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Memo To Apple (AAPL): Smartphone Margins Are Heading South!

 September 23, 2013 12:17 AM
 


By Barry Randall

There was a huge build-up and inevitable let-down associated with Apple's recently announced versions of its iPhone 5. Sadly for Apple bulls, the underwhelming response to recent Apple announcements has become a worrisome trend. We're now three and half years down the road from Apple's last "real" new product release – the original iPad. Everything since then has been an "iYawn."

Apple is still very much a participant in the ‘mobile' mega-trend. However, they are no longer the leader. Moreover, the new leaders are…wait for it…the phone companies! Yes that's right. Ma Bell's children and grandchildren are now calling the shots. Of course, as (still) highly regulated utilities, they're not exactly gee-whiz Silicon Valley darlings. And they don't have the growth trajectory of Facebook or LinkedIn.

What they do have, however, are customers who pay them, and cell phone networks that don't seem threatened any time soon.

One milestone in this transition of power occurred recently when smartphone shipments began making up more than 50% of total handset shipments. Followers of technology adoption models (and related stock market returns) will recognize this threshold as a sign of impending saturation and (broadly), stock underperformance.

Apple has always marched to its own drummer. While it has been a leader in bringing innovative products to market, during periods of incremental innovation (known in other contexts as "commoditization"), it has typically chosen to protect margins, rather than lower prices to maintain share.

Even their recently released ‘cheap' iPhone, the model C, is still ridiculously expensive, and its MSRP in China for an unlocked, unsubsidized version will be US$735. Apparently, Apple Thinks Different than you or me when it comes to the meaning of "cheap."

Make no mistake, there is renewed growth in the handset business and worldwide handset sales are estimated to be more than 1.8 billion units in 2013, up about 7% from last year. But with even Samsung having to ratchet back expectations for its leading Galaxy S 4 phone, it doesn't seem like the handset business is where to be. (Note: I'm using Microsoft's head-scratching acquisition of Nokia's handset business as a contrarian indicator).

Another example of the New World Order is that when Verizon talks about mobile payments in its marketing, it doesn't even mention whose handsets are used. Why? Because it's irrelevant. Mobile payments is a largely server-based, back-office application.

And if you think that the built-in fingerprint reader on the new iPhone 5S means something, it doesn't. For years I followed Authentec, the company Apple bought to own this fingerprint technology. Using a biometric solution like fingerprint recognition was going to go mainstream any day now. Any day now. Until it wasn't. It turns out, passwords work just fine. And they never have a smear of peanut butter on them to stymie the fingerprint reader.

Although not a significant part of our position allocation, we do happen to own four phone companies in our technology model: Turkcell (TKC), Verizon (VZ), America Movil S.A.B (AMX) and Telecom Argentina (TEO). All are growing and the latter three companies' mobile business is growing faster than their fixed line business. No one will confuse any of them with Apple in its heyday. Growth is modest. Capital expenditures are measured in billions of dollars (or pesos or lira).

But no one has figured out a way to provide widespread wireless Internet access without the involvement of major telecom carriers, due to the immense capital requirements. WiMAX adoption has been sporadic at best but even Sprint/Clearwire threw in the towel and wrapped up their WiMAX efforts in favor of the LTE technology already utilized by most major telcos.

Google has big plans to bring to the Internet to wide swaths of the current un-connected world (i.e., Africa). Google's deep pockets and prior successes require taking this effort seriously. But it's not clear that Google could manage to acquire enough licensed spectrum (or utilize unlicensed spectrum, as in Africa) to provide the quality of service that traditional phone companies can and do offer.

So who's got the power? The phone companies. Verizon just executed the largest corporate bond offering in history. With about three weeks of lead time, they placed $49 billion in bonds almost overnight. Verizon has 100 million customers it bills monthly, and generated $33 billion in operating cash flow over the past 12 months. With nobody posing an immediate threat to Verizon's creditworthiness, the deal was a cinch.

Want to guess who previously held the record for the largest corporate bond deal? Apple, with their measly $17 billion offering last Spring. With which proceeds they used to pay a dividend and buyback stock. Doesn't sound like a company holding a winning hand(set) anymore.

Like the PC business before it, I think the handset hardware business is moving toward a zero-margin, loss-leader existence, where the customer experience is defined by software and systems often controlled by others. Tim Cook should ask Michael Dell how that transition has turned out.

The investments discussed are held in client accounts as of September 12th, 2013. These investments may or may not be currently held in client accounts. All opinions included in this material are as of September 12th, 2013 and are subject to change. The opinions and views expressed herein are of the portfolio manager and may differ from other managers, or the firm as a whole.  All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. Past performance does not guarantee future results.

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