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Jan 30

Written by: J. Gerry Purdy

Last week, Apple reported all-time record results for its 13-week fiscal first quarter of 2013 (compared to a 14-week first quarter of 2012):

  • All-time record revenue of $54.7 billion for the quarter.
  • All-time record sales of 47.8 million iPhones.
  • All-time record sales of 22.9 million iPads.
  • Generation of $23 billion in net cash from operations.
With all these record results, why would there be any cause for concern? Why would Apple need to ‘fix’ anything when they are reporting record results? As they often say, don’t fix it if it isn’t broken. But, here are the concerns:
  • Profits were flat at $13.1 billion on revenue of $54.7 billion – exactly the same profit as a year ago when the company reported sales of $46.1 billion. Since they generated higher revenue in 13 weeks instead of 14 weeks last year, you’d expect that they should have generated more profits simply on a pro-rata basis. However, the company earned 23.9% of revenue this quarter but did 28.4% a year ago. The percent of revenue yielding profits was down significantly.

  • Gross margins were 44.7% last year and 38.6% this past quarter. Historically, Apple has achieved gross margins in excess of 40%. Clearly, each product sold (on the average) is yielding less contribution to profits than a year ago.

  • Earnings per share (EPS) were down from $13.87 per diluted share a year ago to $13.81 per diluted share this past quarter.

  • Earnings growth turned negative in the past year, another sign that the engine wasn’t running as well as years past.

  • The stock has dropped over 30% from its high of $703.99 to $439.88 as of last Friday.
The company couldn’t do anything wrong for a long time (years), but now, all of a sudden, it’s like the train isn’t going quite as fast but is consuming more fuel.

It’s, perhaps, too easy for someone to say, “Well, if Steve Jobs were still around, this wouldn’t have happened.” In fact, it just might have been worse. Apple’s CEO, Tim Cook, is a master at operational efficiency, so these were about as good a set of results as the company may have been able to achieve based on plans put in place a year ago (still, well after the passing of Mr. Jobs).
I believe there were some important strategic mistakes that Apple’s executive team simply didn’t accurately predict, including:
  • They priced the new iPad mini too low. It should have been initially priced at $395 and then slowly reduced as they were able to take cost out of the production.

  • They continued to sell the iPhone 4S at a significantly reduced price counting on most buyers in the US purchasing the iPhone 5. Although Apple doesn’t report the breakout of iPhone sales by model, they did say during the earnings call that the sales of the iPhone 4S were constrained during the entire quarter. I suspect that many customers came in to an Apple store expecting to buy the 5, gulped a bit when they saw the price and network costs, and opted for the lower cost of the 4S, which contributed to lower margins. Apple should have started a program to produce a lower cost iPhone that would yield better margins.

  • They reported that they are continuing to increase sales in China, but they have not been able to finalize a relationship with China Mobile that has over 650 million subscribers and adding over a million per month.

  • They likely didn’t expect that the iPad (both large and small) would eat so significantly into the sales of the Mac line. But, Tim Cook mentioned that even if someone purchased an iPad first, they often will come back and buy an iMac or MacBook portable at some point. While PC sales are in a slow decline (but still selling over 300 million units a year), Apple has not done worse, although I suspect management thought they would have done better than the PC market. Tim pointed out that they have had very good reception for the new iMac that began shipping in mid-December so contribution wasn’t significant for the quarter.
You take all of this together, and you see that, while top line results were at an all-time high, the entire Apple product line was yielding lower than expected results to the bottom line. So, while Apple clearly isn’t ‘broken’ (most other companies would dream to do as well), Apple clearly has to do things differently in order to achieve results that will impress the financial community and will, at the same time, delight customers.

Tim Cook often says their entire focus is building great products, but the simple fact that Apple is a public company with a very high profile means they also have to be careful how they manage the pricing and manufacturing to achieve financial results at least closer to historical values and those anticipated by the financial community.

So, here are six things I think Apple’s management team should do in order to return to greatness financially as well as continue to delight customers:
  1. Re-design the iPad mini – Re-design the current iPad mini in two versions – a high end model with the Retina display and correspondingly higher price (and higher gross margins) and a low end model that is cost reduced to increase both revenue per unit and gross margin for the iPad mini line.

  2. Develop an iPhone mini – Abandon the iPhone 4 and 4S (like you abandoned the iPod with hard drives years ago) making an iPhone mini that has a smaller screen and is easier to manufacture and, at the same time, yields 40% or greater gross margins. Call it the iPhone mini so it will have brand harmony with the iPad. If Apple used the same screen resolution as the Retnia display provides, they could put the same information of an iPhone 4S in a smaller form factor that likely would be thinner and less costly to produce.

  3. Work with China Mobile – with 650 million subscribers and growing by one million a month, it’s important that Apple land the world’s largest carrier. This could bring another 60 million units a year – even though it takes a phone technology that is different from the US.

  4. Develop the iPhone 6 – Leapfrog the Samsung Galaxy S line and announce the world’s best smartphone by including a larger Retina display, NFC, biometrics, FM radio and more. Make it truly the next big thing. Wow us. Everyone will applaud and get in line to buy it.

  5. Announce iWallet – Announce new mobile commerce software and services that include Passbook for storing coupons, boarding passes and tickets and verify identity by embedding fingerprint biometrics in the main menu button using their recent purchase of AuthenTec.

  6. Replace iTunes with iMedia – Announce that users can stream iMedia content to any iOS mobile, Mac or Windows PC via either ‘pay per view’ or monthly subscriptions. Movies could be priced individually, but the price for a movie in iMedia could allow the user to stream the movie over a period of one week after they start viewing it. With high gross margin, streaming services from iMedia would add to higher profitability. 
We note that Apple just launched a new iPad with 128GB and Retina display on Jan. 29 which is priced on the high side which should help contribute to higher gross margins But, the version with 4G LTE cellular data costs almost $1,000, so it won’t be the most popular model that Apple sells. Therefore, the new model’s contribution to the bottom line won’t be very significant. It is, however, exactly a step in the right direction.

We commend Apple and the management team (as well as all the partners in the value chain) for creating a company that has built products that truly do delight customers. We anticipate and expect that some of Apple’s best days lie ahead if they will follow some of my above recommendations. And, finally, I hope that Apple will give us ‘One more thing’ and surprise us with something amazing this year. I hope to be there to witness it.

Written By:
J. Gerry Purdy, Ph.D. 
Principal Analyst
Mobile & Wireless
MobileTrax LLC
Disclosure Statement: From time to time, I may have a direct or indirect equity position in a company that is mentioned in this column. If that situation happens, then I’ll disclose it at that time.


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