Apple Is a Hardware Company; Einhorn Just Doesn't Get It

NEW YORK ( TheStreet) -- Hedge fund superstar David Einhorn has been all over the place lately with an important message. It's the same refrain he recited to the Ira Sohn Conference attendees last month. Einhorn, apparently, is among the chosen few who actually understand Apple ( AAPL).

Arguing that "The value comes from iOS, the App store, iTunes and iCloud," Einhorn riffs:
AAPL's ability to consistently offer innovative features . . . encourages users to upgrade every couple of years. This provides a recurring revenue stream . . . Rather than view AAPL as a hardware company, we see it as a software company that monetizes its value through the repeated sales of high margin hardware.

That sounds incredibly sophisticated; it's just too bad it bears scant relevance and holds very little meaning in relation to anything substantive for investors.

I must be clear. I am not dogging Einhorn's decision to be bullish AAPL. Even as somebody who tends toward the bearish side, particularly long-term, on the stock, it's difficult to argue with Apple's dominance. I am just as awestruck by it as the next person. It is, however, critically important that we question his assertion.


Because, as TheStreet's Chris Ciaccia contends:
The next six months for Apple are potentially the most important in the company's history, as Tim Cook continues to steward the ship following the death of Steve Jobs. The world will be watching and waiting with bated breath for the latest "one more thing."

And the profound importance associated with the remainder of 2012 does not revolve around Apple's ecosystem. I'll be the first to admit it's a prime ingredient in Apple's success; however, at day's end, it doesn't generate much direct revenue for Apple. Hardware sales take care of that.

It's a bit like public transportation systems in cities such as San Francisco. They actually lose money, but they're public goods. Without them, the city's other systems -- "hardware" such as housing, jobs and retail -- would not hum along quite as efficiently as they do.

A recent assertion made by Spotify director Sean Parker also lends support to Einhorn's case. At last week's All Things Digital conference, Parker made the very believable claim that Apple attempted to block Spotify's move into the U.S. market. If this is true, Apple was clearly concerned that Spotify could hurt iTunes.

As a new Spotify member, I think it's quite clear that Spotify provides a superior interface to iTunes. Not only has Spotify built a sexier platform, but it succeeded wildly in an area where iTunes failed miserably -- social. Spotify has made it so I do not have to nor do I really want to open iTunes again. There's no need.

Obviously, Apple does not want this to happen; hence it's alleged resistance to Spotify encroaching on its American turf. But, even if more people use Spotify to listen to music, it's not going to hurt Apple's bottom line one bit.

At the risk of stating the obvious, hardware sales drive Apple's revenue and profits.

Last quarter, Apple generated $39.186 billion in sales. Macs, iPods, iPhones and iPads accounted for roughly $35.5 billion of that total. Software and service sales, which include revenue from iTunes, the App Store and iBookstore, made up approximately $3 billion, bringing you to $38.5 billion. Other random hardware sales comprise most of the discrepancy between $39.186 billion total sales and the $38.5 billion figure.

A little rough, back of the envelope math shows us that hardware, primarily Macs and the gadgets we all know and love, comprise more than 90% of Apple's revenue.

I'm not missing some higher level point here. Einhorn's argument boils down to this: Software-based features (though the innovations often come from hardware enhancements) drive repeat sales of high-margin hardware. That's fine, but, from a long-term standpoint, it's a flawed perspective.

Music listeners, for example, could abandon iTunes for Spotify in droves. That will do very little, if anything, to hamper Apple's hardware sales. As with any other platform or app, you'll continue to access Spotify via an Apple device such as iPhone or iPad, particularly if you're one of the faithful. And that's because they are damn good pieces of hardware.

There's no question that Apple's entire ecosystem, including iOS, serves as a value add. But, for all intents and purposes, it's only the diehards who buy Apple products because of iOS's apparent superiority. The general public buys iPods, iPhones, iPads and Macs because they're cool, they work really well and they're beautifully designed. The brilliantly unique hardware hooks people, not the software.

Until this changes, Apple will dominate. The iOS, AppStore, iTunes and iCloud ecosystem will not save Tim Cook's butt if he cannot roll out products the public adopts as quickly as it has iPad and its relatively humble predecessors.

iTV needs to be another device in a long line of hardware that woos you. With it pinned to the wall of your living room, it will need to make you feel as cool as you feel when you extract your iPhone from your hip pocket. That's what drives mass market, mainstream sales -- not embedded features that you can get elsewhere, albeit not as well done. And, again, I'm not talking about creative types from the Apple cult or the education market; I am talking about the average, everyday iPod owner.

It sounds hipster cool when a rich hedge fund guy calls Apple a software company, not a hardware company. If you're an investor, take those words (like anything else, for that matter) with a grain of salt.

If and when Apple releases a new piece of hardware that's not incredibly well-received, expect the stock to tank. If this leads to anything resembling a slowdown in revenue, run for your life because Apple's glory days might have passed them by.

No matter what anybody tries to tell you, the ecosystem will not stop this from happening or salvage a less-than-amazing product launch and run.
At the time of publication, the author held no positions in any of the stocks mentioned.

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