Apple Inc. (AAPL), the most prolific growth story in the tech industry over the past 12 months, appears to be losing some steam in recent times as shares have declined approximately 4.0% since the release of its second quarter 2011 results on April 21, 2011.
Apple reported a stellar second quarter, with earnings per share of $6.40 beating the Zacks Consensus Estimate by $1.06 (19.9%) and increasing 92.2% year over year. Revenues surged 82.7% year over year to $24.67 billion. The results were driven by strong iPhone sales, record Macintosh sales and increased iPad sales, as unit shipments remained robust. For further details please see Apple Fires All Cylinders in 2Q.
Apple expects revenues of approximately $23.0 billion for the third quarter of 2011, reflecting a year-over-year increase of approximately 46.4% but a slight decline of 6.8% sequentially. Although we believe this guidance is conservative, it is noteworthy that Apple is facing some headwinds that may prevent its bullish run going forward. Some of these headwinds are discussed below:
Lack of Innovative Product Launch– After launching a series of innovative products (iPod, iPhone and iPad) successfully, Apple has failed to unveil any new innovative products in recent times (barring iPad 2, which was basically an upgrade of the original version).
Traditionally, Apple has used the Worldwide Developers Conference (WWDC) as a launch pad for their newest gadgets and software. However, the company’s last revelations at the WWDC were iPhone 4 and iOS 4, which were also upgrades.
Moreover, it is rumored that Apple may not unveil any new upgraded hardware product for its iPhone or iPod at this year’s WWDC, thereby breaking the trend of new product launches at WWDCs. Apple is expected to launch an upgraded MacBook Air. Apple may also discuss Mac OS X Lion, its new Macintosh operating system.
Of course, Apple has always maintained the utmost secrecy with respect to any product launches. Therefore, while it looks at this point like the pace of innovation is losing steam, we are taking a cautiously optimistic stand.
Moreover, Apple is entering into the emerging market of cloud computing through its storage and streaming services. Apple is expected to unveil the iTunes cloud music store in WWDC, which will be a new revenue stream (through subscriptions) for Apple over the long term.
We also believe that data center expansion will allow Apple to add more value-added features to the iPhone, while assigning the task of storing and processing applications to the cloud. Transfer of the storage function to the cloud would also be beneficial for Apple, since this could lower hardware costs. Device speed would also increase.
Increasing Competition and Pricing Pressure – Apple is facing tough competition in most of its revenue segments, especially in the smartphone and tablet market.
The iPhone is up against cut throat competition from smartphone makers such as Motorola, Samsung, HTC and LG, which are using Google Inc.’s (GOOG) android operating system. Android being open source has helped Apple’s competitors to create differentiated devices based on the free source code. We think this feature has helped iPhone competitors pick up significant market share. According to research firm Gartner, iOS gained 1.5 percentage points of market share in the first quarter of calendar year 2011 versus 26.4 percentage points garnered by Android during the same period.
We believe that Apple is heavily dependent on iPhone sales (50% of second quarter sales) and the increasing competition will hurt its top-line going forward. In order to gain market share, these competitors are offering lower prices compared to iPhone. The increasing pricing pressure may hurt Apple’s margins going forward.
The iPad is pitted against several new entrants, such as the Motorola Xoom, HTC Flyer, Research In Motion PlayBook, Hewlett Packard TouchPad, Dell Streak, Samsung Galaxy Tab, Cisco Cius, Toshiba SmartPad and Acer Iconia in the tablet market. However, we believe that Apple has an advantage, as most of these companies entered the market late. Moreover, products from these companies have also received mixed reviews as against the iPad, which has seen resounding success.
Increasing Legal and Regulatory Hurdles – Apple is entangled in a number of lawsuits against Nokia Corp. (NOK), HTC, Eastman Kodak (EK) and Samsung. More importantly, Apple has received unfavorable verdicts in a couple of cases at the International Trade Commission (ITC). As ITC has the authority to block import of products that infringe U.S patents, the lawsuits could cause a dent in Apple’s very sizeable cash balance. It may have to pay a hefty fine or a recurring license fee, which will hurt its profitability going forward.
Apple along with Google is facing increasing scrutiny from the US and European regulators for their alleged role in infringement of users’ privacy. We believe Apple’s iAd business will be impacted by increased legislation to protect users’ privacy. Year to date, there have been at least five related legislations, three of which were designed to empower users to turn off tracking.
Conclusion
No doubt, Apple is a great company. But we believe investors are expecting a lot from the company in the near term. We also believe the window for growth is getting narrow as the markets get saturated. Moreover, it’s not possible for a company (of Apple’s stature also) to sustain sales growth of approximately 90% in every quarter, unless it finds a whole new market or revenue segment.
With a loyal customer base, international expansion, competitive pricing strategy and a solid cash position, we remain positive on Apple’s long-term growth. However, increasing competition in most of its major product segments, possible delays in product launch, higher operating expenses and increasing legal complexities compel us to maintain our Hold rating over the long term (6-12 months).
Currently, Apple has a Rank #3, which implies a Hold rating in the near term.
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