Monday, 14 February 2011 12:00

Apple Gears Up To Combat The Margin Compression That Apparently Only It, Google & Reggie Middleton Sees Coming

Ever since the summer of last year, I have been one of the very few - if not the only - commentators that have warned of impending margin compression in the current NASDAQ and general market darling, Apple. This is not speculation, it is basically a foregone conclusion. In addition, it is really not difficult to surmise. Apple enjoyed virtually competition free dominance in the graphical smartphone arena for nearly three years, but the onset of Android has not only brought heavy competition, it has brought competition that is superior in many areas. Competition, almost by definition, means margin pressure. It's simple business logic. Despite what appears on the surface to be common sense, Apple afficiandos from consumers to investors to analysts to arm chair pundits fail to grasp what should be considered a very simple concept. I have spend considerable digital ink attempting to illustrate this last year...

  1. Android is gaining preference as the long-term choice of application developers
  2. A Glimpse of the BoomBustBlog Internal Discussion Concerning the Fate of Apple
  3. Math and the Pace of Smart Phone Innovation May Take a Byte Out of Apple’s (Short-lived?) Dominance
  4. Apple on the Margin
  5. Android Now Outselling iOS? Explaining the Game of Chess That Google Plays in the Smart Phone Space

As it has turned out, my proclamations of Android quickly taking the number one spot in both US and global smartphone sales was right on the money. Now, this level of competition is outstanding for consumers, but investors should be cautious. This is true despite practically all of pundits stating that the market share champion was Apple's crown to take. Apple is a wonderfully inventive, strong and creative company, but Google has painted it into a corner that very few apparently have recognized. As Bloomberg Reports: Apple Said To Work On Cheaper, More Versatile iPhone Models, and Endgadget/WSJ amplifies:

... a device half the size of the iPhone 4, bearing the codename "N97," and said that the handset will be only about half the size of the original, and at only around half the price too.

Again, Apple will face margin compression as it competes with the very Chinese labor force that it sources from, and competes (via the Android battle) with the very same Asian companies that it sources its most critical components from - Samsung and LG, reference  Be aware that although I feel Apple will not win the commoditization fight, it is a fight that it is being forced into due to the proliferation of Android through nearly all price points, geographic markets and carrier platforms - therefore Apple has no choice. Apple has always thrived as a niche company, and entering a space that is being rapidly commoditized by Android is dangerous and at the very least guarantees margin compression. It is not as if money can't be made in the space, but it is much easier to make money in the commoditized space when you don't have to pay for the OS development, you know like the Android adopters. Witness the success of my historically favorite (at least for now) handset maker, HTC after they invested full on into Android and benefited from the commoditization of the high end smartphone...

The margins will shrink even further, even as revenues skyrocket. R&D costs will be massive. Take a look at the level of innovation in the high end smartphone space due to the creatively destructive disruption that is Android that Apple - for the first time since the launch of the iPhone - has to now play catch up to. The level of ingenuity and tech coming out in such a short period of time is utterly stunning, and I believe it will be impossible for Apple to out-engineer all of these hardware vendors AND Google's Android release cycles.

True, glasses free 3D as well as full 1080p HD recording and playback that actually works... Amazing!!!

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A dual-core, full 1080p phone that can power its own netbook as well as power other full screen size multimedia devices...

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Playstation phone w/full controls

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Foldable 4.7 inch cell phone screen

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If that's not enough, I warned all last year "". Witness this Windows Phone 7/Xbox/Kinect integration demonstration. Amazing!

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Apple's tech actually appears boring in comparison to these samplings. It has a lot of work to do just to keep pace.

Back to Endgadget's story:

Amazingly, those anonymous sources continued to divulge information, expressing the idea that Apple could finally make its MobileMe cloud service suite free, and that it just might be the platform from which Apple could finally launch a streaming music platform and lessen the need for all those gigabytes of flash storage in your pocket.

Here we have Apple giving away its cloud services for free, undoubtedly in a bid to compete with Google's extensive cloud offerings, the vast majority of which have always and still are free. Again, margin compression. Last but not least, the cash generation machine that is iTunes will finally succumb to the cloud and the dynamic (and less profitable) pricing of the streaming model. Again, margin compression.

Endgadget also reports that the new iPhone has a lukewarm reception in the Apple stores. Apple has had potential customers spend the night in front of stores, with said lines circling the block more than once over for previous releases. This CDMA iPhone release saw TWO (that's right, 2!) people in line at the opening in this Illinois store. You can also bet that Verizon cut a much harder deal than ATT's Apple-centric sweetheart  agreement. Due to the intense competition from Android and Verizon's own stables gushing handset sales (like everyone else who has touched Android) from the new open source OS adoption, Apple needed this deal a lot more than Verizon did.

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See Apple on the Margin and my on air proclamation just hours before Apple released earnings and declared – surprise, surprise – a drop in margins. Go to 3:40 in the video

Here is the complete analysis of smartphone and vendor handset growth up until Q3 2010. I will parse the numbers and release the most recent quarter soon, and make it available to subscribers. Be sure to scroll through the entire spreadsheet model below using the “<” and  “>” buttons in the lower area of the window. The model is very, very extensive!

Apple has a veritable cult following. Hey, I like the way their products look, I love their marketing prowess, and even own a product or two myself. Of course, for some arcane, unfathomable reason I have never been plugged into the "Matrix" for the new millenium, what some have dubbed Apple's RDF (reality distortion field) wherein many Apple shareholders and product owners somehow fail to see the virtues of competing products and companies. That may be cool if Apple is simply a casual investment, or the product inventory is not a serious business decision (ie, just a fashion statement). For those who must take things a bit more seriously, its time to open your eyes...

Subscribers are reminded to review the Apple iPhone Profit Margin Scenario Analysis ModelTooltip as well as review the Apple Earnings Guidance AnalysisTooltip document that details how Apple's management expertly manages sell side earnings expectations, and consequently their share price. Non-subscription readers should reference ...

Riddle me this – If Apple can consistently beat the estimates of your favorite analysts quarter after quarter, after quarter – for 11 quarters straight, shouldn’t you fire said analysts for incompetency in lieu of celebrating Apple’s ability to surprise? After all, it is no longer a surprise after the 11th consecutive occurrence, is it? I would be surprised if my readers were surprised by an Apple surprise. Seriously! Apple management consistently lowballs guidance to such an extent that it can easily manage, no – actually create outperformance. This has has a very positive effect on their valuation. Of course, I do not blame Apple management for this, of they are charged with maximizing shareholder return. The analytical community and the (sheeple) investors which they serve is another matter though. Subscribers can download the data that shows the blatant game being played between Apple and the Sell Side here: File Icon Apple Earnings Guidance Analysis. Those who need to subscribe can do so here.

Below, I drilled down on the date and used a percentage difference view to illustrate the improvement in P/E stemming from the earnings beats.

In our analysis of Apple, we are using real world assumptions of future performance derived from backing in to the low balling this company is prone to. If you look at its history carefully you can gauge what management is comfortable with, hence what they may be capable of on the margin. Using these more realistic numbers, it is much more likely Apple will deliver a miss in the upcoming quarters in its battle with the Android! The following is the reason why.

Apple is growing like a weed and at expanding margins, but those margins are most likely at (or close to) their peak and will probably drop rather quickly since The Apple “beats” analyzed above include margins, and the company has consistently beat on margin. Keep in mind that Apple has very strong competition in their most lucrative space where they literally had none before. The competition is already outselling them and offering more technical flexibility and diversity. Thus, when (and that is an emphatic when, not an “if”) margins “continues to drift downward, the sheeple will be clueless and probably pile deeper into Apple stock because they will probably still be “beating” at every earnings announcement.

Later on today I will be releasing a list of over a hundred companies in the smart phone space (with and without ADRs) and a shortlist of 6 for subscribers, complete with a veritable rash of information and metrics on each.

Last modified on Monday, 14 February 2011 13:42


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