Apple (AAPL) shares closed down 2.5% Tuesday after the company reported a quarter with modest upside but soft guidance, especially as it pertains to gross margin. Although the stock has bottomed for now, and while although volumes of the iPhone are OK -- at least in the wake of the iPhone 5 launch -- I do not believe the margin issue is going away. I first made the case for long-term margin degradation 11 months ago in "Shed a Tear for Apple," in which I laid out the case for increasing price pressure on the iPhone:
- The unsubsidized iPhone is simply too expensive for average people at $500 to $700.
- The alternative Android-based phones may not be perfect substitutes, but they are "good enough."
- Intense competition from a Softbank-backed Sprint (S), which wholesales bandwidth to third-party "carriers" like Virgin (VMED) Mobile, will result in eroded pricing power for the major carriers that are providing most of the iPhone subsidies.
This was a long-term call, and one year later we see it playing out, with little hope for a change in trend. I think Apple's gross-margin caution is a reflection of the reality that unsubsidized sales will become increasingly relevant in the years ahead, and that the price points will have to come down. The gross margin has been ticking down steadily for the last few quarters, from 38.63% in the December 2012 quarter to 37% most recently. (Ironically, Apple is not a wildly profitable company. The absolute earnings are large, of course, but this is due to volume. Thirty-seven percent gross margin is very middling. Compare that with a standard-issue software company like Oracle (ORCL), which books an 80% gross margin!)
There is little pricing hope for Apple overseas, either. Yes, the iPhone is wildly popular abroad, especially in status-hungry markets like China. The iPhone 5 was actually launched first in Asia as part of a global single-day launch, and it drew huge crowds to Apple stores in Beijing and Shanghai. Nonetheless, beyond the very well-to-do in these markets, their consumers are even more price-sensitive than are folks in the U.S. or Europe.
A recent survey by Chinese Internet company Sina, reported by Tech in Asia, found that only 13% of respondents in China would pay more than $330 for a smartphone. Yes, Apple's brand cache can command a premium over local cellphones in China. But, more important, the survey reflects the fact of limited budgets among a populace with an annual income that comes in at a fraction of that of Western countries.
My long-term thesis on Apple is unchanged. The company is not going out of business, and it is not a short candidate! Rather, I just have no interest. Volumes will be fine, but pricing will be under increasing pressure, which will in turn pressure margins. This puts a lid on profit growth. Fortunately for those already long Apple, the stock is not expensive, and plenty of trading opportunities will arise. But, absent an amazing new product line that can create a huge spurt of growth (whatever happened to Apple TV?), I see Apple as a grind-it-out mature technology company now, not very different from Cisco (CSCO) or Oracle.