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Apple On The Day Of The 'Big' Announcement

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This article is more than 10 years old.

September 10 has arrived and the release of the latest iPhones, leaks, carefully planted on Weibo microblog or otherwise, now leaves little to the imagination for delivery of any new great ingenuity from the stage at Apple’s Cupertino headquarters. Barring some gigantic unexpected flood, it’s like we’ve already seen this girl naked. We already know that for the first time Apple will ship two different versions of the new iPhone, the 5S and the 5C.

We know, or strongly suspect, that Apple will formally announce a long awaited deal with China Mobile (CHL) which contains the world’s largest subscriber base at 700 million and that the 5C will be for the first time a significantly less expensive offering aimed at targeting those Chinese that don’t want to, or can’t afford to pay $820 for a new iPhone 5S. We will learn about the official rollout of iTunes Radio, Apple’s formal response to Pandora. The newest gadgetry is fingerprint ID system in lieu of a password….a little gimmicky but I can see some getting lathered up over that one. The audience will be notified of increasing iPhone screen size offerings to 4.8 and 6 inches, thus abandonment of long held Apple tenant that a smartphone must comfortably fit in the user’s pocket.

A New Strategy

While Apple has been losing market share in a big way to Samsung and others, “rumors of its demise are greatly exaggerated”. Global statistics, provided by Gartner research group, show Apple’s worldwide share of the smartphone market from the 2nd qtr. of 2012 to the 2nd qtr. of 2013 decreased from 18.8 percent to 14.2 percent. At first glance they fell off a cliff. But overall unit sales during that period still increased from 28.94 million to 31.9 million or a little over 10 percent….a positive trend at least. Samsung’s market share of smartphones during this period went up 2 percentage points to 31.7 percent but its sales volume increased over 56 percent.

This is the takeaway from these numbers. Number one is the smartphone market continues to get much much larger. Second there are now a bunch of tough new competitors that have quality products and are happy to offer phones for less to gain market share. Finally, as smartphone growth in the U.S. tapers, the big locomotive for expansion is in China.

Here is why Apple is forced to change direction and offer a less expensive iPhone. In the Apple’s third quarter ending June 29, iPhone Chinese sales plunged a disastrous 14 percent to $4.6 billion from same period in 2012. Yet Chinese smartphone are set to be 352 million units this year, up over 84 percent from 2012. For perspective that is more than double the number in the U.S. Sales are expected to be 421 million units by 2015 making China far and away the world’s largest smartphone market. Apple must regain footing and capture some of this growth.

Having been to China and visited with others who spend a good deal of time there, I can say that the consumer is of a different ilk than in America. Whereas here stateside, we often brag about what a great deal we got on this or that name designer item, in China it is almost the exact opposite. Big name brands are almost never discounted in the boutiques, and it carries much more esteem to have paid full price for that Fendi bag. So the question is if the new less costly iPhone 5C costs $400 (which is the speculation) will consumers embrace it or be embarrassed to bring it out and put it on the lunch table for all to see….after all, is it really a real iPhone? The Chinese consumer is an animal of extremes: they want the cheapest or the most expensive…..how will the Apple’s middle ground play?

Conversely, some analysts see it as a game changer for Apple. Morgan Stanley’s Katy Huberty published an August report suggesting a cheaper iPhone and a China Mobile deal could reap 32 million new annual sales for Apple. Others see it as a giant opportunity for Apple in the countryside provinces where Apple has a much smaller presence. Nicole Peng of Chinese firm Canalys views the deal with China Mobile as critical to the success of the low priced iPhone.

China Mobile has sparred with Apple for years over the iPhone. Now that China Mobile is losing customers to their much smaller competitors China Unicom Ltd. and China Telecom Corp., both of which already carry the iPhone, their attitude is bit less haughty. Apple, for its part, has to custom make phones that are adaptable to the China Mobile unreliable and antiquated 3-G network. Both organizations can now see a symbiosis developing, and the time to act for both is now.

Not All A Bed Of Roses

A low end phone will translate into lower gross margins. Currently Apple has the highest gross margins in the smartphone business.  Apple still has cachet, but good looks carries only so far. I predict margins will also start to compress on the Cadillac flagship iPhone 5S. Samsung and others make very fine products for much less money.

When the iPhone was first introduced it was Apple that flipped the model with the service providers upside down. Traditionally, the AT&T’s (T) and Verizon’s (VZ) of the world held all the power and dictated terms to the lowly hardware manufacturers. That all changed with the iPhone. The iPhone was in such great demand it was subsidized, meaning AT&T, the exclusive provider at the time, lost money on every iPhone that went out the door. To make a profit AT&T  introduced the two year contract to amortize that initial deficit and allow for a much lower front end price. Traditionally, the carrier’s name (AT&T or Verizon) would be prominently displayed on all handsets. The iPhone only carried the now ubiquitous Apple logo and was sold without any service provider logo advertising. That is now the standard for all phone sales.

Today both AT&T and Verizon (VZ) carry Apple products and most other high end smartphones are subsidized. That said, with the introduction of the Samsung Galaxy product line, Apple feels the intense heat of competition. “Android has definitely reduced some of Apples clout with service providers….and as Apple and Samsung pirate each other the consumer has been the real winner in this dogfight”, said one highly placed phone-company executive.

Let’s compare the penetration of Apple IOS operating system to Google’s Android OS. As of 2nd qtr. 2013, Android has a 79 percent global share compared to IOS share of 14.2 percent. One year earlier those figures were 64.2 and 18.8 percent respectively. Android OS is high quality and it is free.  Ask ten people and get all different types of answers on which system is more “elegant”.

The phone executive continued, “To the “non-fanboy” the iPhone and the Galaxy 4 are pretty much equal as far as features are concerned. It is the overall Apple ecosystem which still separates it as a superior device. The cloud photo stream, iTunes…..there app universe is still the best….but Android is fast catching up. The open (Android) system allows software app developers free reign to use their own tools. They are only limited by their imagination. So long term Apple’s IOS proscribed closed system will limit them. The open system environment is much more robust and sooner rather than later will overtake Apple in number and quality of overall apps.”

Perhaps what places Apple at the greatest disadvantage is that Samsung is a much more nimble company. Samsung controls the entire manufacturing process from microprocessors to screens. Conversely Apple is dependent on many different suppliers both to make the parts and then assemble them. It takes coordination from a lot of different corners to manufacture an iPhone. Samsung has much for flexibility to design and change their smartphone menu, including with different screen sizes numerous times each year.

Without any new innovative offerings to differentiate themselves, under this arrangement, Apple will always be playing catch up and fall farther and farther behind. In China the upgrade cycle for a phone is far more frequent than in America. Lenovo’s Liu Jun estimates the life of a phone to be “maybe a half a year”. It becomes imperative for Apple to adjust or continue lagging more vertically integrated competitors.

It’s Not Just Samsung

Several players with strong balance sheets have entered the smartphone sweepstakes. Since buying the IBM PC business in 2005, Lenovo (LNVGY) has overtaken both Dell (DELL) and Hewlett Packard (HPQ) to become the largest PC manufacturer in the world. Even with the PC pie shrinking Lenovo is projected to grow earnings in this low margin contracting business. Forbes reported that in the “smart interconnected device market”……smartphones, tablets and PC’s, Lenovo is now third the world behind Samsung (24%), Apple (14%) and then 7% for Lenovo.

They have climbed the smartphone ladder rapidly to become the number two seller in China where Apple has fallen to a distant seventh. According to Gartner research from 2nd qtr. 2012 to 2nd qtr. 2013 Lenovo has increased smartphone sales over 156% to 10.7 million units. There is LG electronics which has doubled sales year over year and ZTE with a 50 percent increase in sales. Some of this market share gain may be from mid-range priced products, but they wouldn’t be selling unless they were of high quality smartphones. Buyers have simply too much to choose from.

Mr. Carl Icahn, Activist At Apple….Please?

Then there’s the issue of activist investor Carl Icahn. Agitation is his milieu, and while his thesis that Apple is an undervalued asset was true at $440 per share I am less sanguine now that the $500 level has been breached.  Perhaps there is some ego distortion but inserting himself in a stock with a market capitalization of over $460 billion……well his $1 billion share purchase is of little more disturbance than a pimple on an elephants butt. It is just noise, and not very loud at that. His pontifications about massive share buybacks as accretive to shareholder value I meet with equal skepticism. At the end of the day, share repurchases at Apple are analogue to slapping a band aid on a case of gangrene.

To reach Mr. Icahn’s stated share target of $625, Apple must do more than offering fingerprint passwords and few extra colors in the upcoming iPhone release. As astute of an investor as Mr. Icahn most certainly is, it’s going to take more than a little balance sheet gerrymandering to increase the share value much from here. As a tweeting maven, Mr. Icahn is generous enough to keep all of us great unwashed informed about each and every snippet of material that passes between himself and Apple CEO, Tim Cook. There is an upcoming dinner between the two titans in the next fortnight. It is an excellent venue for Mr. Cook to tell Mr. Icahn to butt out and go pound sand.

From this moment forward any significant appreciation, to $600 and beyond, in Apple shares must come from innovation, precisely what made Apple famous. Under his tenure as commander of the spaceship Mr. Cook has not introduced a single new technology that might be termed “outside the box”. Allusions to the iWatch and Apple Television have remained drawing board rumors. One can’t help but wonder that if the great Jobs were still pulling the levers from the corner office if progress in the R&D department might not have been swifter.

Conclusion

As it stands, with all the fanfare and pyrotechnics that will accompany today’s new iPhone launch, Apple is a company at an important inflection point. Yes, the China Mobile deal is big and the $400 phone is a good idea too, but one that is long overdue. These two things will juice earnings for a while but what next. The competition in the smartphone space is just fierce which will compress margins and Android based phones are beginning to have the app bells and whistles that has long been the secret sauce of the Apple ecosystem.

Many of Apple’s competitors have the entire manufacturing capability in house which offers much greater flexibility that Apple is capable of. Apple has 25 to 30 percent of its market capitalization in cash. It continues to generate mountains of cash so financial health is not at issue. Apple already sells for a paltry 11.5 times next year’s earnings. So the market has already been contracting the P/E multiple not really expecting too much in the way of blockbuster inventions.  But it is just that that Apple needs to regain its edge and move the share price in a meaningful way……Mr. Icahn notwithstanding. That $625 share price is at least two new inventions away.

Disclosure: I am long AAPL

Some of the information in this article came from DisclosureNet