Apple’s quarter came in well ahead of expectations on strong overall revenues and iPhone sales. With the company forecasting modestly higher earnings in the coming quarter and expectations that the iPhone 6 could be a blockbuster come September, Apple’s stock soared to levels not seen since the end of last year. Still, CEO Tim Cook thinks the company’s shares are cheap. In announcing Apple will pump an additional $30 billion into a repurchase program, Cook said: “We believe our current stock price does not reflect the full value of the company.” A deeper dive into Apple’s numbers suggests Cook’s beliefs could be reasonable, but there are still important questions facing the company down the road. Here’s a look at some of them:
Can anything be done about the iPad problem? Cook explained that while iPad sales were down significantly versus last year, the situation wasn’t as bad as it seems. And, indeed, Ewan Spence has a post here at Forbes detailing why that’s the case. But even if you accept all the explanations at face value, there’s still the reality that iPad growth has flatlined for now. And that’s not because of a weak hardware cycle either. The successful redesign of the large iPad into the Air and the long awaited Retina iPad Mini should have given Apple a strong enough lineup to reignite sales if product mix was an issue.
While Apple could cut prices (and probably should as I’ve advocated before), the more important challenge is going to be to make the iPad more compelling as a laptop replacement. Perhaps that will be a focal point in iOS 8, expected to be announced at Apple’s Worldwide Developer’s Conference in June, or perhaps it will come in the form of a larger-screen model, now expected in 2015. But some kind of fix is needed if the iPad is going to contribute to Apple’s growth again. There’s plenty of opportunity here for Apple, with the bulk of PCs being sold in the $500-1000 price band where iPad could begin to replace them. Today’s iOS 7 iPad, however, isn’t going to suddenly take off and start selling in much bigger numbers. Evolution of the way Apple tackles this issue is worth tracking closely.
Does the success of the iPhone 4s mean Apple is getting more serious about cheaper phones? A repeated theme in the earnings call was how well Apple was doing in emerging markets, thanks in large part due to a product from 2011: the iPhone 4s. While the exact selling price might vary a bit, we know from the unbsubsidized numbers in the U.S. that it goes for around $450. Overall iPhone average prices fell by $41 last quarter, which was the biggest drop ever. That’s good news, especially since the company says half of that was due to popularity of the cheaper 4s.
This raises the question that was asked extensively last year when much speculation centered on whether the then-rumored iPhone 5c might cost $299: Is Apple ready to target a greater segment of the market at lower prices? The iPhone currently has 60% of the market for smartphones selling above $400. Given Samsung’s marketing spending, it’s unlikely Apple can do tremendously better in that segment. And realistically, in countries like India, a price above $400 gives Apple a potential market size in the single digits.
While no one is suggesting the company try to compete with $99 Android phones (or even low-end branded models like the Nokia X and Moto G), the ability to produce a purposefully designed $299 model for emerging markets is greater than ever. With Apple’s iPhone volumes now at 150+ million annually, the idea of selling 50 million units incrementally also seems less ridiculous than it did two years ago.
The time to build this product, explicitly for lower-priced markets, seems ripe. The cannibalization effect will be minimal, as seen in China where those who can afford the pricey iPhone 5s choose it over the 5c. And Cook was happy to tell analysts yesterday that people who buy any Apple product are much more likely to stay with the company and buy more down the road. If their first product is a $299 iPhone, it’s possible their next one will be a $499 model.
Apple can survive just fine without building this product, but it could thrive if it chooses to pursue it. Oh, and the net effect of building such a phone would be higher revenues and profits. The only number that would go down is the gross-margin percentage, which is a calculated number. Total gross margin dollars would rise.
Is Apple going to get serious about iTunes and the App Store? Growth here slowed greatly in the most recent quarter and it’s now barely in the double digits. That’s again not terrible, but it’s also not the big story it could be. Apple has a number of glaring weaknesses in monetizing the iOS ecosystem that are easy to fix before it moves onto the hard ones surrounding Apple TV.
- It needs a subscription music offering like Spotify. There’s nothing wrong with iTunes Radio, the Pandora clone, but people are looking to the all-you-can-eat model of music rentals that Spotify, Beats, Rdio and others are providing. The margins may not be great, but Apple is the world’s largest digital music seller and is in position to negotiate whatever the best deal going is. With 800 million iTunes accounts, this is a ripe opportunity that Apple should have been pursuing since the days before the iPhone arrived (hint: iPod).
- Something needs to be done about digital content selling. Whatever the compromise is that allows Amazon to sell books through the Kindle app needs to happen. The problem today is that Apple treats all in-app digital purchases the same and takes 30% from all of them. This makes it impossible for e-book sellers and other people who don’t make much selling content to offering purchasing inside their apps. Game makers don’t have this limitation. Apple can figure out a carve out to make it possible to sell copyrighted content inside apps for a smaller “vig,” perhaps 10-15%. Yes, this competes with Apple’s own bookselling and quite possibly its video business too. It’s worth doing.
- Ad sales continue to be a disaster for Apple. iTunes Radio was supposed to fix this and maybe it has helped for iTunes Radio, but not for in-app ads. Some Apple pundits claim the company wants its ads to be lousy because “good” ads are invasive and trample on your privacy, but Google, et al. sell those ads anyway and they run inside of iOS apps. Instead of concocting fanciful theories about why Apple’s ad offerings are a mess, assume Occam’s Razor holds here and that Apple is just bad at it. It’s time the company buy a solution and I continue to like Millennial Media, though I admit to having done no due diligence on it.
I used to advocate Apple buying Netflix, but that was $250 a share ago. The main reason the idea still has merit is that Netflix ends up licensing a lot of content from the same people who own cable systems and Apple ultimately wants to get the AppleTV somehow in the mix as a front-end/set-top box. If owning Netflix provides leverage, it might be worth paying a crazy price to make that happen and — as with Facebook’s acquisitions of Instagram, WhatsApp and Oculus — Apple could let Netflix run mostly independently. A more detailed look at the living room is the subject of an upcoming post.
Is Apple really spending its buyback dollars wisely? The additional $30 billion commitment brings the buyback funds to an unprecedented $90 billion, of which Apple has already spent $46 billion. Apple provided a rough accounting on when it’s been buying its own stock, and the company has shown itself to be an unexceptional market timer. It did spend $16 billion in last year’s fiscal third quarter, when shares ranged between $390-$463. During that time it reduced outstanding shares by a net of 22 million. The numbers don’t gibe because much of the money was spent on so-called “accelerated repurchases,” where the effect isn’t seen till later.
There was no accelerated repurchase in the subsequent quarter, though, which is odd given shares again dipped below $400. Given that Apple stock hasn’t seen levels that low recently, it appears the company got a good buy when it was fishing at $400 the first time and missed an opportunity when it didn’t 3 months later. More recently, it again bought big with $18 billion spent last quarter. In late January and early February, Apple shares flirted with $500 and the WSJ reported Cook saying Apple was being “opportunistic” in buying its own stock on weakness.
With $44 billion to spend and 20 months to do it, Apple now faces questions about when to buy. Historically, share buybacks have had limited effectiveness in large part due to bad timing. So far, Apple hasn’t made any obvious mistakes in overpaying and with shares at roughly 12x fiscal 2014 earnings, the stock isn’t expensive on a valuation basis. But it gets treacherous from here. Spend more now and Apple risks being unable to pull off the move it made in winter, which acted as a support for the stock. Wait too long, and the company risks paying far more to get fewer shares later.
Thus far, the company has retired roughly 62 million shares, or 6.5% of what was outstanding before the buyback. About half of the gain in earnings per share this past quarter could be attributed to repurchases. With $44 billion left to spend, Apple should be able to buy at least another 70 million more shares, representing an additional 8% of the outstanding stock. [Note that with a 7-for-1 split impending, all these numbers would get multiplied or divided, but the percentage of the total would remain the same. If Apple can keep its purchase price below an average of $560 per share from here, the post-split total share pool could come in right around 5 billion.]
Oh, and if you follow guidance… Apple’s numbers yield the following calculated EPS guidance range: $7.75-8.73, using 860-870M shares. Last year’s third quarter was $7.47.
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