Originally published on 1/16/2007 at 10:06 a.m. Neither a Luddite nor a technophile am I. Rather, I pride myself on common sense, logic of argument and a historical perspective. That said, what follows are not more "oohs and aahs" such as those that emanated from the reverential Mac heads when Steve Jobs unveiled the Apple iPhone during his MacWorld keynote speech last Tuesday. What follows is a critical and variant review of both the stock market's response to the iPhone's introduction and a series of questions regarding the virtues of the product that could ultimately lead to a more muted reception by the consumer market.
Getting Past the Buzz
My assessment is positive, but with some real reservations about the lack of certain features. It is less optimistic -- especially when viewed in the context of the amount of additional market capitalization that has already been attributed to the iPhone -- than the near-unanimous optimism expressed by many industry analysts, commentators in the media or, with almost certainty, current holders of shares in Apple common (none of whom have ever used the iPhone in practice). There is no doubt that the phone has numerous innovative features, and time will tell how the product and extensions of the product will fare in the marketplace. My observations are based not only on my own analysis but, more importantly, on actual product reviews in PC Magazine, The New York Times, the Wall Street Journal, Information Week and The Gartner Group, among others. The market's response to the introduction of the iPhone has been breathtaking, especially in light of the fact that few have even had the opportunity to try to use this seemingly innovative product -- and those who have were given only between 15 minutes and an hour of time. Let's assume that about $5 to $10 per share of pre-introduction hype was incorporated into Apple's share price before last week's iPhone announcement. Subsequent to the new product's introduction, the shares rebounded by another $10 a share. So in theory, the iPhone has contributed to about a rise of $17.50 a share, or $15 billion in Apple's market cap. (It now stands at $81 billion.)
Measuring the Bounce
In reality, the $15 billion rise in Apple's market cap is an understatement, as the product is not entirely incremental. The iPhone is intended to and will cannibalize a significant portion of the iPod sales. How much is uncertain, but at the minimum at least one-third of sales will be almost immediately lost. Doing the math would suggest that the iPhone's introduction has provided nearly $20 billion of additional market cap. Let's now put my conservative calculation of a $15 billion rise in market capitalization into perspective. The incremental short-term rise of $15 billion in Apple's market capitalization represents 60% of the entire equity capitalization ($25 billion) of Research In Motion ( RIMM), which appears to have not only a software lock-in but also an annuity-like stream of income from subscriptions. The incremental short-term rise of $15 billion in Apple's market capitalization represents 35% of the $43.5 billion equity capitalization of Motorola ( MOT), which not only already has a 20% share of the global cell-phone market but also includes much more valuable non-handset businesses. The incremental short-term rise in $15 billion in market cap represents 80% of Apple's 12-month trailing revenue. Handset makers Motorola and Nokia ( NOK) trade at 1.03 times and 1.49 times sales, while personal computer makers Hewlett- Packard ( HPQ) and Dell ( DELL) trade at 1.27 times and 1.04 times sales, respectively. This raises the question: How long will it take for Apple to produce annualized iPhone sales that are supportive of the recent price appreciation? Put another way, how much value does Apple hold when it already trades at a price-to-sales ratio of 4.25 times?
Expectations Baked In
Even with the iPhone, analysts are projecting a five-year secular growth rate in earnings of 20% for Apple, compared with 10% to 12% for Motorola, Nokia, Hewlett-Packard and Dell. Even if these figures are achieved at Apple, isn't the elevated price-to-sales ratio of 4.25 times -- or nearly four times that of its competitors -- incorporated in expectations of growth? History shows that the "oohs and aahs" of analyst day are not necessarily an indication of future successes. Consider, for example, the initial "wow factor" associated with the introduction of Motorola's Motofone, which was expected to be the ne plus ultra in the low-end handset market. Or the Krazor, which followed the Razr. Both produced disappointing results and failed to buoy profits or margins. History also shows that it not a great idea to bet against Sir Steven Jobs, the master of innovation. To be sure, the iPod is far from being the next Nehru jacket. According to Walt Mossberg, The Wall Street Journal's personal technology columnist, the many pixels per inch creates a user interface that is very sophisticated and vivid, serving to make his (and my) "Treo look primitive." The iPhone contains many new and innovative features beyond the virtual keyboard, such as its "visual voice mail which allows users to go directly to any of their voice messages without listening to any of the prior messages."
Nevertheless, Apple faces a number of potential obstacles to reaching the company's goal of selling 10 million units next year. (If the company's sales goal for 2008 is achieved, it will represent twice as many as current BlackBerry unit sales and nearly one-fifth of Cingular's total handset sales.) Here are some additional concerns raised by the aforementioned industry reviews: 1. High selling price spells limited marketing potential. Apple is attempting to carve out a niche at the very high end of the smartphone category. The pricing strategy is not without risk. The 4GB model will sell for $499, and the 8GB model will sell for $599. This elevated and premium selling price coupled with a mandated two-year contract (at about $80/monthy) will produce a full-term commitment of about $2,500, suggesting somewhat more limited marketing potential. An 8GB iPod nano and a high-end handset with similar features to the iPhone would retail for under $300, so the planned pricing implies a 100% premium for device integration and "the coolness of all things Apple." 2. Why not target the corporate market? Apple's iPhone is aimed squarely at the consumer market, not the corporate market. Also, it remains unclear whether Apple's brand interface is much more innovative than several products that are already on the market, such as the Nokia n95 which is 3G, and it has GPS and a keyboard (making it easier to serve the primary purpose of a phone, i.e., making phone calls). 3. Closed systems can be confining. Sunday's New York Times carries an interesting story that questions the value of Apple's "crippleware" -- the consumer is locked into Apple's content and peripheral pricing in all of its products including the iPhone. It hasn't yet hurt Apple, but it could in the future. For example, movie studios are trying to find ways to make sure that Apple is not the key distribution factor in the delivery of video content. 4. The slow Cingular Edge network is like the slow boat to China. During last week's presentation, Apple made no mention of data speed on the iPhone. The first users of the iPhone will not likely be traveling in the fast broadlane, as the Cingular Wireless' Edge data network all too often drops to dial-up speeds. According to Information Week, "Cingular's Edge network provides nationwide coverage at average data speeds between 75 Kbps and 135 Kbps. By comparison, the CDMA EV-DO Rev A network being rolled out by Sprint has speeds of 450 Kbps to 800 Kps. (While the iPhone reportedly switches automatically between Edge and Wi-Fi, a hotspot must be found to use the high-speed capability.) In praising the iPhone in the Wall Street Journal late last week, Mossberg mentioned that "running on the relatively slow Edge network ... is a drastically slower alternative that constantly reminded us that we are using a pokey mobile device." As for voice, PCMag.com reported that the sound quality was poor, "kinda fuzzy...not as good as a normal cell phone -- but it should be said that I the reviewer was in an area of the Moscone Center where reception is less than ideal." 5. Lack of keyboard makes typing tedious. This is an area of big risk/big reward. Will no keyboard play in emailing and phone dialing? As the New York Times writes, "The iPhone is not, however, a BlackBerry killer. The absence of a physical keyboard makes it versatile, but also makes typing tedious. Instead of raised alphabet keys, you get virtual keys on the screen. They're fairly small, and of course you can't feel them. So typing is slow going, especially for the fat of finger." Previous experiments with touchscreen keypads have not been successful in the handset industry. A sealed device has limitations. There is no flashcard slot, the battery is sealed (and non-removable), and the consumer is locked into Apple content. Particularly of concern to me is the sealed battery. The new iPhone's battery charge -- Apple has promised five hours of talk time and 16 hours of music playback -- will be challenged by heavy usage. Because I'm playing music on the device, using the touch screen and actively using its operating system, I always travel with an extra battery for my Treo. You can't do that with the iPhone. Apple's iPhone might be too U.S.-centric The iPhone is only 2.5g. That's a fascinating but risky choice. It is hard to understand why the choice was made. Does Apple think WiFi is adequate for high-speed connectivity? If 3g takes off and some killer applications are developed around it, this will be a reasonably big negative for the coolest phone sitting on the shelves, even though it's not 3g and it can't do all the high-data-rate stuff a portable device is meant to do, including simple Web surfing with reasonable speed. (And it seems like Apple has a great Web browser on the handset, making the decision even stranger.) 6. A June introduction might be challenging. It is interesting to note that reviewers, at most, were given less than an hour with the iPhone. I suspect that in certain cases the cell-phone service was not even enabled, because the product is not yet FCC-certified, so reviewers have limited feeling on how it works in practice under real-life conditions. The question of whether or not the device is ready for prime time has to be asked, and I wonder whether Apple felt so much pressure to be innovative that it innovated a lot of stuff that could end up less than it was cracked up to be. For now, Apple plans to produce about one million units per month beginning in April 2007. I am told the product is about five weeks away from completing the FCC approvals process and then will enter the Cingular testing queue at that time. Software glitches and usage quirks during the testing process could develop, even though Apple has tested the product internally. This testing phase is rigorous, and almost half of higher-end models require changes that result in product delays. 7. Will competitors sit still? I expect that in the fullness of time, Apple's handset competitors will strike back with advanced features and lower selling prices. Indeed, yesterday T-Mobile announced the release of a white version of the BlackBery Pearl smartphone. The Pearl is a more broadly distributed device than the iPhone, and its price has been slashed from $199 to $149 per unit. There will be other compelling competitors as well, such as the LG KE850. Unquestionably, many other innovative smartphones will follow in these footsteps.
Putting a Price on Science
In summary, notwithstanding the previous successes of the Mac and iPod, there seem to be enough questions regarding the iPhone (is it really differentiated from products already on the market that have advanced features, strong operating systems, have penetrated enterprise and rely on email as their killer application?) -- especially in light of the market's starry-eyed reaction and Apple's surge in value. Over the course of history, the stock market has often developed a false trust in science. The intertwining of innovation and beauty is a complex exercise, and it often comes with flaws, as was the case in Nathaniel Hawthorne's The Birthmark. Hawthorne writes about a young scientist who kills his wife in the pursuit of a "perfect future." Like Steve Jobs, the scientist (Alymer) was smart, diligent and "an eminent proficient" in natural science. Georgiana was pretty, but she had one fatal flaw: nature provided her with an unsightly birthmark on her face in order to keep balance. Any attempt to remove it should and would result in disaster. Handsets, as with science, love and beauty, will advance, step by step. But no one will never reach a "perfect science." In The Birthmark, Alymer's pursuit of "perfect science" can often lead to disaster, because people live "once for all in eternity to find the perfect future in the present." So it could be with Apple's iPhone. Any single, significant flaw could be problematic. Finally, if this is indeed a new "platform" and if it is broadly adopted, there are several milestones that might be in the path in order to justify the sharp rise in the company's market value. First, the selling price must come down, while EBIT (earnings before interest and taxes) margins need to stay high. Second, the product probably has to penetrate the corporate enterprise market and be a good power email tool (and then might folks be very wrong with respect to Research In Motion?) and the device might need a keyboard to do this (how different is this product from everything else once a keyboard is added)? Third, Apple needs to broaden channels of distribution and air interface standards (but this currently seems not possible, given Cingular's exclusive agreement, its high sales price and given that this expensive device is only 2.5g to begin with!). Fourth, over time, the iPhone might need to be part of an open community of devices, something Apple has clearly rejected in the past. Fifth, one must assume that Nokia, Motorola, Samsung, RIMM and a host of other competitors have learned very little over the last two decades and pose a limited threat to Apple's iPhone. In summary and over time, small, dependable, innovative, cheap and with a broad distribution seem to be the ingredients for success (and profits) in the handset market. Despite its innovations and design choices, it might be premature to take the leap of faith that the iPhone embodies all these strengths which seem to be reflected in the $15 to $20 billion rise in Apple's common shares. As the Wall Street Journal's Mossberg writes "The Apple entry is so full of promise that anyone buying a smartphone in 2007 should at least wait for the full reviews and a chance to try it out. ... Only then will potential customers be able to judge whether the relatively slow data speeds are offset by the other attractive features of the iPhone."
Originally published on 1/17/2007 at 8:28 a.m. On Tuesday I described some reservations I have regarding the market's reaction to Apple's iPhone. While some have criticized my pricing and keyboard concerns, the real objection seems to be to my statement that Apple's shares have benefited from a nearly $20 billion incremental rise in equity capitalization from last week's MacWorld announcement. In actuality, that was being conservative. I would say there was more than $5 to $10 of pre-announcement hype built in to Apple's share price, and then the stock rose another $10. With 870 million shares outstanding, those two pops represent $4.3 billion to $8.7 billion and $8.7 billion, respectively, which is how I arrive at nearly $20 billion in hype. I believe those who have objected to my view are wrong. Here's why. Were it not for the success of the iPod, Apple's growth rate would have plunged over the last two years. (You could argue that the iPod's growth rate, too, is decelerating, albeit from a lofty rate of growth.) If you doubt my assertions on Apple's non-iPod growth, turn to page 54 in Apple's 10k, which highlights the dollar and unit sales contributions by product line and geographic region. From 2004-2006, iPod unit sales rose from 4 million to 39.4 million, representing unit gains of 75% in 2006 over 2005 (69% in revenue) and gains of 409% in 2005 over 2004 (248% in revenue). During the same period, Apple's desktop sales rose from 1.6 to 2.4 million units -- a loss of 3% in 2006 over 2005 (-3% in revenue) and a gain of 55% in 2005 over 2004 (45% in revenue) while Apple's portable products unit sales rose from 2.6 million units to 4.05 million units, representing unit gains of 42% in 2006 over 2005 (+43% in revenue) and unit gains of 11% in 2005 over 2004 (11% in revenue). Stated simply, over the past two years the sales growth in iPods and other music products was responsible for nearly 75% of Apple's incremental revenue of $11 billion (to a total company-wide sales figure of $19.2 billion last year). In fact, if the iPod and other music businesses did not exist in the past two fiscal years, Apple's revenue would have only risen from $8.5 billion to $9.8 billion in 2006, a modest gain of 15%, and down from the 30% growth rate in 2005. Before the iPod, Apple was essentially a stagnating personal computer company with modest market share. After the iPod, Apple's MacIntosh sales grew well in 2005 but that rate of growth dropped by a third in 2006. Despite the protests of many, the iPhone has been hyped for at least the last 12 months as the next growth engine for Apple, intending to replace the iPod's significant contribution. As someone wrote to me last night, without the iPhone's announcement "a stagnant or falling stock price combined with Jobs' involvement in the options backdating scandal would have made for a more hostile environment ... so it sure is a big help that Jobs can make an over-the-top iPhone announcement at MacWorld just two days before the press discloses further damning details of the options scandal. Without the iPhone announcement, MacWorld is a giant yawn ... so the iPhone is announced -- without even having the rights to the name -- months before it is ready to be shipped." So one has to ask, as Alan Murray does in The Wall Street Journal today, why the iPhone was announced so far in advance of its actual introduction in June 2007. Last Tuesday's announcement also runs the risk of both the smartphone and iPod markets freezing up over the next few months. And looking beyond the wow! factor, one has to question many of the features of the iPhone product. I suspect that in the fullness of time there could be even more flaws than I mentioned in my article yesterday. From my perch, the market's very favorable reaction to Apple's iPhone is yet another example of disbelief being suspended ... on the Street of Dreams.
Originally published on 1/17/2007 at 10:06 a.m. I have received many emails regarding why I am not short Apple, especially considering my concerns. It's simple: I am simply questioning the logic behind the market's move (at the margin) based on what I believe to be iPhone hype. These concerns alone are not enough to warrant shorting of the stock. To merit shorting Apple would require a more thorough analyis of its non-iPhone businesses -- something I have not done. Yet!
Originally published on 1/18/2007 at 7:46 a.m. The plot thickens. Wednesday night, on the back of the controversy surrounding the market's reaction to the introduction of the iPhone, Apple's earnings report beat the pants off consensus profit forecasts. But the company cautioned investors regarding the next quarter's results. Reflecting many of the concerns that I expressed Tuesday and Wednesday -- which are now coming to the surface -- I expect some Wall Street downgrades today (J.P. Morgan downgraded Apple to neutral from overweight, citing soft Macintosh shipments and ever-increasing expectations) and for the stock to begin giving back the hype associated with the MacWorld announcement. (In pre-market trading Thursday shares of Apple were down 1.3%.) Many were critical of my concentration on the iPhone's prospects in these columns. "What about Apple's MacIntosh success?" was a common refrain. What about MacIntosh? Units only rose by 28% year over year (1.6 million units vs. Street chatter of 1.8 million-plus), with most expecting 35% to 45% growth! ( Goldman Sachs' model was for 37.4% growth.) The hubris of Apple has been well documented. As I have written over the past week, I remain skeptical regarding the general assumption of a seamless transition into the iPhone's uber-growth forecasts during 2007 and in the market's robust reaction to the iPhone's introductory announcement. The competition will not be standing still. It is inevitable that companies like LG and Samsung, which has its own NAND supply, will bring on cheaper products with similar functionalities and possibly even better displays -- and unlike Apple, open systems. Consider these competitive new market entrants in the handset and MP-3 player markets. Finally, last Tuesday's announcement also runs the real risk that both the handset industry's smartphone and Apple's iPod markets freeze up a bit (as demand wanes) over the next two quarters as consumers await the iPhone.