Apple Investors Should Keep Their Eyes on the Ball

It's no secret that Apple (NASDAQ: AAPL  ) is one of those battleground stocks where bulls and bears have dug in on both sides and are holding their ground. Many people have strong feelings about Apple's products -- either they love their iPhones and iPads, or they think Apple gadgets are dated and overpriced -- and this usually determines whether they like Apple stock.

Obviously, Apple's competitive positioning (particularly vis-a-vis Android phone and tablet vendors) is very important to valuing Apple stock. However, what ultimately matters is how much profit Apple will earn, both now and in the long run.

Products like the iPad arouse strong emotions in many investors. (Photo: Apple.)

Unfortunately, many investors seem to be getting blown off course, focusing on statistics that have no clear relationship to earnings. Instead, long-term investors should tune out the noise and focus on Apple's potential for earnings growth -- since that will determine whether Apple is a good or bad investment.

The market share argument
One common source of "noise" is the periodic release of market share statistics. Many Apple bears harp on the company's falling market share in the smartphone and tablet markets. However, Apple's falling market share is not nearly as important as many people assume.

The problem with evaluating Apple based on market share is that it only really competes at the high end of the smartphone and tablet markets. Both markets have been booming in the past few years, but the vast majority of the growth is at the low end of the market.

A proliferation of smartphones and tablets priced in the $100-$200 range (unsubsidized) have led to big gains in unit sales for vendors that participate in the low end of the market. However, these devices are priced at or very close to cost, whereas Apple earns a healthy margin on every iPhone and iPad sale.

iPhone sales are still growing, even if Apple's market share is falling. (Photo: Apple.)

The result is that Apple is missing out on a lot of sales volume but not much profit. Thus, Apple's falling market share isn't necessarily a problem.

Some bears argue that Android could gain a competitive advantage from its high market share by becoming the preferred platform for developers. However, people don't buy $200 smartphones so they can save hundreds of dollars to spend on apps! Most app spending comes from people with high-end smartphones. Thus, iOS remains a huge cash cow for mobile developers -- Apple paid out a whopping $2 billion to developers in the December quarter.

In summary, market share is a bad yardstick for measuring Apple's success. Apple investors can be perfectly happy in an environment where Android vendors are posting big gains in sales and market share -- as long as Apple's revenue keeps growing and margins remain roughly stable.

The "best in the bunch" argument
At the other end of the spectrum, some Apple bulls focus too much on the profitability gap between Apple and many Android device manufacturers. While it's true that Apple is much more profitable than most of its competitors, this can provide false comfort to Apple investors -- because the key fact is that Apple's profitability is falling.

For example, it's true that Android tablet vendors have boosted sales primarily by introducing cheaper and cheaper devices. While unit sales have skyrocketed, most Android tablets are sold at breakeven or very close to it. This makes the Android tablet market fairly unattractive from an investment perspective.

However, the fact that Android tablet manufacturers have terrible profit margins isn't necessarily good for Apple. The availability of very capable Android tablets for very low prices has clearly had an impact on iPad sales and profitability. Total iPad revenue grew just 3% in Apple's most recent fiscal year because of a steep drop in the average selling price and a slowdown in unit sales growth.

Android tablets are disrupting iPad sales, even if they aren't generating much profit. (Photo: Apple.)

There's no prize for being the best company in an industry with declining profitability. Apple may be better off than most potential competitors, but that didn't prevent it from registering a double-digit earnings decline in FY13.

Block out the noise
Apple doesn't need to fight tooth and nail with low-end Android vendors for smartphone and tablet market share to produce a good return for long-term investors. In fact, Apple is better off continuing to focus its efforts on the upper half of the market.

That said, Apple investors shouldn't be satisfied with the recent trend of stagnant to declining earnings. In that context, the fact that Apple is still far more profitable than other device manufacturers is irrelevant.

So what should Apple investors be looking for? First, Apple needs to be able to grow iPhone and iPad sales -- even a high single-digit rate would be acceptable -- while keeping margins roughly steady. By this metric, the iPhone seems to be successful, but the iPad is falling short.

Second, Apple needs to diversify its revenue base by introducing new products that will catch on with consumers. CEO Tim Cook has repeatedly promised in the past year that Apple will introduce new product lines before the end of 2014. Now investors just have to wait to see what Apple has developed, and whether it will be successful.

Foolish bottom line
Apple bears correctly recognize that the company is not in as strong a position today as it was even two years ago. However, the problem is not that Apple is losing market share, but that it has been forced to sacrifice some of its profit margin to remain competitive.

Meanwhile, Apple bulls wisely ignore the market share statistics but gloss over the fact that Apple's earnings are well below 2012 levels. Clearly, something is wrong, and pointing out that Apple is still the most profitable mobile device manufacturer is beside the point. Investors who can tune out this noise and focus on Apple's fundamentals will have a big advantage over the rest of the market.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 20, 2014, at 1:24 PM, aeosfool wrote:

    "In that context, the fact that Apple is still far more profitable than other device manufacturers is irrelevant." Actual earnings are never irrelevant. Actual earnings allows Apple to pay me more per share in a dividend than I paid for the stock. Actual

    earnings allows Apple to buy back stock so they can actually grow earnings PER SHARE this year even though their actual earnings may have dropped (due in large part this being a year they didn't introduce a new product..which, as you mentioned, should change this coming year).

    The problem with the ipad may be it is so high quality it doesn't need to be replaced nearly as often as the competitors. I still own an Ipad 1(among other ipads) and it still works as good as the day I bought it. If you bought a cheap one, you'll likely have to replace it every other year because you have to, not because you want to).

    In any case, too much is paid in the short term for possible earnings...give me actual earnings and its long term benefits any day.

  • Report this Comment On April 20, 2014, at 1:49 PM, Chiam wrote:

    It is quite simple.

    1. Apple is too big to grow significantly.

    2. No new products and basically the same two updates each year that matter. iPhone and iPad.

    3. Competition is fierce and the market is more and more saturated.

    4. Tim Cook is maintaining what was but not moving forward at all.

    5. Cook is always late to market and never has enough product during the most important holiday season.

    Cook needs to get canned and a visionary like Elon Musk is needed. Apple will buy back stock and that could push up EPS but the company will not get a higher but lower multiple.

    Apple's only real big improvement is a larger phone. Now that is not revolutionary but will give it a jolt this year. But after that there is nothing.

    I don't believe a watch or tv is coming until 2015 at the earliest. I say we may never get a new category. Cook is literally standing still.

  • Report this Comment On April 20, 2014, at 1:56 PM, Greenmagic wrote:

    Author has no clue - iPad sales grew only 3 percent 2012 due to no new model release. The iPad Air was released fall2013 as well as second generation iPad mini.

    And he really makes no mention of new products, a key driver of the stock price.

    New products this year - and increase Year over Year iPad sales

  • Report this Comment On April 20, 2014, at 3:04 PM, zippero wrote:

    Adam, Apple's free cash is actually up $3 bil. to $46 bil. In 2013 from $43 bil. in 2012, despite a lower GAAP net income. In contrast, both Google's and MSFT's free cash flows are 20% lower in 2013 vs. 2012, despite higher GAAP net incomes. It's incorrect for you to say Apple's earnings are actually going down, when in fact their still rising while the next two big tech stocks' earnings are actually falling significantly. Cash earnings are what matters, not GAAP net income which is often a mirage.

    It's true Apple's free cash flow did not rise by double digits as it usually does in 2013 vs. 2012. But this was not because Apple's sales were suffering because of competition from low-end, low-priced competitors, as you claim. It was because of the Galaxy S3 temporarily being able to gain a significant share of the premium market in 2012 and into 2013. But that was a one-off event, and Samsung's profit share has come down to 30% from 53% while Apple's has spiked to 87% from 56%. The Galaxy S4 sold only 40 mil. units despite 63 million units being shipped, according to the Korea Times, and the new Galaxy S5 is not likely to do any better, especially given the large iPhone 6's that will come out in Sept. Apple has already regained the most profitable premium segment in terms of both revenues and profits, Samsung is not likely do do any better, and the low-end will always remain irrelevant as far as revenues and profits on both hardware and app sales are concerned.

  • Report this Comment On April 20, 2014, at 3:21 PM, zippero wrote:

    Adam, Apple's free cash flow actually rose by $3 bil. In 2013 regardless of its GAAP net income. Google's and MSFT's free cash flows both fell by 20% despite their higher reported GAAP net incomes. Don't let GAAP net income throw you off about who's really producing more actual cash profits year over year and who's making less.

    It's true Apple's free cash flow didn't rise by double digits in 2013, but that was NOT because of any competition from cheap, low-end devices, as you still assert. It was because the Samsung Galaxy S3 did successfully make inroads in the premium market in 2012 into 2013, but then the next Galaxy S4 couldn't hold the gains and Samsung's profit share collapsed back to 30% from 53% while Apple's soared to 87% from 56%. It's unlikely Samsung recovers as it was already forced to cut prices by 10% worldwide on its brand-new Galaxy S5 while its BOM is higher, and Samsung itself already announced it expects its earnings to fall this year. On the other hand, Apple is considering raising prices by $50-100 on the larger iPhone 6's, which will steal share away from Samsung's 100 mil. Galaxy S and Note units it used to sell every year. By the end of this year, Apple's free cash flow will hit $50+ bil from $46 bil. in 2013 and its profit share will be up to 95% or so.

  • Report this Comment On April 20, 2014, at 4:48 PM, SimchaStein wrote:

    Good points re market share vs profit share, but....

    The real problem with market share perspectives is that the battle is not touchscreen screen devices but about platform phones. The use of the word SmartPhone lumps platform and touchscreen into a false category. This is not about so-called 'high-end' or premium. It just so happens that the higher priced fully functional touch screens (phones and tablets) are the only true platform products.

    So removing the non-platform products from the analysis we see that Apple is doing very well. It appears that the iOS category is near a peak (with the current form factors). We also see that SW and Services is growing at double digit rates - as expected for platform products. Apple may re-ignite by adding new platforms - form factors, and all the rumored-to-death other products. Wonderful.

    As for margins - Apple leads in this area because they invest heavily in all the platform components. Others just assemble commodity components - not much value-add.

  • Report this Comment On April 20, 2014, at 9:02 PM, TMFGemHunter wrote:

    @zippero: I don't agree with the philosophy that only cash earnings are "real". It's just as easy (possibly easier) to distort cash earnings as to distort GAAP earnings. In Apple's case, the rise in cash flow last year was due entirely to working capital improvements. It's great for shareholders to use less working capital, but this is not a sustainable trend. I would not be surprised to see FCF down in FY14. I think Apple has a pretty good chance for a successful product cycle this fall, which could reignite sustainable growth in FCF next year.

    @Greenmagic: Why don't we just wait until the end of FY14 to test your hypothesis? I doubt Apple will do any better than 3% revenue growth for the iPad in this fiscal year, and it might do worse. We'll at least have an inkling of which direction things are headed when the earnings report comes out this week.

    @aeosfool: I think you've missed my point. Apple is clearly a better business to own than other tablet manufacturers that have terrible margins. But the question is not which tablet maker to own, but rather whether you should own Apple stock or not. If Apple's earnings are in permanent decline -- something I don't believe to be the case but which is certainly plausible based on the recent trend -- then Apple stock will inevitably follow sooner or later.

    Adam

  • Report this Comment On April 20, 2014, at 9:09 PM, TMFAeassa wrote:

    Fantastic article as always, Adam. Thanks for writing!

  • Report this Comment On April 21, 2014, at 1:12 PM, zippero wrote:

    Adam, unsustainable NWC improvements didn't lead to Apple's higher 2013 FCF at all. What happened was Apple had an atypically huge $7 bil. of A/R at the end of fiscal 2012 (vs. $2 bil. at the end of fiscal 2013), so $5 bil. of the $7 bil. was collected by Apple as cash in fiscal 2013. This $7 bil. A/R was included in Apple's $41.7 bil. GAAP net income for 2012, so 2012 earnings as far as cash were actually $5 bil. lower, or $36.7 bil. At the same time, Apple's 2013 earnings were $5 bil. higher than the reported $37 bil., or $42 bil. So Apple's earnings actually rose from $36.7 bil. to $42 bil. from 2012 to 2013. The FCF figures I presented before don't change at all. It's still a $3 bil. Increase from 2012 to 2013. When

  • Report this Comment On April 21, 2014, at 1:14 PM, zippero wrote:

    When the pulling forward of the $7 bil. of A/R from 2013 into 2012 is accounted for, Apple's earnings from 2012 to 2013 increased from $36.7 bil. $42 bil.

  • Report this Comment On April 22, 2014, at 7:34 AM, cmalek wrote:

    Apple hasn't proven yet that it can innovate without Stevw Jobs' vision. Even Apple TV and SmartWatch, to which Fruitco Faithful are pointing as innovation, were instigated by Jobs. As Chiam wrote above, Tim Cook is just a caretaker, he's not a leader.

    @SimchaStein:

    You're cherry picking positive data and conveniently disregarding negative data.

  • Report this Comment On April 22, 2014, at 9:38 AM, TMFGemHunter wrote:

    @zippero: These big swings in working capital are due to the fact that the new iPhones have been coming out a little over a week before the end of the quarter. The accounting numbers mark a phone as being sold when it is shipped/handed to a customer or reseller. The cash numbers typically don't recognize the income until a month or two later (when a reseller like Verizon might pay Apple).

    Personally, I feel that the income statement numbers are more meaningful. When the phone is sold, I know that the cash is going to come in, even if it's in October rather than September.

    I looked back at the cash flow figures, and the bigger impact seems to be the increase in non-cash D&A expense last year. Again, this is a situation where the cash and accounting viewpoints both have some merit. But from my perspective, Apple was getting the benefit of its big 2012 CapEx increase in FY13. As a result, it makes sense to reflect the increased D&A expense in Apple's earnings.

    Adam

  • Report this Comment On April 22, 2014, at 11:48 AM, reyanharris wrote:

    Apple's new CEO is making moves to give back a considerable piece of the organization's money heap to shareholders, therefore http://goo.gl/3wMcWk

  • Report this Comment On April 22, 2014, at 12:19 PM, TMFDanielSparks wrote:

    Outstanding article Adam. Thanks

  • Report this Comment On April 23, 2014, at 10:46 AM, Mathman6577 wrote:

    Great article. It should be required reading by Apple analysts (e.g. Gene Munster and friends). The focus by analysts and the financial media on market share (and margins ... 39.5% vs. 39.2% is not a big deal folks) has been way overdone over the last few years.

    More telling stats that never are discussed much are the share of web traffic generated by mobile devices (Apple is by far the leader with more than 80%) and retention rate (Apple is above 90%). This shows how well the ecosystem is doing (Apple is heads above Google) and what drives long term growth.

    All that said the company surely needs another breakthough product (iWatch, iTV, etc.). It won't be able to buy back shares forever and eventually the high-end phone market will flatten.

    I disagree w/ many of the comments regarding lack of innovation at Apple. There is a big difference between innovation and invention. While the company hasn't really invented anything it constantly innovates. The introduction of Touch ID, motion coprocessor, Retina display, etc. over the last few years is considered innovation. Large screens (i.e. in Samsung phones) and more memory is not innovation.

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