The (Not as) Big Apple: Could the Company’s Best Days Be in the Past?

duffWhen you’re learning a new language, the best sign that you’ve got a lock on it is when it’s in your dreams. It’s a pretty sure thing, then, that many among us have used the new language of “i
Phone” or “iPad” while asleep—because we all speak Apple now. Investors, too. But whereas they once dreamed of an $800 share price, last week they experienced a communal nightmare of a $450 stock. And they were not asleep.

You’ve surely read about Apple’s record-breaking revenues—$54.5 billion for the quarter. That nevertheless disappointed the market, the result of which was a 11 percent fall in the stock price last Thursday. That’s its biggest post-reporting decline in a decade. Yes, even your grandmother has an iPad now. But that’s not good enough, people. Because odds are it’s an iPad mini. Does that make no sense to you? Welcome to Apple’s 115th Dream.

In early December, I wrote about Apple’s last precipitous fall—a 9 percent decline to $533. In that piece, I suggested that the company’s biggest problem was its own stupendous success, and that it was now competing against its own record more than anything else. Sure, it was sticking to its habit of crushing its own records—this quarter’s “disappointing” $54.5 billion was more than $8 billion above the same quarter last year. But even the best record-breakers among us eventually run up against the limits of their own abilities. And the million-dollar question (more like $50 billion, actually) was whether Apple had finally run into its own. Well, the question has been answered.

The cratering has been described in any number of ways, but my favorite is the idea of a “healthy retrenchment” of the stock. That preposterous attempt to see a bright side to such immense value destruction takes as its premise that investors cared one way or the other why their stock was once at $705 a share. The theory is that they’d prefer that it be less about some unknown-but-possibly-awesome future and more about current cash flows. But what would be the fun in that? You might as well buy Treasuries. And $705 is $705, no matter how you slice it. Until you slice it nearly in half.

Interestingly, one of the best articles about Apple last week wasn’t about those disappointing results, but was more of a meditation on the fact that Apple’s valuation has actually been, for some time now, more about its ability to mint money in the present than about an even more wondrous future. Amazon, on the other hand? Did you know that founder Jeff Bezos’s net worth of $25.3 billion is more than four times the $5.4 billion that the online retailer has earned over its entire existence? Talk about betting on an unknown tomorrow. (Adding insult to injury, the late Steve Jobs was never worth anything close to $25 billion. I guess you really can’t win ’em all.)

“Apple makes so much money that investors are leery of whether it can continue growing,” Bloomberg’s Mark Gimein wrote. “In stark contrast, Amazon has made so little that, paradoxically, it continues to hold out the prospect of limitless growth.” In other words, the dream lives on, although it also seems to have moved to Seattle.

That leeriness about Apple’s prospects is really about two things. One, even if the company has secured a monopoly on breathless media coverage, its actual competition has not been sitting still. And two, the market for high-end consumer products has a limit to it. When growth requires a company—any company—to move down-market, margins will suffer as a result. For Apple, these two issues are exemplified in the form of Samsung and the iPad mini.

Samsung has taken dead aim at Cupertino’s phone and tablet franchises and is hitting both marks in a real and injurious way. According to analysts at Citi Research, Samsung’s share of the smartphone market in the fourth quarter of 2011 was 27 percent to Apple’s 20 percent. And both of those numbers are heading in a direction that can’t be pleasing to Apple’s investors—in the same period in 2011, Samsung trailed Apple, with 23 percent to Cupertino’s 24 percent. Whether or not Samsung has engaged in rank theft of Apple’s intellectual property is a question for the courts. But its theft of market share is a fait accompli.

And then there’s the iPad mini. Have you tried one? It’s great. But it’s also cheaper than the iPad itself, with thinner profit margins—just 25 percent versus the iPad’s 41 percent. So even as the overall number of tablets sold continues to skyrocket (22.9 million in the latest quarter, up 48 percent year-over-year), the average price has fallen 21 percent (from $593 to $467). The result: overall tablet revenues rose just 17 percent, to $11.1 billion, and the division’s gross margins are headed down. That’s fine if sales growth is all you want, but not so good if you’re a stickler for maintaining or enhancing profitability.

For years, it wasn’t that hard for the company to do both, as Apple customers (myself included) have had an ingrained habit of just sucking it up and enduring its preposterously steep prices because we just couldn’t resist. But what if Apple itself offers you a discount? You will take it. Who wouldn’t? Sure, bringing more people into the iPad fold can only be good for the company in the long term. But it’s coming at quite the short-term price.

There are bright spots. Sales in greater China, for example, rose 67 percent in the latest quarter versus year-ago results. But there’s competition in China, too. And even the expected strong sales in the region won’t be big enough to make up for an overall tapering in the company’s growth. Not unexpectedly, analysts are now calling for Apple to start increasing the cash return to its investors, whether through more share buybacks or increasing the dividend.

That’s the kind of thing a company does when forecasts of growth-without-restraint have come to an end, and when investors start to focus on astute capital allocation as much as they do anything else. There’s nothing wrong with that—companies like IBM have rewarded their shareholders handsomely while notching only modest revenue gains. But it’s also an adjustment that will put a cap on the stock price. (As I said in my previous column, in technology, you’re either a blockbuster growth story or you’re an art-house flick with a much smaller audience. If you transition from the one to the other, your box-office take—your market value—will come down as well. That’s simple mathematics, nothing more.)

What’s going to get this stock moving again? Analyst Toni Sacconaghi at Bernstein Research sums it up nicely: new iPhone carriers, more cash returned to shareholders and, of course, potential new products, including the still-a-pipe-dream Apple TV. The first two are likely to happen, but they won’t move the needle that much. The third? If and when an Apple TV ever hits the market, you better hope you’re not short Apple stock. But that’s a big if and an even bigger when. Until then, Apple’s best and brightest are going to be taking off their inventor’s hats and putting on the green eyeshades.

And let’s not forget the potential for further downside. How much, you ask? Don’t ask me, ask the analysts at Barclays. They’ll tell you that the upside case is $750 a share, and the downside case is $350. In other words, with 939 million shares outstanding, if everything goes right, the company could end up worth $700 billion. But if it all goes to pot, it’s worth just $325 billion. That difference—$375 billion—is greater than the value of any company in the country save Apple itself ($430 billion at press time) or Exxon ($417 billion). So the analysts are telling you that they think Apple’s future value could vary by almost as much as its entire value today. You will also live through tomorrow or die by nightfall. You never know.

But I digress. Yes, the company is going to sell more iPhones and more iPads in coming years than it has ever sold before, but the peaks in profit margins and market share might already be in the past. What’s left to dream about? What’s the X factor here? Something nobody has even thought of yet, a k a the future. And the really, truly aggravating thing about the future is that you just can’t know it for certain. Maybe Apple will waken its die-hard investors from their nightmares, and maybe it won’t. While we’re on the subject, how much is Amazon’s stock trading for again?

The (Not as) Big Apple: Could the Company’s Best Days Be in the Past?