7 Reasons Why Apple Is On The Decline

Shas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Apple (NASDAQ: AAPL) is the world's biggest company by market share. It is a unique company operating in the computer market with the ability to simultaneously address key segments due to its vertically integrated structure. Vertical integration brings structural and competitive advantage to Apple, against its peers. Rivals such as Samsung or Google (NASDAQ: GOOG) may play in one or two categories ,but they have not been able to demonstrate an ability to effectively compete across all three segments, i.e. smart-phones, tablets and PCs. The company has a continuing legacy of innovative products with a solution based and ease of use focus. It has a strong position in the education and creative markets with a broad channel access including its own Apple stores.

However, the stock has been on the decline for the past three months. Its market cap has fallen from $661 billion to $492 billion, nearly $170 billion. The stock price has fallen from $702.1 to $531.47. Please refer to the chart below:

Source: NASDAQ Website

Some of the main reasons for the decline of the stock are a reshuffling in the management, no new products planned apart from upgrades and Apple TV, lower sales and lower net income growth in FY12 compared to previous years, and lower revenues and gross margin guidance for Q1FY13. Various reasons for the decline are described below:

1. Poor Revenue and Gross Margin Guidance for Q1FY13: Apple has guided to conservative revenues and gross margins for Q1FY13. Revenue guidance of $52 billion is below buy-side expectations and gross margin of some 36% was very surprising, indicating a decline of 400 bps qoq and 870 bps yoy. There are a range of factors that the management said, will weigh on gross margins including:

2. Changes in the Management Team: On Oct. 29, Apple announced changes to its senior management, with Jony Ive (SVP of Industrial Design), Bob Mansfield (SVP), Eddy Cue (SVP Internet Software and Services) and Craig Federighi (SVP Mac Software Engineering) adding responsibilities to their existing roles. It also announced that Scott Forstall (SVP iOS Software) and John Browett (SVP Retail) will be leaving the firm. The company expects the changes to increase collaboration across hardware, software and services. Jony Ive will now lead human interface in addition to industrial design. Eddy Cue will take charge of Siri and Maps, which will move out of iOS and into online services. Craig Federighi will now lead iOS in addition to the OS X. Meanwhile, Bob Mansfield will lead the new Technologies group, which combines Apple's wireless teams across the company.

The company will also include semiconductor teams, where Apple has ambitious plans.

I believe that the management changes will:

  • Impact on Retail Business: Mr. John Browett's short stint (Joined in April 12) after the departure of Mr. Ron Johnson is likely to be viewed negatively for the company's retail momentum.
  • Impact on Mac Business: Mr. Forstall, previously SVP of Mobile Software has been a long time contributor to Apple's Mac and more importantly its iOS lines. His departure might bring execution risk at Mac at least for some time.

3. Deteriorating Sales and Profits: In FY12, the sales growth declined to 45% from 66% in FY11. Net income growth also dropped from 85% in FY11 to 61%. Please refer to the following table:

Financials:

USD mn

2009

2010

2011

2012

Total Revenues

42,905

65,225

108,249

156,508

Growth

 

52%

66%

45%

Cost of Good Sold

25,683

39,541

64,431

87,846

Gross Profit

17,222

25,684

43,818

68,662

Gross Margin

40.1%

39.4%

40.5%

43.9%

R&D

1,333

1,782

2,429

3,381

% of Sales

3.1%

2.7%

2.2%

2.2%

SG&A

4,149

5,517

7,599

10,040

Total Oper Expenses

5,482

7,299

10,028

13,421

% of Sales

12.8%

11.2%

9.3%

8.6%

Operating Income

11,740

18,385

33,790

55,241

Operating Margin

27.4%

28.2%

31.2%

35.3%

Other Income & Expenses

326

155

415

522

Pretax Income

12,066

18,540

34,205

55,763

Income Tax Expense

3,831

4,527

8,283

14,030

         

Net Income

8,235

14,013

25,922

41,733

Growth

 

70.2%

85.0%

61.0%

Net Margin

19.2%

21.5%

23.9%

26.7%

Source: Company Filings

4. Competition: The company is facing fierce competition from established players like Google, Microsoft (NASDAQ: MSFT), Amazon (NASDAQ: AMZN) and of course Samsung.

  • In the overall computer market, in volume terms Apple has approximately 17% market share which is likely to improve in coming years given its growth in smart-phone and tablet markets. Its competitors are doing well in their respective segments, but not in all three segments i.e. PCs, smart-phones and tablets.
  • Google's Android is capturing significant volume share within smart-phones (47%) with small share in tablets (27%) but it needs to expand beyond smartphones. Its Chrome OS still needs to see some strong footing.
  • Microsoft already has a strong hold on the PC market. With Windows 8, which can be controlled entirely by touch and runs on tablets, smart-phones and PCs, Microsoft is set to gain market share in smart-phone and tablet markets too.
  • Apple's pinch-to-zoom patent was preliminarily rejected, shaking one of the cornerstones in its battle against Samsung.

5. Order Cuts from Component Suppliers: The company's Asian suppliers have been reporting order cuts, doubting the market potential of iPhone 5.

6. Dearth of New Launches: There are no new launches planned in the near future, apart from the Apple TV that too appears to have been postponed. All new launches at the moment are upgrades of existing products.

7. US Capital Gains Tax: Investors are booking profits before the higher US capital gains tax comes into effect in 2013. According a report from PWC, "The current federal long-term capital gain rate is 15%. It is scheduled to increase to 20% in 2013. The phase out of itemized deductions also returns for 2013 and acts like an additional tax of 1.2%. Finally, a 3.8% Medicare tax will also apply to investment income beginning in 2013. The combination of these scheduled rate increases means that the 15% maximum capital gains tax rate turns into a 25% tax rate in 2013."

Conclusion

Having listed out the reasons for recent weakness in the stock, I still believe that the stock has upside potential. It is a valuable stock for FY13 as the company indicated that it has planned good investment in the business for a significant level of growth. The company's retail momentum is on track. The company is planning to open 30-35 new stores during FY13, 75% of which would be outside the U.S. It is growing in emerging markets with China leading the growth. Apple's China revenues were up 83% yoy in FY12 to $21 billion. Revenue growth is likely to be in tact with continued very high demand for its new or re-priced versions of products like the iPhone 5, iPad Mini, iMac, MacBook Pro 13-inch, iPod Touch and iPod Nano. The stock is currently trading at a P/E of 10x that looks inexpensive given the growth profile and $128 of net cash per share. Upcoming results of 1QFY13 should serve as a catalyst for the stock to recover with upward earning revisions.


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