Apple Finally Faces Some Competition

 | Jan 15, 2013 | 2:30 PM EST  | Comments
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For what seems to be forever, Apple (AAPL) was the company that could do no wrong. Apple was the most widely touted stock from here to China. It was too risky not to own Apple shares. The icing on the cake came for me when I read an article about a group of individuals who had their entire life savings in Apple stock. I read that article about two or three months ago. Apple shares are down nearly 30% in the past several months.

Let me clear: Apple is a fantastic company that produces outstanding consumer products. When it reports earnings tomorrow, I suspect that its profits will be jaw-dropping. A year from now, Apple is likely to earn more money than it is earning today. Apple still remains the dominant leader in smartphones, and the iPad is the runaway tablet success. So why is such a company trading for $500, or 11x trailing earnings alongside a yield of 2%?

The reason, in my humble opinion, is that Apple's first-mover advantage is fading quickly. The iPhone debut in 2007 was a game-changer in the mobile phone market, and for the past five years Apple has dominated the smartphone market. Since it had no competition, Apple was easily selling phones for $500 or more and was also able to get carriers such as Verizon (VZ) and AT&T (T) to pay Apple $400 for each phone purchased with their contracts. Thanks to the iPhone and the fat profits it was generating, Apple shares advanced nearly 300% in the past five years.

But the undeniable forces of capitalism cannot be stopped. Last year, gross margins from the iPhone were 55%. The iPhone accounts for two-thirds of Apple's profits. So if you are Google (GOOG) or a Microsoft (MSFT) with billions of dollars in cash and you see a rival selling a product that has tremendous growth potential earning 55% gross margins, what are you going to do?

Google and Microsoft came flying in, and now Google's Android platform is a real competitor to the iPhone. And that means it's silly to assume that Apple will continue to get 55% gross margins from its iPhone. Yesterday, the market received confirmation: Apple is ordering fewer components from suppliers for the iPhone 5. The singular truth in technology is that over time, products get not only better but cheaper. I remember my family getting our first Compaq computer back in the early 1990s -- my parents paid $3,000. Today for less than $600, you can get a laptop that is 100 times better.

Google's Android is doing just that, providing the market with a comparable (better according to many consumers) smartphone for a fraction of the cost of Apple's iPhone. So what Apple must do now is shift its focus from selling an expensive product -- which it was able to do when it owned the market -- to selling a lower-priced model and increasing market share.

I uncovered a quote by the late Steve Jobs that sums it up: "What ruined Apple was not growth ... they got very greedy ... instead of following the original vision...to make the thing an appliance and get it out there to as many people as possible ... they went for profits. They made outlandish profits for about four years. What they should have been doing was making rational profits and going for market share."

The most surprising part about this quote is that Jobs said it in 1990. Apple's profits for the past five years have been outlandish, and they could not last forever. Going forward, Apple's goal should be market share, which it has been losing to the lower-priced Android. I suspect that even if Apple reports fantastic profits, if its average price for the iPhone has declined, the shares will sink further.

Understand that Apple still dominates, and the selloff is the market's reaction to what they see as the inevitable for Apple. I'd be shocked if Apple wasn't thinking about this moment a couple of years ago, and if it can successfully execute a plan that maximizes market share, then any further decline in price could be a very attractive entry point.

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