September 22, 2014

Are the best days of Apple behind it

Let me also make it clear that I expect Apple to underperform the markets, but I don't expect Apple's shares to drop from $100 to $55, which would be similar to its decline from September 2012 to May 2013.

I am simply of the view that Apple's shares are overpriced within the context of an expensive U.S. stock market.

At the core of my concern is that Apple's past successes are not likely to be repeated in the future.

The company's sales base has grown so large that Apple is not likely to benefit from the introduction of new needle-moving products. The competitive landscape has changed in the last few years, and Apple's core product (the iPhone) lacks superiority relative to its competition. As a result, Apple's earnings growth is settling down to a more modest path relative to history and to overall corporate profits, and its near-record-high P/E ratio is inflated."

Apart from the sensational title (and reference to doomsayers, which I am not), I felt the Barron's piece was fair, though I disagree with its conclusions. Barron's pushback (and the pushback from other Apple bulls) last week was reminiscent, and no different to, the response I experienced in my bear case for Apple in September 2012, prior to a more than 40% drop in Apple's share price.

At the core of my original argument two years ago was that Apple's shares were overhyped and headed for a fall (and did) as:

-    The competitive landscape was growing more challenging (it did).
-    Apple would start to lose global market share at a faster pace (it did, dropping from about 17% to 12%).
-    The above would reduce profit margins (to be fair, Ray highlighted this, too) that peaked at 44% in 2012 and now are about 38% (so I was correct on this score as well).
-    The above would also result in the absence of big consensus beats in sales and profits, which have characterized the prior five years (the company failed to materially beat in ensuing quarters). 

At the core of my argument in last week's Diary post is my belief that Apple shares will underperform the market:

-    Competitors continue to make market-share inroads into a company (Apple) that sells less for more.
-    Apple's P/E ratio has expanded in the last six months (as Ray noted) and has likely discounted a strong iPhone 6 product upgrade cycle.
-    The iPhone 6 upgrade will likely be the last major upgrade for the company (and valuations, which have expanded in recent months, will contract in the period ahead).
-    Profit margins will continue to slip.
-    After about two quarters of consensus meeting or beating (investor expectations) the upgrade cycle, Apple will continue to lose market share.
-    Apple has challenges to moving the overall needle with new products given the size of the company (each product launch has had a more limited impact on results).
-    Apple is no longer an innovator, and a strategy of selling less for more is not sustainable and does not merit the largest market cap in the world. Selling less for more has already resulted in drastic share loss. Being a market-share loser does not merit the largest market cap in the world. 

Though it's down to 10% in global market share, Apple will remain a strong ecosystem in which consumers continue to upgrade their products regularly. But the near-90% repeat upgrades is exposed and has likely peaked. So will the annual EPS growth of the last five years ever be repeated? EPS growth, which averaged 40% per year in the past five years, is likely to fall into the +5% to +10% range in the next five years, at best , and has a real risk of shrinking after this cycle completes.

Ray uses the argument that Apple's share-price rebound this year is proof that my analysis in 2012 might be wrong. The reality is that Apple has consistently lost market share since my bear case was initially presented two years ago. I think he mixes apples with oranges using this argument, especially since I purchased the stock after being badly beaten up in early 2013.

Apart from the hyperbolic title of the Barron's piece, I thought it was fair. But I stand by my investment conclusion and analysis, and I even look forward to "debating" my buddy Tiernan Ray in the future.

Apple remains all about the iPhone. All the ancillary businesses -- Apple Watch, Apple Pay, HealthKit, HomeKit and the rest -- make customers feel more tied to the iPhone and tells me that the company's installed base will continue to upgrade (albeit at a lesser rate than in the past). You may tell me me that the stock is going up, but don't tell me an overpriced, underspec'd phone that's two years late to the market will forever keep its competitive position and lead.

As evidenced by the brand loyalty (nearly 90% of Apple iPhone users upgrade with another iPhone), for years Apple's success with the iPhone has not been a race to the best technical specs; several manufacturers have offered phones with superior features over the past few years. (As an example, the Q8 processor is a sixth smaller and Apple has stopped adding transistors to the core CPU to extend battery life).

For years, the customer's ease of use (better software and integration) has trumped fewer features at a higher price. This might change in the years ahead. After all, when you are competing based on hardware differentiation, you are a hardware company.

And if it does change, it could jeopardize Apple's core base.

The culture of disruption is often replaced by Apple's past spectacular successes, and its resulting size represents one of the largest headwinds to future growth. The culture of disruption is often replaced by bureaucracy. In that setting, ambitious missions, disruptive goals and spectacular innovation are often left behind.

We can see evidence of the perception of the company's growing maturity by looking at a 15-year price chart of Apple and peg it to these product introduction dates:

    -iTunes, January 2001
    -iPod, October 2001
    -iPod Nano, January 2005
    -iPhone, February 2007
    -iPad, April 2010

If we discount the market crashes of 2001 and 2008, the chart indicates a steady narrowing of the share-price gains from each successive product launch. Meanwhile, research and development expenses continue to climb to sustain the older products, leaving less in each cycle for investment in disruptive technologies.

Not surprisingly, Apple has reported strong initial demand for the iPhone 6 in the last few days, yet the shares have actually fallen. This could be evidence that investors are paying heed to my concern that shares are "overowned" and/or there are few marginal buyers left.

Apple's best days (for the company and the shares) might be behind it, and that its virtuous cycle (with customers, subsidizing telecoms and shareholders) may be ending.