About: Apple Inc. (AAPL), Includes: NOK
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.
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:

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:

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.
If
you like what you just read, click the like-button and consider
following me so you can read my articles before they hit the paywall.
Just scroll up to the top of the article and click the orange
Follow-button. Also, don't forget to join the conversation below. Thanks for your support!
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.
No comments:
Post a Comment