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The Case Against Apple

Fellow Investor,

Apple’s 2012 World Wide Developer’s Conference (WWDC) kicked off yesterday with much fanfare. Within hours, there were analysts breathlessly calling yet again for Apple to hit $1,000 or more a share over the next two years. Even the more restrained analysts are projecting it to hit $850 in the next 12 months.

Not so fast! Before you jump in and buy, please take a moment to consider the case against Apple going to $1,000.

Apple is a terrific company. It’s a GameChanger of the first order — innovative and revolutionary and very well run. I adore their products. I can’t even imagine life without my iPad (okay, iPads. I love mine so much I had to buy two more for my family) but that doesn’t mean I can’t see the problems with the stock.

Yes, it has been on a tear so far this year. At $571 it is off its high of $644, but still up over 40%.
And sure, Apple is statistically a cheap stock, but there are reasons why! Take a look at the challenges Apple is facing these days:

  • Unsustainable margins. Apple’s operating margins are in excess of 30%. This isn’t sustainable from a company that generates 80% of its revenues from cell phones, a product that will become more and more commoditized over time and that is already seeing competition nipping at its heels. While Apple is still the dominant smartphone maker in the U.S., with market share at 29 percent for the first quarter, up 7 percent from a year ago, Samsung's share shot up by 140 percent in the same timeframe.
  • In fact, during the first quarter of 2012, Samsung grabbed a leading global market share of 29.1 percent, according to IDC. That surpassed Apple's share of 24.2 percent. Samsung was also crowned the top dog over Apple by Juniper Research, which stated that Samsung shipped 11.8 million more smartphones than did Apple, giving it a firm lead.

  • Unrealistic expectations for the iPhone 5. There are two problems here. First, the market is expecting to be overwhelmed with the next generation improvements: A “completely redesigned body style,” a larger, 4-plus-inch display, 4G LTE connectivity, an upgraded processor and memory, and a higher-megapixel camera. These high hopes leave a lot of room for error/disappointment in the execution and operation of the new iPhone as well as the timing of the delivery.
  • Second, how much more functionality can really be added to the iPhone 5 that will make customers want to buy a new one every two years and spend the same dollars for a new phone (especially with competition)?

  • Carrier subsidies may wane: These may continue for at least the next two to three years because 1) the iPhone has the lowest churn rate of any device; 2) consumers want it and, 3) if any of the biggest carriers to try and do away with it, there will always exist a second or third place carrier willing to use subsidies. But, the subsidies may be lowered because the phone companies carry debt and if the economy doesn’t improve, they will have no choice. This will pose a problem for Apple — especially with the iPhone begin their widest margin product (the iPhone has a 60 percent gross margin compared to the iPad's 40 percent and Mac's 25 percent).
  • Overzealous expectations regarding China sales: Tim Cook says that sales in China are “mind boggling”. In the U.S. sales dropped 34 percent following the last iPhone's launch quarter, and the street expects that this won’t happen in China because of the growing middle class. But, there are knock-off versions and the competition could find a way to become more appealing as a social status device to the Chinese market. China just isn’t a guaranteed cash cow. Google found that out.
  • Apple TV will be unprofitable: Completely missing from yesterday’s keynote was any mention of Apple TV! Apple is expected to announce a TV as early as December, but not to begin shipping until 2013. It's likely to cost between $1,500 and $2,000 and come in various screen sizes between 42 inches and 55 inches. Analysts expect that, within one to three years, Apple “could ultimately capture 10 percent of the market.” This could be big financial loser for Apple, even if they capture that much market share. The proof: iTunes is just faintly over a break-even business.
  • There has been “some cannibalization” of Macs by the iPad: Those were the words of Tim Cook at the last earnings call. The Macs sell for more than twice as much as the iPad on average. Sure the world is going towards tablets, but a shrinking revenue number on Macs isn’t a good sign. In calendar year 2012, expectations are for between 60 million and 70 million iPads to be sold, representing roughly two-thirds of the total tablet market. But while about 100 million tablets will be sold this year in total, research firm IDC estimates that the PC market will still be considerably larger, with 371 million units sold in 2012.
  • Competition is lurking everywhere, not just for the iPhone and is the motivating factor around announcements at this conference: Apple is working hard to stay in front of Microsoft’s Windows 8, which will be released later this year. The release of the new OS will be MSFT’s first serious effort at competing with Apple’s iPad. The new Mac OS X Mountain Lion and the upcoming iOS 6 with software and services also the focus such as major enhancements to Maps, iCloud and Siri, announced yesterday are a direct response to Windows 8.

Add all of these challenges up, and I believe there's a real chance that Apple could miss earnings estimates in the second half of the fiscal year (it ends September 30th) as customers delay buying the iPhone 4S while waiting for iPhone 5 to be introduced. If that happens, analysts and the media will turn on Tim Cook - and the stock.

Here’s the paradox with Apple, and why the stock isn’t headed for $1,000 any time soon. The fear of a margin squeeze (see my first bullet about unsustainable margins) has kept the valuation down even though sales have continued to rise. Thus, the stock “looks” cheap, but the bottom line is that Apple stock sells for just 11X the fiscal 2013 earnings estimates for all the reasons we’ve just discussed. Look for AAPL to be stuck under $600 for a while.

Yesterday, Fox Business had me on to discuss Apple and Tim Cook’s WWDC keynote speech, along with two other experts on the company. You can see the portion of our discussion that focused on the new Mountain Lion OS here.

Apple announces new operating system 'Mountain Lion'

Sincerely,

Signed- Hilary Kramer

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