Friday, February 1, 2019

Is Apple The Next Nokia?





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About: Apple Inc. (AAPL), Includes: NOK
Long only, Growth, long-term horizon
Summary
 
I was clearly wrong about Apple’s Q1 2019 guidance being conservative. Their miss raises concerns.
Taking a closer look at the business you can identify many growth challenges.
However, Apple is not the next Nokia.
Their ecosystem is strong and the long-term business outlook remains positive.
It is unclear if shares are going to substantially outperform the market in the long term.
I was wrong about Apple (AAPL).
In my last article, I argued that guidance for Q1 2019 was very conservative, and since Apple didn’t miss their guidance in more than 15 years, felt confident that it wouldn't happen any time soon. Of course, Tim Cook released his warning letter only a couple of hours after my article got published. Talk about good timing.
But in a way, I’m also glad that this happened. I have to admit that I have been guilty of being complacent as an Apple shareholder – after all, this has been a no-brainer long-term investment for many years. The miss by the company (and by me as a writer) has made me take a deeper look. Here is what I found out:

Is Apple The Next Nokia?

When Goldman compared Apple to 2007-Nokia (NOK) at the beginning of the year, citing a "rapid expansion of replacement rates“, it made investors a bit baffled. Could they be serious? Just to remind you, in 2013 Nokia – the former dominant leader in mobile phones – sold its Devices and Services division to Microsoft for $7.2 billion after being worth more than $100 billion as recent as 2007. It cannot be that bad, can it?
Let’s rewind a bit. In 2007 Apple released its first iPhone which completely changed the mobile phone industry. From then on, your mobile phone wasn’t just a phone to take calls (and maybe handle your e-mails), but a mini-computer matching the capabilities of your laptop and bringing about a 1,000-fold increase in possible use cases through applications. Nokia completely missed that train by being late with developing their operating system MeeGo. When they finally realized it was too late to establish their own operating system, they fumbled again by partnering with the wrong software company – Microsoft instead of Google’s Android. In his famous 'burning platform' memo to employees, then-CEO of Nokia, Stephen Elop, acknowledged that “the battle of devices has now become a war of ecosystems“.
Nokia lost this war because they had no ecosystem, not because their replacement cycle expanded. There was no talk of a replacement anymore. People just didn’t buy their phones because the industry changed dramatically and Nokia wasn’t quick enough to adapt. Now, if Goldman really believes that Apple is comparable to 2007-Nokia, where do they see this fundamental shift in the smartphone industry today? What comes after the ecosystem?
The short answer is that you cannot compare 2007 to 2019. There is no substitution to the smartphone and the duopoly of Android and iOS on the horizon – at least as far as I can see. Apple is not the new Nokia, it's far from it. However, that doesn’t mean that there are no challenges to Apple’s business, there are plenty. But they are all related to the challenge of continuing to grow (or preventing to decline) from a position of extreme strength, rather than the challenge of being disrupted by new technology.

The Strength Of The Ecosystem

Apple still has a very strong ecosystem of products and services, arguably the strongest it has ever been. People still sign up to the ecosystem in droves and looking at the numbers you simply cannot draw any parallels to Nokia's demise.
Apple reached 1.4 billion active installed devices at the end of 2018 and has therefore added approximately 100 million active devices per year for the last three years. Also, Apple's loyalty rate, which to my surprise has been lower than Android’s in the past, has been catching up. In Q3 2018 Apple’s retention rate was estimated between 85% to 89%, while Android’s came in between 89% and 92%. These are both very high loyalty rates. However, since Android’s market share and their installed base is much larger than Apple’s, naturally, Android loses more users on a per capita basis every year. For example, in 2017, iOS only “lost” about 30 million users to Android, while Android “lost” about 112 million to iOS. In balance, Apple has therefore added approximately 82 million users in 2017.
According to IDC, Apple’s iOS has even been gaining market share slightly versus Android in every quarter since the start of 2018. In Q1-Q3 2018 iOS market share was estimated at 15.7% (14.7% in 2017), 12.1% (11.8%) and 13.2% (12.4%) respectively. StatCounter also recorded slight market share gains of iOS in 2018 (from 19.91% at the start to 21.98% at the end of 2018). If you look at longer-term data, going back to 2009, you can see a clear trend of declining iOS market share versus Android. But that is not terribly surprising since Android's open ecosystem strategy makes growth much easier.
While Apple hasn't excelled at gaining market share in the past they certainly made up for it by raking in most profits generated in the industry. In that sense, their closed ecosystem strategy is playing out very nicely. And if you couple the facts presented above with customer satisfaction being at all-time highs you can only surmise that Apple's business is doing great.

Many Challenges Ahead

But that doesn't mean necessarily that shares are a great buy now. The biggest challenge for Apple is that the smartphone market is saturating, replacement cycles are getting longer and since iPhone sales account for 60% of Apple’s revenue, their decline could mean serious trouble for future growth.
Apple knows this for a long time and had some solutions for it: They started focusing on their last remaining big growth markets (China and, to a much lesser extent, India), they continuously hiked prices of their products and they shifted their focus more towards non-iPhone sales. But that hasn't all worked out perfectly.
A lot has been written about China already. We now know that China sales are down 27% in Q1 2019. That is a huge drop and can not only be explained by a weak Chinese economy, the trade war, and foreign exchange headwinds. As a reference, Starbucks (SBUX) recently reported Q1 2019 earnings and saw China comparable store sales up 1% and total China stores up 18% yoy, which shows that consumer spending is quite robust in China.
There are many more reasons for Apple’s struggles in China and they are much more challenging to resolve than macroeconomic headwinds: First and foremost new iPhones are simply too expensive, a problem that has been increased by dwindling carrier subsidies. Also important, Apple started to fall behind Chinese competitors. A reason for that could be a more specific aspect of the Chinese market: They mostly use WeChat as their operating system for their smartphones, which largely removes Apple’s software and ecosystem advantage.
There is no denying that Apple has an emerging market problem and it is most likely a result of their own pricing decisions. Nowhere is that more apparent than in India, where Apple is clearly losing out at the moment because they are simply too expensive (with massive import tariffs adding to the damage).
Apple can’t keep increasing prices at will, even in the developed markets. For example, not only China was down in the quarter, but also Europe and Japan saw slightly shrinking revenues. And with shrinking unit sales and no room for price hikes for the iPhone, growth will come by very hard in the future.
Apple is arguing that raised prices are a reflection of maximizing product quality, durability and sustainability. This is a good marketing slogan and from a long-term perspective it might be a good strategic move but it is by no means alleviating the fundamental problem of smartphone market saturation. On the contrary, by increasing the lifecycle of their products they are intentionally extending the replacement cycle. That's not really a good thing.

Services And Other Products Growth Might Not Be Enough

 

Adding to the injury, Apple's non-iPhone segments will most likely not be able to offset the lost revenues, not even the often highlighted services segment. That was very evident this quarter. Revenue from iPhone declined 15% yoy, and while revenue from everything else grew 19%, total revenue was down 4.5%. In Q2 this will continue with a projected revenue decline of 6.7% yoy. One analyst called the sequential decline from Q1 to Q2 the steepest in iPhone history. iPhones still make up the lion's share of Apple's revenue. And that is a problem for the overall business. Even after the iPhone sales decline, the revenue mix didn't materially change:

Product mix  

Source: Graphic from Author, Numbers from Apple Q1 2019 Results.

Another issue is that a considerable portion of Apple’s services revenue could actually come from AppleCare, which, as basically a warranty, has to be seen, for the most part, as an extension of iPhone sales. Some analysts estimate that it could account for up to 30% of the services segment. If this was true the revenue diversification effect of the emerging services segment could be much lower than portrayed by the company.
It’s easy to jump on the bandwagon regarding services. Their margins are great (62.8%), they are growing paid subscribers rapidly (currently 360 million, of which 120 million were added in the last 12 months; they expect to reach 500 million in 2020), and Tim Cook recently commented that Apple's most important contribution to mankind will be in health. That may become true. But how will they meaningfully monetize their health services to make this an important contribution to shareholders as well? The Apple Watch has been a success but it's still less than 8% of overall revenue. Also, if they "only" grow subscribers to 500 million by 2020 their growth rate will drop from 50% in 2018 to 18% in 2019 and 2020.
Overall, services and new products will be important for Apple’s future, no doubt. But looking five years out, they just won’t move the needle for the company as a whole.

Valuation And Some Awesome Numbers

Apple also posted some amazing numbers in the quarter. As always, the sheer scale of Apple is just breathtaking. Their smallest segment, Wearables and Home, made $7.3 billion in sales in one quarter alone and was growing a whopping 33%. They also shared the installed base number for iPhones for the first time, which is 900 million (and growing 9% yoy). As already mentioned, their installed base reached 1.4 billion devices at the end of 2018. They reached operating cash flow of $26.7 billion during the quarter, set an all-time EPS record of $4.18, returned over $13 billion to investors and ended the quarter with a net cash balance of $130 billion.
At the same time, their valuation appears to be dirt cheap:
Chart  
Data by YCharts
Can someone explain to me how Apple can trade at a lower valuation than P&G? And this graph doesn't even exclude Apple's cash balance which would decrease the PE ratio even further. There still seems to be a lot of FUD surrounding Apple. Some of that was removed by the earnings report but certainly not all. Rightly so?

Conclusion

It's hard not to get a feeling of ambivalence about Apple's shares after diving a bit deeper. For one thing, they post incredible numbers each quarter, continue to improve their ecosystem and are trading at dirt cheap valuations according to traditional metrics. But then again, there is this sword of Damocles of smartphone saturation and shrinking iPhone sales hanging over them that just seems very hard to overcome.
Didn't I call Apple shares a screaming buy in my last article, citing high FUD-levels and low valuation? Well, he who shouts is not always right. After contemplating about it more I reminded myself of something I thought I had already learned: Valuation doesn't tell you a lot about the future performance of a stock. Just as "overvalued" stocks can stay overvalued for extended periods of time if they keep performing (and make the "overvaluation" of the past look like an extreme bargain in hindsight), "undervalued" stocks can stay undervalued for extended periods of time if they don't show improved business metrics.
What does that mean for Apple shareholders? Selling now in the depth of a cyclical downturn is probably not ideal. At the same time being heavily overweighted in a mature company with unclear growth prospects could really hurt your long-term returns. I personally used the after earnings pop to sell some shares that I bought in late 2018 and early 2019 for a small gain because I see better opportunities elsewhere.
My remaining Apple position still makes up 5% of my portfolio and I intend to hold that part. But mentally I moved this position from the "no-brainer long-term investment"-category to the "keep on a short leash and watch closely"-category. I think you should too.
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Disclosure:  

I am/we are long AAPL. 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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