Reality Check: Apple Performance Slowdown a Matter of When, Not If (AAPL)

Posted by · July 25, 2012 1:07 pm

Well, what do you know? The folks at Apple are human after all. Sure that’s a given, but with the incessant speculation of an Apple that is somehow divorced from the market forces that, sooner or later, force a company to reckon with reality, I feel that it needed to be said.

After reporting revenues of $35 billion for the third quarter on Tuesday’s earnings call—falling just over $2 billion short of Wall Street expectations—Apple stock began to take a much-needed turn back toward reality. Quite predictably, such a downturn—which has continued today—has caused widespread pandemonium surrounding Apple’s now-uncertain future. Reacting to the company’s comparatively “weak” performance for the quarter, Goldman Sachs proceeded to cut its price target for Apple down from an extremely generous $850 to a still-generous $790.

Noting the change, Goldman analyst Bill Shope observed the following:

While we had expected some weaknesses as a result of a pause in the iPhone demand ahead of the iPhone 5 refresh, the impact was greater than we anticipated. In addition, Apple’s gross margin performance and macro commentary served as key sources of disappointment.

However, he adds:

While several elements of Apple’s June quarter results were surprising and disappointing to us, we believe most of these issues are temporary. In fact, we believe the December quarter will enjoy a tailwind from the iPhone 5 and consumer seasonality that will likely quickly eliminate current investor concerns.

Similar commentary could be found in all corners of the investment sector. Dashed hopes of an ever-inflating Apple stock—an imminent phenomenon whose writing was on the wall months ago—have caused investors and pundits to look for something to blame, namely slowing iPhone performance in the lead-up to the unveiling of the next-generation iPhone in the fall.

“The results demonstrate customer anticipation for the next iPhone that will make its debut one of the biggest consumer electronics introductions ever,” notes Bloomberg reporting on a conversation with ISI Group analyst Brian Marshall.

Others sought to blame it on a narrowed vision by Apple’s executive leadership. Forbes notes:

The product pipeline matters. That include more than [the] iPhone 5. It includes the mini iPad and iTV, a product Tim Cook clearly does not know like Steve Jobs [did]. And maybe even more importantly, the product pipeline includes how Apple organizes and markets a launch.

Jobs told his marketing staff: “You worry about the back covers. I’ll worry about the front covers.” Now with Jobs gone, there is nobody to say “no” to bad design and there is nobody left to adequately take care of “front cover” marketing.

And still others call it the result of one of Apple’s “biggest risks,” which, Henry Blodget of Business Insider observes, also happens to “stem from one of the company’s most amazing strengths.” That strength, he writes, is Apple’s “shockingly high profit margin.”

Blodget goes on to discuss the stereotypically low margins that most hardware companies work on, highlighting Apple’s historic ability to dodge that otherwise industry-wide rule. He continues:

Profit margins for hardware companies are normally in the single-digits, because hardware is generally a brutally competitive business. The big profits, meanwhile, have gone to the software providers—like Microsoft—which have low cost-of-goods sold and can sell the same product to different hardware manufacturers.

. . .

And with the mind-blowing success and profitability of its biggest product, the iPhone, Apple’s profit margin has steadily increased—to the point that its margins now blow away those of most software companies.

As the chart he later points to seems to confirm (see below), such a slowdown in iPhone sales after years of steady growth may well mark the initial pangs of an ultimate reconciliation of Apple with the rest of its hardware-producing competitors. But then again, increases in iPad sales over the same period of time seem to punch holes in even that theory.

Credit: Business Insider

Meanwhile, I think that this dip in Apple profits and share values marks something much broader in scale. To be sure, such news serves to underscore as unsustainable the thought that yearly releases of a product will continually reap the hype and consumption that it does in the first few years of that product’s existence. In the case of the iPhone, users seem to be more interested in getting a reliable smartphone that they can keep for more than a year before being forced into the next-generation model.

Now that Apple has a steady following behind the iPhone, it seems that market forces may be telling the company that it is time to shift away from these annual hardware release cycles and toward offering enhancements to the software that these products already support. Not only would this approach cost less to maintain, but it would also create opportunities to open up more sustainable revenue streams—ones that don’t demand the stoking of consumer hype each and every year.

The devices are already in customers’ hands. Now is the time for Apple to utilize its proven iPhone ecosystem as a medium to promote its other products and services—as a means to an end rather than an end in itself. Competitors like Google and Amazon have clearly already noticed that trend in the market; however, in an effort to capitalize on that trend, these companies also haven’t invested nearly as much in their devices as Apple has.

As a result, Apple is left with a rare opportunity to address its current market woes and beat competitors at their own game.

It’s just a matter of time before the consumer love affair with annual releases of a new iPad follow the iPhone’s lead, forcing Apple to do one of two things: either invent the next amazing product since the tablet (a huge gamble) or start using its market-proven devices as a means of getting users engaged with its own suite of proprietary content.

If I were Apple, I’d choose the latter.

For more on the Apple performance slowdown…