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Apple Gets Whacked

By Ashraf Eassa - Jan 2, 2014 at 2:30PM

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A downgrade of Apple on margins - again! Does it have teeth, or should investors ignore it?

Shares of Apple (AAPL -0.09%) are down in the Jan. 2 session following a downgrade from Wells Fargo. While the voice of one analyst isn't enough to have a material long-term impact on the stock, it is important to take a look at the concerns raised and to see if they are material to the long-term investment thesis. So, is Wells Fargo making mountain out of a mole-hill, or are their concerns legitimate?

It's the margin question – again
The long and the short of it is that Wells downgraded Apple from "outperform" (i.e. buy) to "market perform" (i.e. neutral that really means "sell"). What's interesting is that the firm's bullish thesis had originally been predicated on gross margin expansion as a result of what Apple is doing with the iPhone 5c and 5s. While Wells is still bullish on the short-term stabilization/expansion, the firm is cautious about the long-term sustainability of "large" subsidies that allow for Apple's robust iPhone gross margins.

Should this be a concern?
There are really two schools of thought here. The first – and the one that's typically bearish for Apple – is that the carriers really have all of the power here. This is an interesting point of view because, at the end of the day, smartphones are valuable precisely due to the fact that they offer Internet access just about anywhere – something enabled by the carriers. The idea here is that people will want to buy smartphones anyway, putting the carriers in the position of power.

The other school of thought is that the iPhone is a premium product that drives smartphone subscriptions, increased data usage, and so on. While this is probably a more dubious argument (since, again, the smartphone revolution is a very powerful secular trend), there's no denying that customers love their iPhones and if a carrier were to make it difficult for customers to use iPhones, another carrier may end up offering the subsidies in a bid to attract customers.

Apple seems safe – for now
The bottom line here is that Apple is probably safe for as long as Apple's brand remains aspirational and powerful. However, it's tough to ignore the threat that Samsung (NASDAQOTH: SSNLF), Apple's chief competitor, brings to the table with its wide array of Android devices. From the lowest-of-the-low end, free-with-contract phones to devices like the Galaxy Note 3 that command a premium to Apple's devices in their base configurations, Samsung has become a truly viable alternative to Apple.

What would make Apple a much easier investment would be to see it continue to expand its high end, premium iPhone lineup in order to capture further share of the high end market. If Apple's "larger" iPhone 6 can drive Samsung further into the lower end of the handset market and capture more share of the high end, then Apple's premium brand and its pricing power will remain intact, keeping the balance of power between Apple and the carriers roughly where it is today – and Apple's margins stable. 

Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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