Understanding Apple: Three Keys To Stock Price – 3. Looking Ahead

Apple  share price has been slammed recently, falling as low as $92.43 last Wednesday. The question for investors is whether this downward trend will continue, if the price will remain range bound as it has for over a year, or if share prices will reverse and continue to appreciate.

I have identified three key factors in the future value of Apple stock. The first article focused on iPhone sales which many see as leveling off in growth, or even declining in the current year. Since this product currently accounts for well over 60% of Apple’s income, this would clearly affect performance. Fears over this are what drove the price down.

The second post focused on how the Services and Other Products categories – particularly the new Apple Watch – will likely drive moderate growth.

In this post we will examine what may be the most important influence on Apple stock price:

  • Apple’s forward guidance for the March quarter

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Apple Pay – Superficial Critiques

I really do not like to get snarky, but sometimes I see blog posts that are so superficial that I cannot help but be a little testy.

Case in point Apple Pay Has Finally Arrived! Great – But Here Are 7 Reasons It Won’t Be A Slam-Dunk Success by Robert Hof, in Forbes.

First – I totally agree with Hof when he writes

it’s apparent that Apple Pay is far from a guaranteed success.

This definitely is true. No one can predict with surety two basic factors:

  1. Will it work properly?
  2. Will the public accept it?

Typically, Apple’s products and services work pretty well, but there have been some notable exceptions. The move from .mac to me.com was a tremendous mess, and the introduction of Maps seriously flawed. Any system failure even vaguely approaching those will be a disaster. This is people’s credit cards and payments, not simply directions to the nearest movie theater.

As for number two, Apple seems to have a really refined system, and if it works as effortlessly as in Apple’s demo, it will certainly be the easiest method of paying yet available. A simple swipe of your iPhone or Apple Watch by the NFC reader while holding the home button (on the iPhone) and you are done.

But none of this is guaranteed. That is the nature of any business, especially one that is creating a whole new product.

But Hof goes on to list seven important areas where Apple Pay is lacking.

1 –You can’t use Apple Pay unless you buy an iPhone 6 or 6 Plus

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The Definitive Debunking of Touch ID Fingerprint Hack

When Touch ID was announced at the iPhone 5s launch, it was immediately besieged by detractors.

One area in particular for detractors is that the Touch ID system is susceptible is via spoofing an owner’s fingerprint. If true, this would  pretty much leave the whole system open to an attacker, and now, with the iPhone 6 and Apple Pay, spoofing would easily expose the owner to fraudulent charges placed on the his credit cards.

The most convincing  exposition on this was by the German Chaos Club group which quickly posted online video of how to spoof the Touch ID sensor system.

With the advent of Apple Pay based on Touch ID, this issue becomes even more critical.

Screen Shot 2014-09-24 at 8.19.58 AM

Two facts are clear:

  1. it works,
  2. it is not all that difficult.

However, there is one clarification to point #2. It ought to read:

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Apple’s Missed Opportunity

The pundits will go on about the initial weekend sales for the new iPhones, but one thing is clear:Apple (NASDAQ: AAPL  ) has missed an opportunity here.

It’s no news that the iPhone 5s is the new flagship model, with a blazingly fast processor, and breakthrough fingerprint sensor. The colorful 5c models have replaced the previous flagship iPhone 5, with only small changes aside from the plastic bodies.

So what’s been missed? Apple stock dropped after the September 9 announcement that the 5c would be priced just $100 below the 5s. Investors had been looking for a drop into the lower price range. Personally, I agree with Apple that the 5c should be priced exactly where it is.

What is missing, however, is the iPhone 4c.

There should have been another model added that would relate to the 4s just as the 5c does to the 5s, priced $100 bellow the 4s, unsubsidized at $350.

Model Unsubsidized Price
 iPhone 5s $650
 iPhone 5c $550
 iPhone 4s $450
 iPhone 4c $350

Source: Apple.com and author’s estimates.

Rationale 
Apple iOS’s main competitor is Android, built by Google. Recently they have pushed their global smartphone market share to almost 80%,  largely by dominating the low end market, a segment that Apple does not care to enter – and rightfully so. However, to drop below 14% looks bad. It makes them appear marginalized. A 4c entry would allow Apple to enter a lower tier, and regain significant share.

Features
The theoretical iPhone 4c would sport these feature changes:

  1. Case: colorful plastic
  2. CPU: A5 chip of 4s
  3. Screen: Revert to pre-retina display resolution (163 ppi)
  4. Memory: Revert to 8 GB
  5. Camera: 6 Megapixel

It’s quite possible that Apple could produce such a device for under $150 in hardware and component costs, which suggests that a $350 iPhone 4c could fetch hardware margins of over 57%. In contrast, IHS iSuppli estimates that the new iPhone 5s costs $199 to build after including manufacturing costs, while the iPhone 5c total is around $173.

Sales
With the strongly reduced feature set, I do not think that the 4c would significantly cannibalize higher priced models. This is seen in the new 5s. Reports have sales of 5s outnumbering 5c by 2.4 to one. It shows that the existence of a lower priced model does not necessarily cannibalize the higher priced one when there is significant differentiation.

Fortune’s Philip Elmer-DeWitt wrote a few weeks ago of Apple’s low end opportunity:

In a note to clients Thursday, RBC’s Amit Daryanani used Strategy Analytics’ market research to estimate what a $300 iPhone 5C might do to Apple’s bottom line…

And he quotes Daryanani:

“From an EPS perspective we believe the Company can add $4.00+ in EPS to our CY14E estimate of $39.74, with a successful launch of an affordable iPhone. On a 12x multiple, this would add roughly $50 to Apple’s stock-price. We believe our ~56M unit estimate is conservative given that it represents 12% of the total low-end Smartphone market.”

Granted, he is talking of a sub $300 price point, so let’s round his 56 million units down to 50 million. Even if there was some cannibalization from the 4s, this would bring in more than $17.5 billion new revenue. . This could potentially add over $4.40 in earnings per share.

Margins

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Some would argue that this would only increase Apple’s woes by further compressing margins. But there are two points to make here. First, the gross margin is significantly lower for the 5, but not horrendously lower. More importantly, $17.5 billion is a large number for incremental revenue, and would go a long way to reducing overhead and operations as a percentage of overall revenue, so it is likely that this would counteract the slightly lower gross margin.

Conclusion
Apple has a great game plan and will probably thrive on its new iPhone product line. Still, it seems to have thrown away a great opportunity to expand its reach into the smartphone culture and bring in millions of new customers. This would reach into the growing share of Google’s Android operating system led by Samsung, and Apple could have done this without sacrificing the quality that they prize so much.

Apple will thrive, but I believe they could have done even better.

New York Times on Apple Job Growth

The New York Times has published a rather silly article in which they claim that Apple has never contributed any jobs to the economy.

Well – they do not put it exactly that way – but their article practically says it outright.

I will agree with the quote:

… said Gary P. Pisano, a professor of business administration at Harvard Business School. “It’s hard to say the exact size.”

I agree as well that the methods used by the company they hired could be the subject of legitimate debate (as long as that statement is NOT interpreted as an innuendo that someone was dishonest.)

However, the following quote is a bit odd:

David Autor, an economics professor at the Massachusetts Institute of Technology, said via e-mail that the “entire business of claiming ‘direct and indirect’ job creation is disreputable” because most of the workers Apple is taking credit for would have been employed elsewhere in the company’s absence.

They go on to note:

Mr. Cappelli said. “If you say, ‘If there had been no Apple, those people would not have jobs,’ that’s not true.”

Of course it is not true that every single one of those individuals would be jobless, but if there were no Apple and engineer X took a job at HP then there would be some other engineer who would not have a job.

According to the logic provided, then no business anywhere creates any jobs at all. Everybody else would have been working somewhere else. This is – of course – utter foolishness.

I will admit that they do conclude with the statement:

Apple is, however, an innovative company that created a market for tablets and radically increased demand for smartphones.

In reality – the smartphones existing before the iPhone are not today considered smartphone. Additionally, the app business was relatively nonexistent prior to the iPhone, so perhaps they should be credited with ALL the apps developers (snicker).

As for people buying alternative products if Apple did not exist… sure they would be buying Asus and Lenovo computer that are totally designed, engineered, and built in China in factories with absolutely NO oversight at all. And…

They would be running DOS 12.1. (What a pleasant thought.)

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AnandTech iPhone 4s Tests – What do they mean?

AnandTech (www.anandtech.com) is truly a professional blog with some of the best technical analysis you will find. They have just published a set of tests results on the iPhone 4s, titled:

iPhone 4S Preliminary Benchmarks: ~800MHz A5, Slightly Slower GPU than iPad 2, Still Very Fast 

I thought I would explain some of this to those with less technical backgrounds.

First, a few points:

  1. Apparently, these tests were not made by Anand Tech themselves, but gathered from other bloggers who seemed to have had early access to 4s units. Hence the “Preliminary” in the title. AnandTech will be running their own tests as soon as they get their own units.

Some Tech Basics

  1. CPU = Central Processing Unit: This is the “Brains” of a computer that reads instructions from programs, and makes everything happen in the computer. (Smartphones are miniature computers with phones incorporated.)
  2. GPU = Graphics Processing Unit: This is a special kind of processor, similar to a CPU, but designed to process image data. They are designed to perform certain mathematical operations repeatedly on millions of graphical data points. (They can also be used to process certain types of mathematical problems and are seeing new uses in this area.)

Click here for more Computer Basics Terms

One thing that is important to note is that the overall performance (speed) of a system is dependent on many things, and not simply the speed of the processor and/or the number of cores, nor on any other single factor. Additionally, the overall design of the system and subsystems may enhance certain aspects of performance will neglect other aspects. So one system may load and render multiple web pages very quickly, but be slower at certain types of graphics operations.

Finally – System performance is dependent on software as well as hardware. This applies both to the Operating System (OS) and to the particular application being run.


There are basically two types of tests. (Well I am sure you can come up with other classifications, but for our purpose this will do.) These are “real-life” tests which use real software programs, and benchmark tests which are programs designed specifically to test system performance. While the latter are more likely to test compare real limitations of a system (or some part thereof), they sometimes are not indicative of real user experience of said system. A mix of both types of tests is important to get a useful view of a system. I think one could say that benchmark tests test the hardware to the limits, while software tests give better overall system analysis. The problem with software tests is that you cannot test every aspect of even one piece of software, let alone of all software in its class.

Test Results:

Browser Tests

There were two browser benchmark tests with slightly different results. In both cases, the 4s handily beat all Android phones, pretty much tying the Galaxy Tab, which, of course, is a tablet not a phone. It should be noted here that the iPhone 4 (no ‘S’) was roughly comparable with the best Android phones when upgraded to iOS 5. So people who keep these phones should see a very significant browser improvement when they upgrade.

Graphics Tests

In the graphics tests listed, again, the 4s handily beat all Android phones, and  the Galaxy Tab as well.

A5 Clock Speed

It appears that the A5 chip in the iPhone 4s is clocked at 800MHz instead of 1GHz (1000MHz) as in the iPad. Now why would Apple want to “cripple” its CPU? Simple. Two reasons.

  1. In the fabrication of Integrated Circuit chips, each chip is tested after production. A percentage pass and a percentage fail. But some of the failures can still be used at reduced speed. Thus, lower speed means you get higher production from the fabs.
  2. More importantly, I am sure, is the reduction in electrical current consumption. As the report state:
    • Dropping a CPU’s core voltage, yields a greater-than-linear decrease in power consumption, making the marginal loss in clock speed a good choice.
What are the implications of this? Again as AT continues:
    • Apple does have to exploit its strengths in software to avoid any tangible performance penalties. Apple has traditionally done this very well in the past…

I would like to add, that this is not only software, but the A5 also has superiority over the competing Tegra 2 chip frequently used in Android phones, particularly in the GPU. Without getting too technical here, both system are based on the same design by the ARM group. The specifications for the dual-core ARM Cortex-A9  architecture allows for different GPUs, and Apple elected to implement a much faster GPU than is found in the Tegra 2. The results of tests bear this out.


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The importance of iCloud

The importance of iCloud should not be underestimated!

  • The iCloud is the biggest shift in computing paradigm since personal computers replaced the client-server model.

Strong statement. Let’s look at it.

First, what is it?

iCloud provides a set of internet based (cloud) services. While these services differ a bit in specifics, they mostly are a form of:

    1. Internet based storage of user data files: photos, videos, settings, documents, mail, calendars, and applications.
    2. Any one of these items is instantly available to a user on any connectable device (iOS or OSX, Others via internet).
    3. Any update to any of these is instantly available across all your  devices. This includes photos taken with other cameras and imported to iPhoto on your Mac.
    4. On iOS and Mac OSX Lion, all this occurs transparently to the user. It just looks like everything is right there.
    5. Backup functionality.
    6. Find my friends.
    7. Find my iPhone (any iOS device and Macs).
    8. If the user loses connection to the internet, some files will not be accessible.
    9. User also gets a free email account.

Usage Model

The main concept is that you have instant access to all files on any device with access to your account. You take a photo with your iPhone, and your iPad and computer see them virtually instantly. All your iTunes media (songs, movies, podcasts) are stored in the iCloud. They are always ready to be viewed, on whatever machine you are using.

All this happens without you doing anything. Theoretically, you could login on a Mac at a cybercafe in Jakarta, link to your iCloud account, and have the identical environment that you have at home. Heck, if you have setup internet file sharing, you would even have access to your hard drive.

Now, while there are other services that provide similar functionalities, (Dropbox) none do it so transparently and pervasively as iCloud. The functionality is not an add-on. It is built into the operating system and any application can choose to participate in it.

Now, whatever you changes you make to documents, or to media files (take or edit photos|video|music) these changes instantly appear everywhere. Of course…

You must be connected to the internet  to view any files that do not have local copies.

One more benefit. Your files are all effectively backed up. Assuming that Apple never has a breakdown or break-in, you never have to worry about losing any of your files. If your devices are lost or stolen or break, all your data is safe up in the iCloud, accessible from any other device you own. (You DO need to be aware of the iCloud photo policy. I believe it actually does delete certain photos after a period of time

Why so good for Apple? (Investors take note.)

While the benefits for the user are exceptional, there are also incredible benefits for Apple. And this is something that the investor need to mark!

Differentiator. First, the service really improves the overall user experience. (This is assuming there is no repeat of the MobileMe launch experience!) This means it drives users to their products at least in part for this feature. It is a differentiator from the competition. As mentioned above, no one else has a system as deeply integrated as iCloud, although Amazon’s Kindle Fire approaches it. (More on that below.)

Strategically:

More importantly… iCloud provides real incentives for users to stick with the iOS products. When you have this on your iPad, you are much more likely to buy an iPhone and shun the competing systems. This is really leveraging the current total dominance of the iPad.

More importantly yet… It provides a very strong motivation to select a Mac as your next computer. Let’s face it. Macs are expensive. You can buy Win-based computers for a lot less. [I do not want to get into a discussion here as to whether they are worth it or not. This is irrelevant to the current discussion.] People buy any product for only one reason – Perceived Value. Therefore, in order for someone to overcome a significant price differential, he must have a sense that it has additional value over the alternative. In the past, arguments for this have been many and debatable. But the value of iCloud, of having instant, transparent access to all your files, this is a strong positive that is not really debatable. Lion connects seamlessly to iCloud. No other system does. Period. End of argument.

Now, there are about 60 million Macs in the world, but over 250 million iOS devices! Ever since the original iPod, there has been a “halo effect” moving customers to the Mac. The iCould will greatly accelerate this! Here is a very strong motivation to move to the Mac. Mac has always been easier than Windows® (at least so they say), here is a system in which they definitely excel. Again – a very powerful motivation to switch.

Stickiness (the dark side?)

Here is one more very powerful benefit to Apple. Once you spends some time in the iCloud system, you have you have a lot of data that exists up there, and only up there. It becomes much more difficult to move to another system.

Suppose you currently use iTunes for your music and have an iPhone. All your music is physically on your computer. If you want to switch to another phone system, you just need to figure out how to gobble the music from iTunes into your new phone. Pretty easy really. When you move to the iCloud system, however, your files never really live on your devices, but up in the cloud. Now you can still change to another phone, just download all your music to your computer. Repeat with photos and video. And documents. Not terribly difficult, but it is is an extra step that takes time and patience. A bit of a pain.  A real motivation not to change.


Broader Strategic Implications – Why Amazon is on Fire

OK, OK! So there are some benefits for Apple here, but this is not so earth shattering. Apple gets to tie up their customers with “velvet handcuffs” to their system. It helps them out. Not really a big deal. Is it?

I think yes it is. The cloud is the battle ground for the customer space of the future. Sure, Apple does not own its customers. They are free to purchase from anywhere they want. BUT! they are within the Apple system and spend their their time there, and Apple has access to all their information.

Apple lives by hardware sales. Amazon lives by retail sales. They need these customers, and this is why they have created a cloud based system with a lot of similar features.

As I outline in my post:

    • There’s gold in them thar hills!
      That’s right, there’s gold, and if you don’t stake your claim PDQ you are out. Period! The gold is customers, and any company that wants to play big in the online sales business had better stake out a claim or forever be a has-been. Amazon realizes this and they are in the game to win.

      http://jmmxkindlepage.wordpress.com/analysis-kindle-fire/

This is why they are willing lose money in order to stake out their claim in the Internet Cloud.

Amazon is a very smart company that sees the implications here, realize their importance, and has gone all out with a brilliant strategy to buy into the top-tier marketers of the future. They are one of the few that is holding its own against Apple.

Still, the amount of energy and money they are investing show how really important it is to them!

Their strategy?

    • Do not go head to head with Apple – at least not at first. (Fire is not directly competing – see above link)
    • It is OK to lose a little money at first.
    • Slowly build:
      • Services
      • Experience
      • Customers
    • When customer base is sufficient, move up to more competitive products.
    • When customer base and experience are sufficient, move to profitable products.

Profit for Amazon always includes the value of an added customer who is to some degree locked into their system.


I know that some of these ideas are not original to me. However, I feel I have put them all together in a unique way. I also think that not many others see the real implications of the Cloud Computing paradigm, and how important it is.

Let me know what you think!

In Summary

Perhaps this statement, “biggest shift…” is a little too strong. Whether it is exaggerated or not, however, the important thing is that the impacts are real.