Media speculation over the last couple weeks has suggested that Apple will introduce two iPhone models in September that will help them better compete with Samsung’s 5 inch Galaxy smartphonesand 6 inch Note Phablets. Investors seemed to appreciate the rumors, lifting the stock back towards technical resistance at $550 although failing to hold what would have been a new closing high since the sell-off on its disappointing fiscal Q1 results in late January:
I can’t for the life of me figure out how any investor at this point could get excited about the prospects for a new AAPL iPhone 6 months before its launch, especially given their string of evolutionary upgrades over the last couple years. I have heard lots of very solid arguments for the stock, with one tenet being sound data that suggests iOS being the mobile operating system with a far superior retention and upgrade rate, despite having an installed base of only about 30% of Android (about 250 million vs 800 million respectively), and how this fall will be an epic upgrade cycle with the broadest lineup of iPhones yet.
I would suggest that the more important set of rumors regarding AAPL over the last couple weeks has more to do with software and services than hardware. Media speculation that AAPL would license their iTunes Radio to non-iOS platforms, could be one of their most important product introductions since the opening of the App Store. Why? Well, AAPL currently has over 600 million active iTunes accounts (that means people who have input their credit card data to Apple and have made a purchase) and less than half of those people have an iOS device. This means that consumers have demand for their services but have yet to been wooed by their mobile hardware. Which brings me back to retention – once AAPL gets a new iOS customer, more than three quarters of them stick with AAPL.
If AAPL were to license iTunes Radio and Apps for iTunes music management, iMessage, Facetime and iPhoto (with an Instagram twist), the company would be breaking with their long standing policy of not licensing their operating system and most software for non Apple hardware (read my discussion here of how AAPL could take on Facebook’s move into Messaging with their WhatsApp acquisition: MorningWord 2/21/14: WhatsApple Gonna Do?).
One thing is certain, while AAPL is putting up a strong battle to maintain their industry leading profitability, they are losing the market share war. No matter how high their retention rate remains, if Android continues to extend their lead at this pace, AAPL will be forced to make hard decisions from a position of weakness in the future rather than whatever level of relative strength they are perceived to have right now.
To be clear, I have had all 7 iPhones, I have tried a few Android phones during this time period and always go back. I am hooked on the iOS platform and the related services, I believe iPhone is the best smartphone on the market, despite the 4 inch screen. But it won’t be the screen size alone that causes AAPL t0 retake market share, it will be a combination of a more compelling offering, assisted by a suite of services that have more to do with transacting and consuming rather than talking and surfing. The only way hundreds of millions of potential iPhone users will have the ability to test drive iOS though will likely be on non Apple hardware.
So for those of you Apple investors waiting for the new phones in the fall, my sense is that this launch will probably disappoint as the iPhone 5, 5s and 5c launches have over the last couple years if they are just judged on a hardware basis. The iPhone 5s only cost a few bucks more to make than the iPhone 5 from the prior year, despite an upgraded processor, finger sensor and the usual expanded memory and improved display, yet year over year (from fiscal 2012 to 2013) AAPL’s gross margins declined 6 points from a record high of 43.87% to 37.62% and are expected to be flat for the next two years. If I were an AAPL investor I would hope that profitability declines would be coupled with increased market share and hopefully market leading products, neither appear to be the case at the present.
The company needs to accept the laws of gravity as so many other hardware providers have before them. When Apple launches larger screen phones in the fall, Samsung will compete on price. AAPL will need to either cede some of the profit from their massive market up on NAND storage to make their phones as competitive as high end Android offerings, or face a widening market share gap that will eventually massively disadvantage the company’s competitive position. But there is a potential compromise, let Android users take iOS apps for a spin, who knows, they may even put down those plastic hunks of junk and switch over to iPhone. While there has been a lot of noise about ‘Wearables”, it is our view that the hardware is not likely to move the needle anytime soon for AAPL, but services, clearly could, like the rumored health monitoring (read our post from February on the topic: Why Apple’s Wearable is a BFD Or How I Learned To Stop Worrying and Let Apple Monitor my Body). So you see, AAPL’s next great product is fixing their woeful iCloud, revamping current Apps like, iPhoto (think Instagram), iMessage (think WhatsApp), iTunes Radio (think Pandora/Spotify), iTunes (think Netflix, or the 600 million active accounts and the cross selling opportunities), Facetime (think Skype), and the list goes on to the unreleased like health monitoring etc. But make them cool and then get them in the hands of almost billion Android users, let them subtly win back your lost market share.
On the investment front, many large institutional investors view the company’s products secondary to financial engineering capabilities in their investment thesis (for now), but this will likely change when we get word from the company in the next few weeks as to what their dividend increase and any new buyback authority will be. I remain in the camp that I would rather own AAPL’s balance sheet, dividend yield and installed base at a massive discount to the broad market then owning the S&P 500 at current levels. But make no mistake, 2014 is going to be a very important year for AAPL, and the decisions they make now may determine their mobile relevance for years to come.