The Case Against Apple Bears

Are the valid bearish arguments strong enough to merit the iEmpire's extremely conservative valuation?

Daniel Sparks
Daniel Sparks
Mar 12, 2013 at 7:00PM
Technology and Telecom

Apple (NASDAQ:AAPL) shares have plummeted to borderline irrational lows. At just 8.2 times forward earnings, investors now have the opportunity to get their hands on a great company at a great price. But two major issues keep many investors glued to the sidelines: slipping margins and increasing competition.

Slipping margins, or a well-executed product mix shift?
Apple's gross margin is down significantly. In Apple's first quarter, it decreased to 38.6%, from 44.7% in the year-ago quarter. But does this mean Apple's lower margins from the first quarter are the new norm? Not necessarily.

First, Apple's product mix during its first quarter was very unusual, as Apple CEO Tim Cook pointed out during the company's first-quarter earnings call. More than 80% of revenue during the quarter came from new products. "The number of ramps were unprecedented in the fact that we had new products in every category is something we had not done before," Cook said.

Second, Apple clearly explained that the iPad Mini gross margin is "significantly below the corporate average" and that the new product mix from the cannibalization of full-sized, higher-margin iPads by iPad Minis is a shift management eagerly chooses. "I see cannibalization as a huge opportunity for us," Cook explained. "Our base philosophy is to never fear cannibalization. If we do, somebody else will just do it and so we never fear it."

So far, it looks like choosing lower margins is helping Apple bring in a lot more dollars in revenue, even if it's collecting less profit on each unit it sells. Apple's iPad segment, for instance, was the company's fastest-growing segment in the first quarter, with iPad unit sales increasing 48% from the year-ago quarter. Furthermore, estimates from Canalys suggest that "Apple would surely have lost ground to its competitors" without the launch of the iPad Mini; according to Canalys' estimates, the iPad Mini made up over half of Apple's total tablet shipments during the quarter.

Apple remains the clear leader in the high-end hardware market
It's no secret that Apple sacrifices revenue in pursuit of higher margins. Yes, Apple is losing market share. Yes, lower price points from competitors may have been a major influence in Apple's decision to sell a lower-priced tablet. But there is still very little evidence that Apple's position as the high-end producer is threatened.

A December 2012 report from IDC showed that Apple shipped 15% of all "connected devices" in the third quarter, trailing Samsung at 21.8%. But Apple was able to maintain an average selling price, or ASP, of $744 across its device categories, compared to Samsung's $434 ASP.

As IDC's Reith points out, "The fact that Apple's ASP is $320 higher than Samsung's with just over 20 million fewer shipments in the quarter speaks volumes about the premium product line that Apple sells."

Furthermore, though Apple's year-over-year gross profit margin has declined, it still remains significantly higher than the gross margins of other publicly traded hardware producers. Hewlett-Packard (NYSE:HPQ) and Dell (UNKNOWN:DELL.DL), for instance, have trailing-12-month gross profit margins of 23.2% and 21.3%, respectively. Compare this to Apple's TTM gross profit margin of 41.9%.

What about the exploding market growth in smartphones and tablets?
IDC claimed HP as the only company among the top five device makers to report slowing sales growth in the third quarter of 2012, as sales shifted to smartphones and tablets. Dell, which didn't make IDC's list, saw PC sales decline by 16% in the fourth quarter, the second-worst performance (next to Acer) of the top five PC manufacturers on Gartner's list.

Going forward, HP and Dell could face more of the same if they can't successfully crack the smartphone or tablet markets. Gartner reported a 4.9% decline in sales of PCs on a global basis, and it expects the trend to continue.

These are legitimate reasons for low multiples on forward earnings. But Apple's market outlook differs drastically. IDC expects smartphone and tablet categories to grow by 95.9% and 131.2% by 2016, respectively. And fortunately for Apple investors, these two categories make up a whopping 86% of Apple's revenue.

A classic case of shortsightedness
In general, buying opportunities surface when pessimism peaks -- not when the bull is already running. So if you are looking for a buy signal, this could very well be it. At just 10 times trailing-12-month earnings, pessimism seems already priced into Apple's stock, with the company's market opportunities getting little respect.

If you've considered buying Apple shares, don't let a sell-off dissuade you. It should entice you.