Of Course Apple is Doomed - it's Earnings Season

by Mark W. Hibben
7/13/13

Affectation of Inevitability

As we approach Apple's earnings report on July 23, the steady stream of negative pronouncements, downgrades, and forbodings of imminent demise reaches a crescendo of despair. You would think Apple had turned into . . . Blackberry.

The list of negative articles in the tech business media is already too extensive for me to summarize here, so I'll only touch on the most egregious:

1) Rocco Pendola's "There's No Question Now: Apple is Dead" which made the Mac Observer's Apple Death Knell Counter list as the 62nd and most recent entry.

2) Adam Lashinsky's "Are Apple's Best Days Behind it?" in money.cnn.com. Although Lashinsky never quite answers his rhetorical question, he makes it clear what he thinks the answer is.

3) Trip Chowdhry of Global Equities (as reported by Philip Elmer-Dewitt: "The current executive team led by Tim Cook and Peter Oppenheimer have destroyed the shareholder value at Apple."

And the list goes on and will undoubtedly get longer before July 23. What bothers me about the doomsayers is the affectation of inevitability, as if Apple's predicted decline and fall were the result of a force of nature. Apple's cash hoard of $130 billion has at least made Apple's management the masters of their fate, free to succeed or fail based on the decisions they make.

Not that I always agree with Apple management's decisions. I don't put Apple on a pedestal or regard Apple management as infallible, and I don't see how any Apple investor could be happy about what has happened to Apple's stock price this year, even if you weren't directly hurt by it. Unlike many Apple supporters, I don't regard Apple's current valuation as merely the product of irrational hostility. Just as the doomsayers often base their predictions on some kernel of truth, there is a core of concern about Apple's competitiveness which is legitimate, based on Apple's Q1 performance and the guidance Apple gave for Q2.

Although total revenue had grown in Q1 by 11% to $43.6 billion year over year, operating income suffered a steep decline by 18.4% to $12.6 billion as gross margin declined about 10 percentage points to 37.5%. At the time I counseled patience, and argued that Apple's margins should come down further in order to protect market share without cheapening the Apple brand. Here my logic was simple: lower, more competitive prices don't cheapen the brand, but cheap (in quality) products do. Investors would need to take the long view that protecting market share was more important than near term profit.

Apple's guidance at the time confirmed that Apple was indeed aiming to sacrifice some near term profit on behalf of market share. Using Apple's most optimistic combination of revenue and gross margin, Apple's guidance still predicted another even steeper year over year decline of 19.8% in operating income to $9.285 billion on revenue of $35.5 billion.

Prospects for Q2

Apple's prospects for Q2 are unlikely to break out of the guidance range of the Q1 earnings report. With the new Haswell equipped MacBook Airs as almost the only new Apple products that consumers can buy, Apple doesn't have much to move the earnings needle. Furthermore, the argument that a slowdown in Samsung smartphone sales growth indicates a broader market slowdown is probably valid. As the charts below show, my model predicts a continuing steep sequential decline in both iPhone and iPad sales volume and revenue, although with slight year over year increases.

I expect Mac unit sales to escape the brunt of the worldwide PC sales decline of 10.9% recently reported by Gartner, but I still expect a year over year decline of roughly 5% to 3.8 million units. My model predicts total revenue of $35.2 billion, which is essentially flat year over year, and an operating income of $8.73 billion, an almost 25% decline year over year. As can be seen in the chart below, operating income is predicted to be at its lowest point since Q3 2011.

Hope for a turnaround

While I concur with Apple's move to lower margins, of concern is the indication that this isn't doing much to arrest unit sales declines in Apple's major product groups. Apple may exceed my expectation in this regard, but I consider the model predictions realistic given the derth of new iOS products or new product categories.

Assuming that worldwide sales for Q2 will be about the same as Q1, a fairly dramatic slowdown in growth, total smartphone sales to end users will be around 210 million, and Apple's market share will have declined to 14% from 18% last quarter and 18.8% a year ago.

Until Apple begins to roll out new products in the fall, I don't see much hope for a turnaround in Apple's market share decline, and I don't expect Apple's share price to do more than tread water somewhere in the $400-425 range.

As I've stated before, I consider product diversification, especially in the iPhone product family to be key to defending and expanding market share. The iPod media players consist of three distinct form factors and price points, and this variety has been instrumental in defending iPod market share in the U.S.

What to look for in the report

Investors, lacking better news, should look for signs that Apple is making tangible progress to diversify and expand its product lines. One of these is boosting R&D spending above the roughly 3% of revenue that is the Apple historical norm. Boosting R&D is a necessary and probably sufficient condition in order for Apple to bring new products and product updates to market faster. Other signs include a boost in Marketing expenditures as an indirect indicator of impending new product rollouts. And of course, Apple may drop some hints about new products.

Most importantly, Apple's gross margin should continue to come down. I look for Apple to guide to 35% gross margin for Q3.

So far I've seen little progress in the product diversification and R&D spending, but I'm willing to hang in there until the fall product rollouts. Really new products can take many months, even years to develop, so I'm not one of those calling for regime change at Apple, even though Cook does seem less and less like the leader Apple needs.

In the end, I'm still an Apple investor because even if the current leadership proves itself unworthy, better leadership can and will be found.

 

Apple's Ebook Trial: the Takeaway

by Mark W. Hibben
7/11/13

Not Even Close

When I wrote about Apple's ebook antitrust trial not long ago, some of the comments I received expressed incredulity that I could even contemplate an Apple loss. Didn't I realize that the government's case was a shambles? Had I even followed the trial? The daily coverage of the trial by Philip Elmer-Dewitt (PED) in money.cnn.com was held up to me as a model of accurate, insightful reporting.

Today (7/11/13) PED issued his mea culpa, after spending the evening reading through Judge Denise Cote's 160 page official Opinion & Order. He acknowledged that he had completely misread the state of the government's case, as well as Cote's attitude towards Apple. Although he admitted being mystified by anti-trust law, he nevertheless held out the hope to his readers that Cote's decision would be overturned on appeal, and of course, Apple will appeal.

I also have read through the Opinion, and I would characterize the chances of Apple overturning the decision as vanishingly small. Judge Cote makes it clear in the Opinion that Apple wasn't even close to mounting a successful defense in the trial. She repeatedly characterizes the government's evidence against Apple as "overwhelming" and "compelling", whereas the kindest word she uses to describe Apple's arguments in its defense is "creative".

Furthermore, Cote repeatedly characterized the testimony of key Apple executives, especially Eduardo Cue as "lacking credibility". Most importantly, Apple was found to be in per se violation, meaning that the conspiracy between Apple management and the so-called Publisher Defendants was so blatant and obvious that even if it had not succeeded, it would still have been a violation of Section 1 of the Sherman Antitrust Act (SAA).

It was also obvious to Amazon that it was the focus of concerted action by the Publishers in 2010 who within days of executing their contracts with Apple, demanded that Amazon give the Publishers the same terms that Apple had or be boycotted for book releases. Amazon executives objected strenuously to the Publishers' demands but within a few weeks capitulated. Amazon had no choice. In order to continue selling ebooks and Kindles, it had to accept the terms dictated by the Publishers.

The fact of this action and its effect on prices was probably the most damning evidence in the government's case, but it was by no means the only evidence. The evidence was simply vast, as well as compelling.

Judge Cote also emphasized that even if Apple had not been found in per se violation, it would have still been in violation of SAA under the more difficult to prove "rule of reason". This means that even if an outright conspiracy cannot be proved, if the defendent's actions produce an "unreasonable restraint of trade", then the defendant has nevertheless violated SAA. Judge Cote makes clear that the DOJ offered more than sufficient evidence to show that Apple's actions tended to produce an unlawful restraint of trade and that it harmed consumers.

So Apple lost on both points, and not by a small margin.

Unfairly Targeted?

Through the contracts that Apple executed with major book publishers on the eve of the debut of the iPad in January 2010, Apple and the publishers acted in concert to force Amazon and subsequently Google to accept the publishers' new terms for e-book pricing. Amazon had been selling many ebooks at a loss for $9.99, presumably to stimulate sales of its Kindle e-reader. Amazon had a virtual monopoly on the ebook market, estimated at 90% prior to the introduction of the iPad. With the advent of the iPad and the new price structure imposed by the publishers, prices for most NYT Bestsellers and new trade books rose to levels specified in the Apple publisher contracts, roughly $12.99 - $14.99.

Some believe that Apple has been unfairly targeted and that Amazon, as the obvious monopolist in early 2010, should have been the subject of the anti-trust suit. This is simplistic, though understandable given the ambivalence of the U.S. legal system towards monopoly.

Monopoly isn't automatically illegal under SAA. In fact, the American legal system has a long standing tradition, which predates antitrust legislation, of rewarding innovation with monopoly status through the patent system. Likewise, a company that achieves monopoly status through innovative business practices, as Amazon had done, isn't necessarily considered harmful or illegal. It would be a difficult case to make that consumers were being harmed by Amazon taking a loss on every ebook it sold in 2010.

Impacts to Apple and the Ebook Business

Now that the concept of Apple losing the ebook trial has become more believable, it's time to reexamine my thesis that this could lead to further investigation of Apple, in light of Cote's Opinion.

Certainly DOJ antitrust division attorneys, typically young, ambitious, and anxious to make names for themselves before entering the private sector, will see a further investigation of Apple as an opportunity to score additional legal victories at Apple's expense. Given how extensively Judge Cote impugned the integrity of Eddy Cue, and his involvement with setting up Apple's iTunes, it would just be due diligence anyway.

In her opinion, Judge Cote was careful to specify that her findings applied only to Apple's conduct in setting up the iBookStore, and should not be inferred to apply to other Apple businesses such as iTunes. She was also careful to state that the terms of Apple's contracts with the publishers were not inherently illegal in themselves, except as they were used to achieve the goal of price fixing ebooks.

Thus, Cote appears to rule out a need for further investigation, but this was just proper judicial restraint on her part. It's not for her to investigate Apple beyond the fact-finding required in this particular case. That role is properly the government's, and that door she left wide open.

I continue to believe that a new round of investigations will be a drag on Apple's share price, once it's announced by the DOJ, probably pushing Apple's price back down to $400.

In the mean time, Apple's contracts with Publishers, as well as Amazon's and Google's, have already been overturned as part of the Publisher's prior settlement's with the DOJ. The much despised (by the Publishers) $9.99 price point has returned to the ebook stores of Amazon, Google and Apple. The three major ebook sellers are now competing on price as well as services and content availability.