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  (Source: Lifehack)
Investors had hoped to witness diversification with the launch of the Apple Watch. Instead Apple has backslid.

Apple, Inc. (AAPL) is a maddening proposition for investors.  Perhaps no company can look absolutely brilliant -- financially speaking, at least -- from one angle, yet appear so incredibly insecure from another vantage point.

I. Apple's iPhone Grows More Monolithic

First the good.  In today's digital world the top three most coveted publicly traded companies on the S&P index, as measured by market cap are the tech industry's big three.  There's Microsoft Corp. (MSFT) -- master of the traditional personal computer market and enterprise market -- with a value north of $380B USD.  Next up there's Google Inc. (GOOG) -- the internet's top services firm and king of the budget mobile market.  Its worth has eclipsed $460B USD.

And on top of the pile is Apple -- king of the premium smartphone and digital media markets -- with a market cap well over $750B USD.  And as they the old adage goes "heavy is the head that wears the crown."  So it is with Apple who can post enviable financials, yet still send shareholders into a panic in after hours trading.

 


On Tuesday night that's precisely what happened after Apple reported its fiscal third quarter results.  While at first blush Apple's quarter might look like a blowout, it didn't take long for shareholders to voice concern on at least two core fronts.

Financials aren't one of them.  Apple's profit, cashflow, and supply chain remains strong.  It squeezes the entire chain from the supplier to the customer tighter than any other OEM in the business today and it gets way with it.  In the April-June window, the Cupertino, Calif.-based company made a net income of $10.7B USD on a revenue of $49.6B USD.  Compared to the same quarter last year, that's roughly a third more revenue (up from $37.4B USD in Q3 2014) and nearly two-fifths more profit (up from $7.7B USD).

Tim Cook
Apple's Tim Cook is keeping the ship stead, but has struggled to answer the big questions facing Apple. [Image Source: Bloomberg]

CEO Tim Cook spoke in glowing terms of his company's gains:

We had an amazing quarter, with iPhone revenue up 59 percent over last year, strong sales of Mac, all-time record revenue from services, driven by the App Store, and a great start for Apple Watch.  The excitement for Apple Music has been incredible, and we’re looking forward to releasing iOS 9, OS X El Capitan and watchOS 2 to customers in the fall.

But if you read between the lines you might spot the first major concern in what Apple didn't mention.  Apple boasts in its earnings release:

The growth was fueled by record third quarter sales of iPhone® and Mac®, all-time record revenue from services and the successful launch of Apple Watch™.

Notice the lack of mention of the iPad?  Well, if you dig into its 10-Q filing [PDF], you'll see why.  In Q3 2014 Apple sold 13.276m iPads.  In Q3 2015 Apple sold only 10.931m.  So as Apple boosted profits by two-fifths, iPad unit sales declined by a fifth.  And the problem is this isn't the first quarter to see this decline.  Indeed the iPad sales have been falling for some time now.  The iPad is looking a lot like the iPod -- a dwindling business for Apple.

iPad sales

In Q3 2015, most of its profit was leveraged on a single product -- the iPhone.  iPhone unit sales soared from 35.203m in the quarter a year prior to 47.534m in Q3 2015.  That's an increase of more than 12m -- more than third increase in unit sales.  

And yet while Apple is inarguably iPhone dependent, it is a bit unfair to call Apple a one-trick pony.  Bear in mind: the iPhone is an entire ecosystem for Apple.  But on the flip side, it is a somewhat singular package.  As the iPhone goes so too does Apple's content and services earnings.  So the iPhone's bullish 59 percent growth was invariably a key factor in making Apple's newly launched Spotify-challenger a hit.

iOS 8.4 Music


Driven by the legions of iPhone owners, the "Apple Music" premium streaming service is Apple's biggest new success story of the past two years.  But it's painfully obvious that Apple Music is dependent on the iPhone, not the other way around.

Yes, the Mac business celebrated "record" sales for the second calendar quarter of the year.  But Apple's glowing language overstates the Macs' value.  In Q3 2015 Apple sold 4.796m Mac computers -- a rise of just 8.7% percent over the 4.413m Macs it moved a year prior.  Macs did leapfrog the iPad in revenue.  

15-inch MacBook pro

But combined the iPad and Mac business account for only roughly $10.5M USD in revenue -- about a third of what the iPhone business commands.  And in services (which the iPhone drives) and the "other" product category (the garbage heap for Apple's less succesful/more niche offerings -- and you will come to the rude realization that the iPhone hardware revenue alone is driving nearly two-thirds of Apple's revenue.

II. Number One With a Bullet -- Apple Watch Goes Down Swinging

And of course there's the elephant in the room -- the Apple Watch.  As expected Apple dropped it into the "other" category likely in part to avoid having to bother to report sales.  But anyone who's been following the market research will recount that this is all but expected.  Through June Apple Watch sales had sunk to a few thousand units on a good day -- 1k or less on a bad one.

Apple Watch -- sales
Consider that every day a million customers (roughly) visit Apple's 450+ retail stores around the world.  Consider next that on a not-so-good day Apple is selling less than 1,000 Apple Watches.  Now led the cold reality sink in -- Apple is only selling two smartwatches per store (roughly on a bad day).  And only 1 approximately in 1,000 visitors to the store buy an Apple Watch on a daily basis.  And the trend suggests it's getting much worse.

The Apple Watch does deserve some respect.  In smartwatch terms it's a massive hit.  Last year Google's Android Wear alliance only managed 720k unit sales, approximately.  To date the Apple Watch to its credit, has managed to move around 3m units.  Among the phone-on-your-wrist style smartwatches (which include Apple's Android Wear competitors) that's a herculean feat and it's made Apple king of the hill.

The problem for Apple is that hill is no mountain peak -- it's a short stack of earth.  And analysts were hoping Apple would make a mountain out of the molehill.

Thus while Apple has the top smartwatch, its "other" segment revenue rose less than a billion dollars.  The Apple Watch is clearly not the diversification blockbuster analysts had dreamingly forecast.  Consider the oft maligned Surface is bringing in roughly more than a billion dollars in hardware revenue for Microsoft.  Apple's Watch on its incredibly overhyped introductory quarter wasn't even able to crack a billion in sales.  And with Fitbit Inc.'s (FIT) smartbands outselling the Apple Watch nearly two-to-one in late June, it's easy to see where the disappoint invariably sets in for investors.

And don't expect Apple to turn this one around.  It's likely to get worse, if anything.  It appears that most of the people who wanted an Apple Watch bought one.  If you want a convenient excuse, you could hypothesis Apple pidgeonholed itself by making the Watch iPhone exclusive.  But let's be frank.  Japan's Seiko Holdings Corp. (TYO:8050) was selling "wrist computers" back in the 1980s when Apple was peddling its Apple II line.  In three decades smartwatches have grown ever smarter -- amounting to what was once a supercomputer.

But much like a tablet, computing power wasn't the limiting factor to sales.  For three decades now many -- including Apple -- have stubbornly tread the same path to disappointment, failing to recognize that to become ubiquitous wearables need to evolve -- become more purpose built, less obtrusive.

Instead Apple is stuck rehashing the 1980s.  

Watch OS 2?  It crams apps into the Watch!  You can do much more.  But at the end of the day Apple's fundamental strategy here is flawed.  The Apple Watch is trying to be a precious, quirky smartphone on your wrist.  But to own one you must have a smartphone.  And the reality is the Apple Watch is an inferior smartphone to your iPhone, even if you're an Apple fan.  So aside from some novelty factor, there's no reason why even the average Apple customers would want or need an Apple Watch.

Thus at the end of the day shareholders watch chagrined as Apple's hopes at diversification evaporated.  Apple is backsliding and turning to its iPod of the modern era -- the iPhone.  It's a strategy that works, for now.

III. C.R.E.A.M., Get the Green (Investor Edition)

But even while the good times are rolling, investors were also riled on another point -- returns.  Apple is well aware of this reoccurring line of grumbling.  Recall Apple had a far larger, more liquid cash pile (comprised largely of the ultimate liquid asset -- cold cash in USD).  But to try to placate shareholders Tim Cook rained that money down on them.  Now the sharks are back for more blood.

CFO Luca Maestri tries to pitch the glass half full to shareholders, commenting:

In the third quarter our year-over-year growth rate accelerated from the first half of fiscal 2015, with revenue up 33 percent and earnings per share up 45 percent.  We generated very strong operating cash flow of $15 billion, and we returned over $13 billion to shareholders through our capital return program

And there's more where that came from.  

Apple money
[Image Source: iMore]

Apple announced in its 10-Q a $10.0B USD share repurchasing plan for Q4 along with $3.1B USD in dividends.  But with Apple's impressive cashflow in Q3 2015 some investors are complaining that there should be even more incentive offerings, particularly in view of Apple's precarious dependence on the iPhone.

Double Irish w/ a Dutch Sandwich
Apple uses the "Double Irish w/ a Dutch Sandwich" strategy to lower its overseas taxrates to as low as 2 percent, allegedly. [Image Source: The New York Times]

In its defense Apple only has about $10.5B USD in cash.  But it's also sitting on a pile of more than $40B USD in U.S. national debt (Treasure bonds) and $110B+ plus is marketable securities.  Investors who are interested in Apple's long term well being might be more sympathetic to Apple's approach.  But some shareholders want more cake.

The problem -- as TechCrunch alludes to -- is that even if Apple wants to play ball, it's going to have a hard time doing so.  Of Apple's nearly $50B USD in revenue, only two-fifths of it was domestic.  Much of Apple's profits are stuck overseas in the company's tax havens.  if Apple brings those profits home it will wind up paying more taxes.  So it's effectively adopting a wait and see approach until the tax climate in the U.S. grows more favorable.  And investors will have to wait.



Apple's international cash dilemma is showcased by the fact that it actually borrowed $8B USD in May.  In some ways this tactic kills two birds with one stone, as it does placate institutional investors to some extent (by giving their bank holdings another profit angle).  But it's also a shell game.  Apple is buying up debt overseas, while taking out debt domestically to cover the shortfall.

IV. Apple is 90s Microsoft -- But It Will Survive

I would forecast that H2 2015 (fiscal Q4 2015 and Q1 2016) will be a strong one for Apple.  Apple's earnings are driven by the iPhone.  And the iPhone 6S -- the ninth generation iPhone -- is rumored to be a strong showing.  iOS 9 -- for its part -- looks like Apple's most polished release in some time.  Thus I would assume that Apple will see more records -- more profit, more iPhone sales, more growth in iPhone-hungry markets (e.g. China), and more service revenue.

iOS 9

But I also predict that as strong as Apple's financials will look over the next couple quarters it has a couple of fundamental problem that may at some point sink shares.  The issue of cashflow shareholder incentives is perhaps the more temporal challenge, as it could be solved in the near future.

But Apple's true weak spot lies in its greatest strength -- the iPhone.  With hungry rivals like Samsung Electronics Comp., Ltd. (KRX:005930) (KRX:005935) and the legion of Chinese OEMs gunning to knock it off its pedastal, Apple is in a vulnerable position.  At this point Apple must defend the iPhone as if its profit and future depends on it -- because it quite literally does.  Good or bad, to some extent the Mac, the iPad, and certainly the Apple Watch don't matter all that much.  The iPhone will determine Apple's growth and earnings.

The great challenge for Apple remains the same one the company has been grappling with since late CEO Steve Jobs passed away -- diversification.

The iPad Mini wasn't the answer.  The Apple Watch wasn't the answer.  Apple has a handful of other pet projects developing or in the works -- namely a rumored smart TV offering and its car infotainment platform.  If I were to hold out hope on one it would be the smart TV.  Sure, Jobs wasn't a fan of it.  But a clear upside is the more obvious product direction.  And I think it's reasonable to hope that as they mature, smart TVs appeal to a broader audience than watch wearables.  The key difference -- TV are a high volume product and getting a bit smarter doesn't interfere with their traditional usage.

Investors should be somewhat bearish on the automotive angle, though.  Infotainment is deceptive  -- just look at BlackBerry, Ltd. (TSE:BB) the car infotainment market's dominant statesman (with its QNX automotive operating system platform).  BlackBerry is powering tens of millions of vehicles (or more) a quarter, yet has very little to show for it.  

Apple iOS infotainment
Siri Eyes-Free is front and center on the new Chevrolet Spark.

Apple may find a way to monetize a bit better should it be able to gain market share.  But infotainment is somewhat analogous to the internet services market in its low margins -- even if you monetize it brilliantly and dominate, at best you're pulling in a billion or two in profit quarterly.  That's not enough money to be Apple's diversification answer.

So if the smart TV fails to materialize or -- worse yet -- pulls an Apple Watch and fails to become a strong second pillar to the iPhone, what does Apple have left to try next?  Again that's a question without an obvious answer.  (Smart home?  Some sort of ballooning of Beats?)

But fear not investors.  Shares will rise (in H2 2015) and fall (sooner or later), but Apple is to some extent too big to fail, vulnerable as the iPhone may be.  Apple's position is in many ways akin to Microsoft in the 90s.  With its size Apple will invariably facing increasing degrees of scrutiny on the tax and antitrust fronts.  And like Microsoft whose star products all revolved around Windows, Apple's products revolve about the iPhone.  

Apple is Microsoft of the 90s
[Image Source: Bloomberg (left); Corbis (right)]

There will be growing pains.  If Apple doesn't answer the hard questions it may lose it's spot as the dominant tech company of the decade.  But unlike BlackBerry, Apple's position for some time now has been far more dominant.  Financially speaking, it's the top tech company of the decade.  And much like Microsoft's torrid 90s, hangover or not Apple isn't going anywhere.  It's vulnerable to devaluation, but even in the worse case, it's likely too big to fail.

It may take a while, but in time Apple will find a way to evolve and diversify.  it can afford to take its time even if that leaves investors pulling out their hair follicles.

Sources: Apple [press release], [10-Q], TechCrunch





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