would likely buy an Apple television soon after the product's launch. [Jonny Evans]

Considering the fact that there are quite a few TV makers struggling (Panasonic, Sharp, etc.) and that some of these are also suppliers for Apple screens, it isn't very likely that Apple TV will actually be a TV. Of course, "Apple TV" already exists, in the form of a cute little black box that enables streaming content from the internet to play on TVs. But higher-end TVs have similar capabilities embedded within, so Apple must really be able to do something special here in order to live up to the hype.

The "finally cracked it" remark from Jobs' biography refers to an interface that is both extremely easy to use and independent of actual devices. The most likely interpretation of that is some cloud-based DVR service. Apparently, Apple is already negotiating with cable companies for months (per The Wall Street Journal), but this really is complex. The license and rights vary from owner to program to country to platform -- this is a nightmare.

To move toward Jobs's vision, Apple will have to convince networks and cable operators to give it access to real-time, present-day programming. That won't be easy -- and it may not be possible. [Tech Hive]

Cable companies aren't likely to play ball unless there is a big pay-off for them:

Apple has another challenge it needs to meet: cable firms have invested heavily in their user interfaces. Apple might have a fabulous user interface it wants to put out there, but cable firms must agree with its vision. [Computerworld]

Apple could get a licensing deal with cable providers that lets existing customers access their cable service through Apple's box (like a "Comcast" app on your iPad), but it would have to make a deal with every regional cable company out there, and we're not even mentioning the international landscape.

Maybe Apple can pull it off -- don't count it out just yet -- or it could have another hit product that no one's thought about, or an existing product or service that Apple manages to make just so much better. But don't count on it, in terms of the share price.

Apple is giving it every shot, though:

In 1998, Steve Jobs told Fortune: "Innovation has nothing to do with how many R&D dollars you have." He shut down Apple's long-term research lab division to prove it. Last week, Apple's disclosure that it increased its annual research and development spending by nearly $1 billion, or 39 percent... [Technology Review]

Here is where the Apple magic has to come from, but it comes with a price tag. Apple used to spend very little on R&D compared to Google or Microsoft -- just 2-3% of sales -- but now it's upping that substantially. But another way to see this is as another margin squeeze.

Market Share And Margins
So we have a line up of Google Nexus phones and tablets that mirror those of Apple, with the Nexus 4, 7 and 10, which are similar in specifications to the Apple iPhone, iPad Mini and iPad 4. However, these products are significantly cheaper -- the Nexus 4 even dramatically so.

This simply can't be good news for Apple. Either it's going to lose more market share and momentum, or margins will be compromised, or both. This really shouldn't come as a surprise. Apple has some unique capabilities, which enabled it to create markets, and then dominate these for quite some time, enjoying outsized margins in the process.

But as any economist would predict, the existence of super-normal profits in newly created markets would entice competition and new entries, and that's exactly what has happened. Many of these markets still have plenty of growth opportunities volume wise (and there is the yearly circus of new models), but market share and margins are likely to decline.

Now, Apple's shares have already come to terms with this reality.

At $558 a share, it's declined just over 20% from the top set at the end of September. Unless there is a large market sell-off, we think that most of it is done here, especially if you factor in the extremely healthy balance sheet with no debt and $121B in cash. But there's no denying it -- some of that Apple magic has been lost.

Disclosure: I 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.