Kass: Apple's Core Is Weak

Back in September 2012, I outlined my bear case for Apple (AAPL). At the time, the shares had eclipsed $700. To say it mildly, my view was in the minority and was the subject of a lot of criticism and numerous Bronx cheers.

Within eight months, the share price dropped from $700 to under $400.

Since second quarter 2013, I have traded Apple both on the long and short side. I have not had a strong view throughout most of this year, but given the recent share price climb (back to the levels last seen in September 2012) and in light of this week's product launches, I do now have an opinion on the shares.

This week I have taken a short position in Apple, a maturing company whose profit prospects going forward are less attractive than in the past and whose valuation is inflated relative to other hardware companies.

My comments this morning will be focused on the iPhone, which is the dominant sales and profit driver for Apple. (I don't believe that Apple Pay or the iWatch will move the company's needle.)

Let me start by stating that I approach my analysis of Apple as a generalist, not as an industry specialist immersed in the reams of data and depth of issues.

Let me also make it clear that I expect Apple to underperform the markets, but I don't expect Apple's shares to drop from $100 to $55, which would be similar to its decline from September 2012 to May 2013.

I am simply of the view that Apple's shares are overpriced within the context of an expensive U.S. stock market.

Bottom Line

At the core of my concern is that Apple's past successes are not likely to be repeated in the future.

The company's sales base has grown so large that Apple is not likely to benefit from the introduction of new needle-moving products. The competitive landscape has changed in the last few years, and Apple's core product (the iPhone) lacks superiority relative to its competition. As a result, Apple's earnings growth is settling down to a more modest path relative to history and to overall corporate profits, and its near-record-high P/E ratio is inflated.

The New iPhone Is Inferior to Rival Products

Apple's newest big-screen smartphones are more expensive than and inferior to the Android-based compare. Having said that, I expect Apple to have a reasonable and consensus-meeting cycle, as the company's installed base upgrades, but in my view, most of it is has been discounted by robust investor expectations, which, not surprisingly, are north of Street numbers (which have already been ratcheted up).

The delay of the iWatch, while it may smooth revenue a bit, also takes out a portion of the short-term fireworks that numerous momentum investors were hoping for.

This could be the beginning of the end and the last big hurrah for a company with a ton of market cap and well above industry margins but no longer the best products on the market. Apple can get away with it for a while, but I have never seen selling less for more as a sustainable business model.

It is fascinating that just catching up to the industry (and catching up is generous as the phones are more expensive with lower specs) is getting all the hoopla it is.

When a company is catching up, it is not being an innovator. Innovators command industry-leading margins. Followers, with me-too products at best, are usually called Hewlett-Packard (HPQ), Nokia (NOK), Microsoft (MSFT), or are no longer in business.

Selling Less for More

Over the past decade Apple has been the only hardware company in which Wal-Mart (WMT), Verizon (VZ) and others have agreed to eat into their own margins to sell iPhones, owing to their traffic-generating ability. Since ever more hardware stimulates more recurring revenue, a virtuous cycle has been in place for the company and its partners.

I fear that Apple's virtuous cycle is ending.

On a hardware basis, Apple is simply selling less for more. The published comparisons to Android products are unambiguous. Apple is giving you a lower quality screen and camera, among other functions, for more money. In fact, the warning sign a few years ago was when Apple started competing on the basis of hardware differentiation (e.g., Retina display, etc.). When you compete on the basis of hardware differentiation, you are a hardware company and cannot command sustainable above-industry pricing and margins and hold or grow share.

To my point, here is a comparison (and there are many similar comparisons currently being published) of the new iPhone to a three-month-old Android phone.

Here's what happened. In 2012 Apple released the iPhone 5, and the world went mad. Everyone was running around thrusting iPhones into each other's faces and screaming, "Buy one this instant!" Then other tech companies realized that the iPhone could be beaten, and that's what they did.

On paper the iPhone 6's specs are mediocre; there's nothing special about 1GB of RAM, nothing special about a 2GHz quad-core CPU, and there's nothing special about a 1,810 mAh battery. The only thing truly staggering about the iPhone 6 is how much Apple is charging for the right to own barely more than a high- to midrange phone.

Not Much There There

The media is not bending over backward in its excitement over Apple's products, similar to the way they have in the past. Numerous reviews are making the same negative points about the new iPhones and calling the iWatch a dud.

When is the last time Apple delivered a true innovation? Arguably there has not been anything since the original iPhone and App Store. The iPod touches and iPads are extensions of the phone but not truly innovative. And they already seem to be in a state of attrition.

On a software basis, which is the real point of distinction, Apple is now far behind Google's (GOOG/GOOGL) Android ecosystem and probably cannot catch up. And end of day software is the point of differentiation and competitive advantage. That was when Apple was worth it, when the company had the software nobody else had. A nice screen, for example, is not a sustainable competitive advantage.

Google is far out ahead when it comes to integrating information in a useful fashion. Many techies have already figured this out (including numerous former Apple fans) and are switching to Android.

Google is the world's information repository and has a huge structural advantage in terms of ability to integrate info in a useful way that Apple can't do because the company doesn't have the info or ability to integrate it.

Google Now makes Siri look like amateur hour. Google Now is like having your own personal assistant. For example, I can get an email saying "gentlemen your golf match is Friday at noon." Phone reads the email, understands the text, automatically checks against my calendar, notices the golf match not in there and asks me if I want to put it in my calendar. Or I could get an invite to a Kentucky Derby party and put it in my calendar. Before the party the Google Now service automatically sends me directions how to get there and the odds on all the horses. It figured out to how to get the directions and betting odds itself. And it is impressive for it to be able to figure out what the Kentucky Derby is and that betting odds would be relevant to someone going to a Kentucky Derby party.

Even bumbling Microsoft is picking on Apple in its commercials for the same thing. Here is an example.

Google also has the advantage of more third parties innovating around Android. The new Moto X+1 phone (which is about to come to market) has some amazing features such as active display and touchless controls and the new Moto Hint that works along with it. These two products alone have much more in the way of useful and practical innovation than the new iPhones do.

Software is the value-added feature to technology products. Apple seems to be falling further and further behind. As I inferred earlier, I have never seen so much fanfare around a company coming to market with a product two to three years too late that is worse than the products already on the market. And they are being awarded the largest market cap in the world for this? Apple may be a lot of things, but a cheap stock and an innovation leader with market-leading products no longer seem to be two of those things.


This column originally appeared on Real Money Pro at 10:18 a.m. EDT on Sept. 11.

At the time of publication, Kass and/or his funds were short AAPL, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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