Big Tech: Let Me Upgrade Ya!

While it may seem everyone was getting a new smartphone last year, growth rates in the sector slowed considerably last year. PC shipments are much worse off though, as most producers saw a bleak drop in sales, and the sector fell to sales levels not seen since 2007.

In this episode of Technology Industry Focus, Sean O'Reilly and Dylan Lewis explain what's behind the data for these two tech segments.

A full transcript follows the video.

This podcast was recorded on Jan. 15, 2016.

Sean O'Reilly: We're talking tech saturation on this tech edition of Industry Focus. Greetings, Fools! Sean O'Reilly here at Fool headquarters in Alexandria, Va. It is Friday, Jan. 15, 2016. Joining me to chat global technology saturation, as always, is the only editor I know who can throw a baseball at 85 mph.

Dylan Lewis: I like that. A throwback to my high school days. I appreciate that.

O'Reilly: Yeah, you bet. I actually was going to ask you, Dylan. Do you have a specialty? A curve ball? Fastball?

Lewis: I was a curveball guy.

O'Reilly: You're kidding me!

Lewis: Yeah, I was crafty.

O'Reilly: Oh, no.

Lewis: I was a paint-the-corners kind of guy, yeah.

O'Reilly: Really? I was going to make a mean fastball guess.

Lewis: Yeah, no.

O'Reilly: You didn't spit on your palm or anything sneaky, did you?

Lewis: No. I could throw a pretty decent mess-around knuckleball. I wouldn't throw it in a game, but --

O'Reilly: Oh my gosh!

Lewis: -- hanging out in the --

O'Reilly: You're throwing the crazy pitches!

Lewis: Hanging out in the bullpen, you know, during practice and stuff like that. Yeah.

O'Reilly: Cool. Well, starting off today with smartphones, and what's going on there. A bit of a lead-in: Best Buy (BBY 0.18%) reported holiday sales, and they were not pretty. This is for smartphones.

Lewis: Yes. Well, they reported holiday sales in general, but the particularly ugly part of the report was smartphones.

O'Reilly: Because lots of people buy -- yeah. Domestic sales over the nine weeks ended Jan. 2 fell 1.2%, excluding new stores and closures year over year, and according to a press release, the domestic decline was primarily driven by the mobile-phone category. So they're actually calling out mobile-phone sales. Do you think they're being a little weak there? Or what?

Lewis: They go on to say, "Excluding mobile phones, domestic revenue increased year over year due to our strong performance in health wearables, home theater, and appliances."

O'Reilly: So maybe they're warranted.

Lewis: Yeah. And they actually do a segment by segment breakout here, and they look at some of the numbers, and domestically, the computing and mobile phone segment, which is actually what we're going to spend quite a bit of the show talking about, was down 7% from last year, and that's lapping a 2% decrease the year before.

O'Reilly: Everybody I know -- Christine and James upstairs were talking about buying new phones. People are buying phones. What's going on here?

Lewis: That's the weird thing about it. Everyone you see has a smartphone. Everyone you know has a laptop or a tablet or something like that. You don't think of these as struggling businesses.

O'Reilly: When did the iPhone 6 come out? Earlier this year, so that's not it ...

Lewis: So, the 6S came out in the fall, and the 6 came out --

O'Reilly: Spring, right?

Lewis: Yeah. Another piece of news -- the way Best Buy was stating this was "domestic." But this is not just a domestic issue with these slowing growth rates. Taiwan Semiconductor Manufacturing Company, they are a component company that makes chips that power the iPhones, said that it expects Q1 revenue to be down 11% year over year, and that is due to soft demand for high-end smartphones. And just to give you an idea of their relationship with Apple (AAPL -1.59%) as it relates to their larger financials, roughly 20% of their revenue comes from sales to Apple.

O'Reilly: Wow.

Lewis: Two other Apple providers, Largan Precision, a company that makes camera modules, and Catcher Technology Co., a company that specializes in metal casings, both have issued similar guidance about what they expect for 2016.

O'Reilly: So what Best Buy said was clearly the tip of the iceberg. What do you think is going on here?

Lewis: It's kind of crazy, right?

O'Reilly: This seems like something out of The Onion. There's no way.

Lewis: Yeah. When you look at Best Buy, there are a whole bunch of competitive issues at play there, where someone like [Amazon.com] creeps in or something like that --

O'Reilly: That was a bad example ...

Lewis: But to be clear, these are still growing markets. The growth rates just aren't what they were. IDC estimates that the global smartphone market in 2015 grew 9.8%. Growth was over 20% in 2014 year over year. So this is actually the first year of single-digit-percentage growth year over year for the smartphone market globally.

O'Reilly: Ever.

Lewis: So I think there's a couple things you can look at here as reasons for why this is happening. One of the big things, as you alluded to in our intro here, is saturation with the market. Like we talked about, everyone you know has a smartphone at this point, for the most part.

O'Reilly: Yeah. I've had one since ... when did you get your first one?

Lewis: Probably four years ago.

O'Reilly: I think I got mine about five, and I actually got it because of my co-workers at ... yeah, I kind of had to because everybody else had it.

Lewis: And the market is much more developed here in the U.S., but part of the reason why we saw such explosive growth in 2014, 2013, was some of that developing parts of the world, China in particular, there were a lot of first-time buyers that were getting these devices. So you think about the typical refresh cycle, the particular upgrade cycle for a lot of these devices, it's usually two and a half, three years.

And so, knowing that 2014 was a particularly big year for sales, it's not surprising that 2015's a little weak. So that's one of the things. I think one of the other big trends is, obviously, we're in the mid-upgrade wave for Apple products. Like you said, the most recent product release was in the fall with 6S. We will be expecting the iPhone 7 to be coming out this year, in the fall. So that's keeping with the typical calendar that Apple releases a new major upgrade to its line every two years.

O'Reilly: Isn't it funny, that that's where I immediately went when you were talking about lackluster sales in smartphones? It was like, "Wait a minute, when did the iPhone ... "

Lewis: Yeah, it's the major barometer. Granted, the 6S had some cool new features: 3D touch, live photo, stuff like that. But consumers know that the big changes come when the number changes on the device. So I think maybe the second half of 2016 will bode a little better for this market.

O'Reilly: My mother just got the 6S, and there was some debate. She really wanted the newer one, but there was some, "OK, should we wait for the 7?"

Lewis: I couldn't wait.

O'Reilly: I know you couldn't. You were so happy that day, too.

Lewis: I was giddy, yeah. And lastly, these are tough comps to be going up against. Like I talked about. The iPhone 6 and the iPhone 6 Plus, which was Apple's first foray into the phablet market, did remarkably well. Just, awesome products, they sold tons of devices. And so you're going up against really tough year-over-year comparisons in 2016. So that's particularly difficult. All that said, I think there are a few things to watch here.

Most of the pessimism that I've seen, particularly that coming from Apple suppliers, is really confined to the first half of 2016, which isn't surprising, because like I said, the iPhone update will be coming out in the second half of 2016. So the second half should be much stronger. We'll get some insight from Apple as to what they expect for the year in terms of guidance at the end of this month when they report earnings. So we'll get some color there in addition to what they've done in the past with the holiday season and everything like that.

But I think one of the most interesting things, Apple trying to get ahead of some of these trends and trying to push the upgrade cycle faster than the two and a half to three years that some consumers seem to be on is the Apple iPhone upgrade program, where you pay the monthly $30 or so and you can upgrade yearly.

O'Reilly: Do you think that's a good deal?

Lewis: We did the math on it. If you're someone who actively wants the best model, and you are divorced from a carrier subsidy model, then it's not bad. And that's one other thing that also comes into play with a lot of these numbers, you look at some of the major carriers. You know this space a little bit better than I do. But most of them are moving away from allowing new customers to sign up for subsidy plans.

O'Reilly: It was a big deal when Verizon did it. I knew that big things were happening, because a little over a year ago, when I was doing this same show with Nathan Hamilton, he started talking to me about what T-Mobile, and I was like, "I should switch to T-Mobile." I switched to T-Mobile from Verizon because of the show. And then, I didn't realize how big of a deal or how quickly it had happened, because now they're all like that. Sprint's begging for my mother-in-law to stay with them, all kinds of stuff.

Lewis: Yeah. Before we started doing the show, before we came in the studio, talking with Kristine Harjes, the healthcare editor --

O'Reilly: That's right, folks. We do talk to each other.

Lewis: She'd said, "You guys are talking about iPhone update rates, I've had the same --" she has an iPhone 5, "-- iPhone for 3 years." And I was like, "Do you not have subsidies through your carrier?" She was like, "No. So I don't really want to pay the $650 or so it would cost to get a new phone."

And I think that's one of the issues with all the carriers moving away from the subsidy is, a lot of people are so ingrained into that thought of, "OK, this new phone will cost me $150 through my plan." And then you see the actual retail sticker price that phone is worth, and without a subsidy model, you're paying $650. You're like, "Man, that's a lot of money!"

O'Reilly: That was the thing that happened when I went in and did the T-Mobile switch, because the one way they can mitigate that is just, no interest, two years, you pay off the phone. So it's $650, 24 months. So I'm paying like $28 or so a month. The second that ends, my cell phone bill gets really cheap, and it's going to be awesome. But then I'm going to want the new iPhone. Agh!

Lewis: Yeah, then they're going to drop some new features ...

O'Reilly: They're going to give me some wireless headphones and all this stuff, and game over. Before we move on, and this is completely off the cuff, do you think there's any possibility that the lack of growth -- we're talking about high-end smartphones.

Lewis: Yeah, Samsung and Apple.

O'Reilly: You and I both know Apple's profit margins on the iPhones are ...

Lewis: Gaudy.

O'Reilly: They're beautiful.

Lewis: Yes.

O'Reilly: Is it possible that the cheaper smartphones are starting to affect people's buying decisions with that? Is it possible that might be rolling over a little bit?

Lewis: I think so. You're talking about Xiaomi and some of the cheaper Chinese manufacturers?

O'Reilly: Yes. Without calling out any particular names, which you just did ...

Lewis: Particularly in developing markets, where they're very popular. I think there's something to that. I think that it is something that manages to ...

O'Reilly: I love how seamless the iPhone is as much as the next person. I try to get away from it, and I can't. But economics eventually sets in, you know what I mean?

Lewis: I think what you get with Xiaomi and some of those products, if you don't want to spend a lot of money on a smartphone, you get the minimum viable product that is also a smartphone and stylistically looks similar to an iPhone, so I get that. I do think that, in China in particular, it's a very luxury-oriented market. So there's going to always be that huge divide between low end and high end.

O'Reilly: There's a reason the world's biggest Coach store is in Beijing.

Lewis: Yeah. So I think it definitely hurts, but maybe to counter that, it also gets people using smartphones as an intro device --

O'Reilly: And then, when they get a little more money, maybe they want the iPhone.

Lewis: Yeah. So maybe it's a negligible net result for the high-value smartphone manufacturers.

O'Reilly: We shall see. Before we move on, I want to point our listeners to the newly redesigned focus.fool.com. There, you'll discover a special offer to join The Motley Fool's Stock Advisor newsletter to start your year off Foolishly. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription, just go to focus.fool.com to take advantage of this offer. Once again, that's focus.fool.com.

Pivoting over to the PC market ... boy, we're just whomping on hardware today, aren't we?

Lewis: Yeah.

O'Reilly: Do you feel bad about it?

Lewis: Little bit. But, I mean, we're just painting a picture.

O'Reilly: Yeah. Actually, I tried to go Mac when I got my computer choice here at the Fool, and I couldn't, because unfortunately, Windows owns me. Anyway.

Lewis: Full disclosure -- I use a Mac at home; I use a ThinkPad here at work.

O'Reilly: So you're a bigamist?

Lewis: I like having something that truly runs Office. Not a version of Office, and not having to run on Parallels to be able to run the true version of Office.

O'Reilly: This is when I was on your -- do you remember the day I was trying the MacBook?

Lewis: Yeah.

O'Reilly: And it was really funny when it happened, because that was the day the queue was huge. Ladies and gentlemen, one of Dylan's and my other jobs is, we edit articles that go out on fool.com, and I had a bunch of articles I needed to get through, and I wasn't quick enough on the Mac. And I was like, "Dang it, I could be doing this if I was on the PC!"

Lewis: It definitely takes a little getting used to.

O'Reilly: Yeah.

Lewis: Especially if you're so ingrained in the Windows interface.

O'Reilly: Before that, I think the last time that I'd used the Mac was in the third grade.

Lewis: Yeah. It's funny to think --

O'Reilly: We all had it.

Lewis: You're talking about the translucent, cut-out boxy ones that they used to put in classrooms?

O'Reilly: Yeah. They used to play Oregon Trail and get dysentery on Macs.

Lewis: "You have died of dysentery."

O'Reilly: So switching over to the PC market. What's going on?

Lewis: PC sales have fallen to levels not seen since 2007, incidentally the year the iPhone was introduced.

O'Reilly: Coincidence, Dylan?

Lewis: According to International Data Corp. So grand total was 276 million shipments in 2015, versus 308 million shipments in 2014. We can look, specifically, at some of the shipment leaders here to give you an idea of what the market looks like: Lenovo in first place, roughly 57 million shipments in 2015; HP (HPQ 0.56%) in second with just under 54 million; Dell in third with 40 million; Apple coming in fourth at 21 million; and Acer bringing up the bottom of the top five with 20 million shipments. So I think those shipment volume numbers are great to give you a sense of market share. But I think the 2015-2014 growth is where one of the more interesting stories plays out. Out of those five, Sean, how many of them do you think experienced year-over-year growth?

O'Reilly: One.

Lewis: Yeah.

O'Reilly: Oh! I didn't look, I swear!

Lewis: Did you cheat?

O'Reilly: No!

Lewis: You know who it is, right?

O'Reilly: Is it Acer?

Lewis: No.

O'Reilly: Is it Apple?

Lewis: Yeah. All of the other ones experienced declines.

O'Reilly: I went with my gut. Cool. Yeah, Lenovo's down, HP's down, Dell's down, and Acer. Cool. Good job, Tim Cook!

Lewis: We'll talk a little bit about, broadly, what's going on here in the market, and then maybe get into some of the granularity of why some of these companies are better off. Similar to some of the issues that are plaguing the smartphone market right now, PCs seem to be suffering from slower upgrade cycles. That's being a victim of your own success, in a lot of ways. Creating products that people want to continue to use that aren't breaking every four years, and are lasting longer. So that's one of the struggles. Do you have a personal computer?

O'Reilly: Actually, I use the work computer, and then my wife and I share a computer at home. And that thing ... I've replaced the hard drive. It's old. But it works. It's like, "I don't care, whatever."

Lewis: Exactly. I got a MacBook Air two summers ago. That's well within what the PC industry wants in terms of an upgrade cycle, year and a half or so. But before that, I think I had a Dell that I'd owned for five years.

O'Reilly: A little indicative of this, I literally just found this out the other day about Microsoft (MSFT -1.24%), and it blew my mind. This is kind of indicative because Microsoft basically is PCs. In the year ended June 30, 2000, Microsoft's revenues were just under $23 billion. Guess what their net income was after paying taxes and everything?

Lewis: $4 billion?

O'Reilly: $9.4 billion net income.

Lewis: That's actually a pretty good margin.

O'Reilly: That is insane. Guess what it is today?

Lewis: On similar revenue?

O'Reilly: No. Their revenues for the 12 months ended Sept. 30, 2015, so the last 12 months, not year-end June 30 -- actually, let's just do the year. Is that fair?

Lewis: Yeah.

O'Reilly: Yeah, ended June 30, 2015, $94 billion in revenue. Growing just under fourfold on revenue. There's a one-year charge there, but guess what their net income was for that year?

Lewis: I'm going to stick with the same margin profile from before. That was $4 billion on $23 billion, roughly one-sixth, so one-sixth of 90-something -- $15 billion?

O'Reilly: $22 billion.

Lewis: So better than I thought, but that's a huge contraction.

O'Reilly: That is a huge margin contraction. Microsoft is having to work way harder to make money. And I did not know that until a couple days ago, and my jaw hit the floor, because I assumed Microsoft would be ... because their stock finally recovered in the last couple years to where it was in 2000, if you remember. Anyway, that's just indicative of what's happened to PCs in the last 15 years. Microsoft's having to work harder and harder and harder to make money.

Lewis: One of the interesting things that I read in IDC's coverage of the shipment data, they usually have some nice research notes to parse out the data and read between the lines a little bit, when after analysts talked a little bit about how Microsoft giving away Windows 10 as a free upgrade --

O'Reilly: Need you say more?

Lewis: -- also might have been a detriment to the PC upgrade cycle.

O'Reilly: Just think, in 2000, what were they getting per edition of Windows -- $200, $300?

Lewis: Yeah. So the thought with that analyst's note is that the new operating system refreshed the computer and gave people a sense of a new computer, even if it was the same hardware, so they weren't as willing to upgrade. So that's another reason explaining what's going on. Also, some people always fall back on the strong dollar hurting some of these tech companies, which is valid, but I always feel like that's a bit of a cop-out, because it's something that affects multi-national.

But I think more than anything else, it's staggering to me that only one of the top five in terms of shipments has been able to buck the trend, and that's Apple. And I think that just goes to show how strong and sticky their ecosystem is, that people are going to continue to buy iProducts because they love the integration of --

O'Reilly: What's the market share now? Did you catch that?

Lewis: As of 2015, it's 7.5%. And that's up from 6.3% in 2014.

O'Reilly: Very respectable.

Lewis: Yeah. They have a solid little carved-out niche there. And just for context, Lenovo, the market leader, is at just under 21%. So they have a solid foothold there. But like I said, it is crazy to me to see only one company being able to buck such a huge industry trend.

O'Reilly: Yeah. Cool. Just a side note for the Microsoft stuff, that year, last year, did have a bunch of one-time charges, but throwing that back in, it was $22 billion. I think, GAAP basis, it was like $12 billion. They get sued all the time for antitrust reasons.

Lewis: Your margin contraction point was still made.

O'Reilly: Isn't that crazy?

Lewis: Yeah.

O'Reilly: Cool, thanks for your thoughts, Dylan.

Lewis: Always a pleasure.

O'Reilly: I will see you later. That is it for us, folks. If you're interested in business development companies, also known as BDCs, be sure to tune into Gaby Lapera's financial Industry Focus episode on Monday. As always, if you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Dylan Lewis, I am Sean O'Reilly. Thanks for listening, and Fool on!