Apple's Strategic Blunder

 | Sep 11, 2013 | 2:30 PM EDT
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This commentary originally appeared earlier today on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

China is Apple's third-largest market. But after seeing some encouraging signs there, Apple reported that its "greater China" revenue (which includes Hong Kong and Taiwan) fell 14% in its most recent quarter from the same period a year earlier. It was down a whopping 43% from the previous quarter.

 -- The Los Angeles Times 

Just how far behind is Apple (AAPL) trying to fall?

I do not get Tuesday's release and product launches. Something is just wrong.

Customers clearly want a big screen, yet Apple will not offer it.

The developed world is saturated with smartphones (at the high end), so future unit growth will be geared toward the emerging and undeveloped markets.

Emerging market customers are price-sensitive and want a lower-priced phone, yet Apple's newest iPhone dud won't hit a low enough price point that could drive market share gains and potentially lead to upward earnings revisions. (Note: There was no China phone announcement made Tuesday night.)

I fully recognize that Apple must somehow walk a tightrope between sustaining (elevated) profit margins and growing market share, but it did neither with Tuesday's announcements. Rather, it slipped badly.

From my perch, market share now is so valuable, not current gross margins -- it remains my view that Apple is making a strategic mistake. Is Apple trying to lose as much market share as possible in a world where the value of the market share is immense given the ecosystem that goes along with it?

Many in the Wall Street research community disagree with my view that giving up market share by retaining high average selling products is a tactical mistake (which will ultimately result in more margin degradation in the future).

  • Morgan Stanley -- new iPhones signal in-line units, better ASP/margins (Overweight): "We walk away from Apple's iPhone launch event with the view that estimates are likely to trend higher.... The iPhone 5c was priced higher than expected, which may limit unit upside but alleviates margin concerns and puts upward pressure on ASPs. Net, EPS estimates are likely to drift higher, especially if the potential China Mobile deal hits before year-end, pulling along the stock price, in our view."
  • Barclays -- new phones could have better margins than expected as pricing unchanged so far (Overweight): "In short, the pricing schemes are positive for margins as the products are basically in line with expectations...."

And then there is the iPad. There are now multiple lower-priced tablet devices just as good as Apple's iPad. Apple will begin to lose serious market share in the tablet market, a market that is already getting fairly saturated. (Remember: Apple's iPad business shrunk in units last quarter!)

The aggregate loss of market share at Apple across various products is a meaningful threat in the intermediate term. It is a circular issue, losing share in phones, more consumers get Android phones, then tablets, etc.

Market share expansion is now critical, so strategically, one has to be perplexed by Apple seemingly prioritizing margins (which still remain exposed and well above all competitors) over share gains.

Forbidden Fruit

I am getting a lot of emails from subscribers as to whether Apple should be purchased into today's downturn.

My answer is no.

The stock market is not always right. In the case of Apple, it might even be underreacting!

Today, investors are disappointed that the new iPhone is not different, the price point is too high and that the China event was a dud.

The stock market may have not figured out how bad the loss of share is (with the bullish Wall Street analysts still talking about margins holding up) and how much of a strategic blunder Tuesday's release was.

What is being ignored is that not only are Apple's profit margins substantially above any of its peers but the company's price-to-sales ratio is astronomical relative to its competition and absolutely high (given that it still is a hardware business).

While Apple's competition grows much stronger, the company is getting to the point where the franchise is being jeopardized by slipping so much in market share.

If you think my view is moderately insane, the same thing happened in the personal computer space three decades ago -- the industry went from equal footing to nothing as Microsoft (MSFT) became the standard.

The stock market understands the value of market share.

Why do growth companies such as Amazon (AMZN), (CRM) and numerous others get such high multiples? Because Mr. Market wants them to grow and get share as much as possible now, earn the money later.

The value of the share is tremendously important.

If you sell diamonds or have a monopoly, worry about price. In industries such as Apple's, worry about share.

Bottom Line

Tuesday's announcements were disappointing, and Apple remains a value trap -- a view I have had throughout most of the past 12 months, since my bear case for Apple written back in September 2012.

The share price drop from $700 to below $400 has attracted value investors like Carl Ichan, but even Carl Icahn makes mistakes.

I expect Apple's shares to trend lower, as consensus estimates (which had incorporated significant emerging market demand for the company's products) are still far too optimistic and will likely be reduced in the months ahead.

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