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Dead Money: Inevitable Margin Pressure To Take A Bite From Apple

|Includes: Apple Inc. (AAPL)

Thesis: Apple (NASDAQ:AAPL) has been and continues to be a product cycle driven company. The iPhone has greatly exceeded all expectations, leaving Apple overly exposed to a maturing smartphone market and, therefore, vulnerable to a significant decline in margins and profitability.

Smartphone Markets Are Approaching Maturity

The main thrust of my article is that the ubiquitous smartphone has reached maturity. And, when a market hits maturity, volumes not only stop growing, but pricing comes down.

Let's start with the market for all mobile phones. One can assume that, by definition, the market for smartphones will not exceed the market for cellphones overall. And, the market for cellphones has stopped growing.

As the above chart shows, the market for mobile phones has really begun to flatline in terms of growth. While it's predicted to grow slightly going forward, I believe it's safe to say that the market for mobile phones (meaning new users and replacements) has reached a point where of saturation.

The market for smartphones is still growing, as the chart demonstrates. However, the rate of growth is slowing dramatically. The market for smartphones basically increased 6-fold from 2009 until 2015. The above forecast shows 10% growth for the next two years and, if it keeps that up, smartphone sales will approach 95% of the mobile phone market by 2020.

Thus, sticking with the truism that smartphone sales can't exceed the market for mobile phones. And, based on the fact that mobile phone sales growth rate is declining, it stands to reason that smartphone growth is as a replacement for other phones not the creation of a new market. Therefore, I am predicting that the market for smartphone sales will hit maturity, meaning the level at which its growth matches global growth, by 2020. And, in the meantime, the rate of growth will have to decline towards the low single digits.

Yeah, but what makes this statement timely?

Okay, that's a good question. I've simply stated the obvious that, as more people get smartphones, the market for smartphones has to slow. Investors don't care about 2020. They only care about the next two years (if that!).

I will look to address the timeliness of this article by demonstrating two things; that the market for smartphones is simultaneously showing cracks and suffering from saturation. Both these points are easily addressed by looking at China.

I've demonstrated that the overall market for phones is slowing. However, as the above graph shows, China has been a very large driver for the growth that exists in the global smartphone market. With unit shipments growing from under 20M per quarter in 2011 to around 100M by year end 2014, the growth in China has been nothing short of phenomenal. It is what has driven global demand increases for smartphones. And, Apple has been a major beneficiary of this growth.

As IDC shows us, Apple has had great growth in China, actually outperforming the market by taking significant market share, primarily from Samsung. We'll get into what part of Apple's total growth came from China later. But, would you allow me to say that, based on the growth of the market and Apple's share, it's been a key driver for Apple?

Assuming you're okay with my theory that China has helped drive not only the global smartphone market but Apple in particular, the following headlines from the last week might be cause for alarm.

Gartner Says Worldwide Smartphone Sales Recorded Slowest Growth Rate Since 2013 (and in the article, "smartphone sales in China fell for the first time year over year, recording a 4 percent decline")

China's Smartphone Startups Face Crowded Market, Falling Demand

Huawei Beats Apple, Samsung With New Smartphone

Those are the headlines I picked, but I could have chosen another hundred or so. The market for smartphones in China has hit a turning point. Emerging markets were driving growth in smartphones and the biggest, baddest of all emerging markets has just laid an egg. Is this temporary? I'm not sure, but I can say with certainty that we are nearer the end than the beginning of the smartphone cycle in China.

You'll notice that the second headline I chose speaks not only to falling demand, but a "crowded market". This is the saturation I spoke to earlier. The major manufacturers are being attacked by startups and rivals as they all compete for market share. And, they are competing on price.

"China's Smartphone Sector Set for Shakeout, Says Huawei" - Wall Street Journal, Sept. 4, 2015. Yep, it's happening and it's happening now.

I said earlier that I'd discuss how much of Apple's growth comes from China. And, to be honest, it's not as much as one might think, which is a reason for optimism against my negative rant. Here is a total shipment volume of iPhones chart.

And, a search online tells me that China was around 20% of total iPhone sales in Q1 of 2015 versus 17% in Q1 of 2014. So, China isn't the driving factor for Apple sales although it has grown faster than the rest of the world.

Thus, Apple would seem to be a little insulated to issues in China's smartphone market. But, I think that's not the case. As, in this day of globalization, when you have cracks in one market, they can ripple elsewhere. And, new manufacturers in China can easily sell product elsewhere. So, in this case, I think the cracks in the Chinese market, the global leader for the last few years in smartphones, will have repercussions globally. I look for them to show up in margin pressure for all handset manufacturers.

One Trick Pony?

I've laid out my thesis that the smartphone market is maturing and that the key growth driver for that market, and a strong one for iPhone sales, was China. And, it's a market that is in trouble.

But, Apple has more going on for it than just iPhones, right? How important is the iPhone to Apple? Actually, while Apple has a lot of successful product lines, the iPhone is far and away their most significant business line. Allow me to explain in a couple bar charts.

The following chart shows iPhone revenue as a percentage of Apple's total revenue over the last 6 years.

As you can see, the iPhone represents close to 2/3rds of Apple's total revenue. This is by far the most important product in the company's portfolio from a revenue standpoint. And, looking below from a profit standpoint as well.

The above chart is a little dated. However, one can assume that the percentage of profit derived from the iPhone has only increased during the past year.

The iPhone has been a resounding success. It accounts for 2/3rds of Apples revenue and an equal share of its profits. It is at once Steve Job's greatest success and, now, the Achilles Heel of Apple stock.

Hardware History: It's Ugly

I remember the Motorola RAZR. What a great phone! Everyone had to have one and Motorola was on top of the world.

But, really, the Blackberry was the best. Email on your phone. The full keyboard. What more could you ask for?!?

Wait, what about the Nokia 1100? Wasn't that something to run out and buy?

I think you get the point. History is literally littered with companies that had "the next big thing". At the time of their success, these companies could do no wrong. And, their shares reflected this by going steadily higher.

It's really been a foregone conclusion, until Apple at least, that hardware companies are cannibalistic by nature. They devour each other in an effort to gain market share at the expense of margins.

Take your pic of the industry. Personal computers? Wow. Dell, Compaq, HP, etc. All trainwrecks as margins got squeezed once growth slowed in the industry.

Hmmm...maybe larger computers. Wang, Digital Equipment, IBM (before they focused on services). All disasters as margins got squeezed as growth slowed in the industry.

How have the top handset manufacturers faired over time? No better. Nokia, RIMM, Ericson, Motorola. These were all once leaders in the space. In each case, they missed a product cycle, volumes declined and margins got squeezed.

Now, I like Apple and its products. I don't wish anything negative upon them. But, look at this chart.

And, when you look at the chart, realize that, throughout history, hardware manufacturers have always ended up suffering from declining margins. As the bar graph below shows, this has yet to be the case with Apple.

As we know, the iPhone is possibly the greatest product ever. It has generated stable margins in an industry that is not known as anything but volatile. It was the perfect product for the right time as smartphones went from unknown to ubiquitous. Cudos to Apple.

Now, however, two thirds of Apples revenues and profits come from the iPhone. It is a universally copied and imitated item. They have one in every size and color. The market for cell phones is saturated and slowing.

The iPhone is, maybe, the most successful consumer product in history. But, the last few product launches have only been interesting from a "size of the phone" standpoint. The product is pretty fully developed. Thus, this pony has run its race and Apple, like all leading hardware companies that preceeded it, will eventually come under margin pressure on the iPhone. And, when that happens, it will be ugly.

What Is Next For Apple?

This is where I become a neophyte on Apple. I am simply not sure what comes next...but, due to the overwhelming influence of the iPhone on the sales and earnings of Apple, I'm not sure it's too important over the next couple of years to know what else they're working on. Let me explain.

First off, I'm not a fan of the iWatch. I just don't see this being a large growth driver for Apple anytime soon. And, a potential Apple Car is many years from reality.

The iPad, on the other hand, is an amazing product. It also has run its course in terms of being a market leader and unique. There are imitators, there are no compelling reasons to upgrade, and my old one works fine. Sales of the iPad reflect this as that market is in decline. I actually think the recent past for the iPad is a great preview of what one might expect to happen to the iPhone.

I own a Macbook and, possibly, Apple can take this product to the corporate market. If so, there's a good opportunity for unit growth. But, that market is shrinking, margins stink, and, in order for Apple to take share, they would need cut prices and suffer margin pressure across the whole product line; something I just don't see them doing. Consumers will pay up for an Apple product, corporations probably not.

Apple TV is always rumored to be the next big thing. And, I wish they would churn out a great product that simplifies my home systems. Truly, that would be amazing. But, I don't see it happening anytime soon based on what I have heard and read.

All of which leads me to my conclusion that, due to the unbelievable success of the iPhone, there isn't any product in the pipeline at Apple that can sustain it during the inevitable down cycle that is coming.

The bottom line for me is that Apple is a hardware manufacturer. Throughout history, technology hardware companies have always suffered margin pressures and most haven't always managed to be ahead of the curve on product cycles. Only one company in my memory has avoided these issues. That company is Apple. And, with their over-reliance on the iPhone and cracks appearing in the market, along with increased competition, I am very worried that history will repeat itself yet again.

How to value Apple?

This is possibly the most interesting company in history. Apple is throwing off cash in quantities that are almost unrealistic. They are also buying back shares hand over fist.

Apple is currently trading at around $110 per share, which gives it a P/E of 11.3 times forward earnings estimates. That makes it rather a cheap stock...if earnings are hit. On an EV to EBITDA basis, Apple is a little more expensive, trading at over an 8 multiple. Not obscene, but not bargain basement, either.

There's one funny things about stocks, however, and most people don't realize this. They can be most expensive on their lows and cheapest on their highs. A good example of this is looking at energy stocks. Right now, a good portion of these companies are losing money, i.e. infinite P/E ratios. My guess is that last summer, when they were trading at their highs, their forward and trailing P/E ratios looked cheap.

This is because stocks have high P/Es when business has room for improvement and low P/Es when things are as good as they can get. Don't fall into the value trap on Apple; the market is telling us that things can't get any better and this is why the stock has languished since March despite strong earnings.

Am I predicting losses for Apple? Heck no! I do think that the iPhone will suffer margin pressure. Look at the above graph and ask yourself, "is this sustainable?" The iPhone is good, but really?

My guess is that margins on the iPhone, which are so much higher than all other manufacturers, have the potential to come in as much as 50% over the next couple years. This would cause a reduction in profits of almost 1/3 from current levels since 2/3rds of their profits are iPhone generated.

So, my bottom line on Apple is that the company is trading at around 13 times my expected 2017 earnings. If I'm right on that number, earnings will have to come down over the next two years. And, if that happens, Apple's stock will continue to drift sideways as it has in 2015. I like Apple's products. I think the stock is dead money and I'd look for opportunity elsewhere.

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