MorningWord 4/27/16: $AAPL – What Would Dan Benton Do?

by Dan April 27, 2016 9:26 am • Commentary

In case you missed it, Apple (AAPL) reported their fiscal Q2 results last night. They were generally in-line, representing the first year over year quarterly revenue decline since 2003. But what’s really spooking investors (the stock is down 8% in the pre-market) is the Q3 revenue guidance. Its mid-point of $42 billion is $5.5 billion below consensus. Importantly, the company guided gross margins to 37.75% for the June quarter, and frankly listening to the company’s reasoning for the sequential decline, I don’t think this will be a one off.  AAPL’s CFO said the gross margin decline is a result of the loss of leverage from selling fewer iPhones and the introduction of the low end iPhone SE and thus increased mix shift to lower priced phones. With smartphone growth in developed markets ground to a halt, and possibly threatening year over year declines in 2017 for the first time ever, AAPL has souped up its old iPhone 5s called it the SE, and made it the company’s great hope for capturing market share in places like India.

But I’d like to add a couple points on that. On last night’s call, CEO Tim Cook spoke of India on a few occasions, stating that, India, the 3rd largest smartphone market in the world, has very low 4G penetration, and the rollout will “unleash the power and capability of the iPhone” and that the company has just started “building the channel out” in retail as the majority of phones are not sold from wireless carriers.  Cook stated that India is “where China was 7 to 10 years ago”.  If that is the case it may take just a few more years for AAPL’s sales in India to move the needle on their current $200+ billion in sales in the current fiscal year. AAPL introduced the iPhone 3GS in China in 2009, and total sales in the region were less than 10% of their $36.5 billion total in fiscal 2009, but you can see the ramp over the next 5 years, with the March quarter’s contribution 24% of AAPL’s $50.5 billion total.

From the Verge, via A16z
From the Verge, via A16z

It’s going to be hard for India to save the day any time soon, as demand for the iPhone SE continues to erode iPhone average selling prices (ASPs) that hit a high last quarter at $691, dropped to $645 in the March quarter and is still 3x that of average Android ASPs in Q1 of $215.  And one more thing on India, recently I took a fairly unscientific look (here)at how the opportunity there may be very different than that of China, and there is one very important point that sticks out like a sore thumb, despite the inexorable emerging middle class in India, the “cost of an iPhone (not subsidized) is 26.5% of annual household income in the country, vs 13.5% in China and less than 2% in the United States.

So the question AAPL investors need to ask themselves is whether the maturing smartphone cycle that’s driving AAPL to go to lower price points for the first time (in markets they have previously ceded to Android) will also be the driver for lower gross margins, and thus profitability?  Given AAPL’s current quarter guidance, and the likelihood that the SE may offset the positive effects of the iPhone Plus on the margin front, coupled with saturation of high-end developed markets and growth markets being skewed to SE, the consensus for 2017 gross margins at 39.3% is probably too high. I would also add, that the drop from 43.87% in 2012, to 37.62% in 2013 coincided with a 45% drop in the stock.

From Bloomberg
From Bloomberg

AAPL is currently down about 30% (including the pre-market losses) from its all time highs made last Spring, apparently the big money has been anticipated this sort of margin pressure for some time.

I’ll finish with a few investing rules from Dan Benton, former Goldman Sach’s Hardware analyst in the 1990s, and massively successful hedge fund investor since. Benton published (more than 25 years ago) his 20 rules (you may have come across over the years) for technology investing that might be applicable to the current situation in AAPL. Especially rules #1, #8, and #20, from

Dan Benton’s rules for technology stock investing

1. Sell technology stocks when estimates are being reduced.
2. Buy technology stocks only for positive earnings surprises.
3. Positive earnings surprises occur when revenue and earnings growth are accelerating, when average selling prices are rising, and when gross margin and operating margin are rising.
4. Most technology stock ideas are product-cycle stories.
5. New product cycles often lead to earnings surprises; product cycle transitions usually lead to earnings disappointments.
6. Technology stocks also do well when companies rebound from periods of poor execution.

7. Value investors don’t make money in technology. There are few “cheap” technology stocks.
8. Don’t buy on relative P/E, P/B, P/R, particularly when estimates are falling (see Rules 1 and 2).

9. Technology stocks perform poorly in the summer.
10. Seasonal slowdowns cause secular concerns.
11. Second-tier companies do poorest in the weakest seasonal period and provide anecdotal evidence of an industry slowdown.


12. Reorganizations without restructuring charges usually lead to earnings disappointments within two quarters.
13. One-quarter problems exist (but only if caused by supply constraints).
14. Management usually appears weakest at the bottom of a product cycle.
15. Insider selling doesn’t matter; management gets new stock options every year.

Old World/New World
16. Traditional mainframe and minicomputer companies are in secular decline.
17. It is increasingly difficult to differentiate companies that sell microprocessor-based computers.
18. Execution is the most important distinguishing factor in a standards-based world.
19. It is hard to forecast execution.

20. Don’t forget Rule 1.

Source: Goldman Sachs

As I said in my quarterly preview yesterday, and on Twitter last evening while the call was going on, a break of the 2016 lows would most likely put a re-test of the long term uptrend in the mid to low $80s in play:

I see absolutely not rush to buy AAPL here as a trade or for a full position for a long term holder. If you are willing to look past what will likely be a messy couple quarters, with the possibility of a ramp into and out of the iPhone 7 launch in September, then dollar cost averaging from the mid $90s to possibly the mid $80s could make sense, but that will take discipline, and patience.  Yesterday we detailed a simple put buy as a hedge idea for long holders into the event. Later we will detail a put selling strategy that may help achieve some similar goals of averaging in at lower prices. Stay tuned.