Wireless Watch: Quarterly setback may force Apple to rethink one-handset strategy Jul 26, 2012 – Rethink Research
Significance: While still stunning by most firms’ standards, Apple’s fiscal Q3 disappointed Wall Street as the ageing iPhone 4S lost some momentum. Although a new iPhone is probably three months away, consumers are already holding out for it – or looking to other high profile alternatives. As the industry’s design cycles accelerate and competition from Samsung intensifies, Apple will be under pressure to launch more than one model a year, and at different price points. The impact of the transition period was seen both in the US and China, and the rapidly expanding iPad was not enough to offset.
A 21% rise in net income and a share price of $565 wouldn’t usually be disappointing in a time of recession, but this was Apple, whose fiscal third quarter came in below Wall Street’s skyhigh expectations. On one hand, this can be seen as a welcome dose of sanity about a stock which has taken on an almost mystical quality, which cannot be sustainable forever. On the other, though, the factors which led Apple to underperform do point to challenges for the firm which will last beyond the current quarter.
The biggest topic for CEO Tim Cook’s post mortem may well be the one-product strategy which has served Apple well so far in the smartphone business, but is now looking tired. One of the biggest factors in the quarterly results was the transition period between models, with the market waiting for a new iPhone which will not arrive until October (probably). That is too long a wait now that the firm is so heavily dependent on the iPhone – with Mac sales slowing and tablets not yet, for all their growth, a really mass market item.
So it was no shock that the wait for a new iPhone hit Apple’s fiscal third quarter, and the firm missed Wall Street expectations for only the second time since 2003. The vendor sold 26m iPhones in the quarter, behind consensus analyst forecasts of 28.4m. After massive sales of the iPhone 4S when it launched in the holiday quarter of 2011, these have lulled as consumers await the fall appearance of the ‘iPhone 5’, and as rivals like Samsung unleash bighitting models of their own.
That shows how the iPhone is becoming very seasonal in its performance, with a huge boost to sales in the latest model’s launch quarter, but swiftly followed by the ‘waiting game’. With another year to wait for the new model, there are many opportunities for increasingly credible alternatives like Samsung – with its large variety of carefully targeted Galaxy variants – to leap into the breach.
In the era of rapid design cycles, that puts pressure on Apple’s once-a-year cycle, and a second, lower cost model, with a staggered launch timeframe, may be the answer. Michael Obuchowski of North Shore Asset Management told Bloomberg: “Because everybody else has a much faster design cycle, Apple has to come up with a new phone that’s competitive not just when it comes out, but will stay competitive for a long period of time. That’s going to be increasingly difficult.”
Even for Apple loyalists, the firm is risking becoming a victim of its own stunningly successful rumor mill. No rival can match its ability to stir up anticipation of a new product and leak just sufficient information to keep the conversation chattering almost throughout the year. The problem is, the build-up now starts so early that the period of excitement about the newly launched model is curtailed.
This may all point to the need to do at least two iPhone launches a year. The iPad was supposed to create an interim buzz between handset debuts, and it does perform that function for the Apple brand as a whole, but it does not stop handset buyers looking to Samsung or HTC, or delaying their next purchase. There are, of course, other reasons why multiple iPhones may become necessary to fend off the increasingly dangerous Samsung. The most important is to support a mass market line – not cheap, but suited to prepaid carriers and emerging markets – while also preserving the cachet of the brand with a high end offering, positioned as a premium device and probably restricted to a small group of carriers, as with the original iPhone.
Grabbing back some of the exclusivity associated with early iPhones, which was lost with the widely distributed iPhone 4S, would be a useful weapon against Samsung, whose brand, though highly regarded, does not quite have that Apple ‘magic’. But that brings us on to another risk highlighted by this quarter’s figures – the huge expectations around Apple, both from investors and consumers, and the rising fear that it will disappoint. It is more essential than ever before that the next iPhone has a massive impact and changes the handset goalposts again, because for the first time Apple has serious competition at the high end, and a solid but non-revolutionary upgrade could consign it to the pool of quality smartphone providers, rather than keeping it on its pedestal.
The firm has another quarter to get through before a new iPhone has its impact, hence some caution about the current period as well as the Q3 results. CFO Peter Oppenheimer saying the current quarter’s results would be worse, as anticipation of a new iPhone had “caused some pause” in sales. The company said sales in the quarter ending in September would fall to about $34bn with profit down to $7.65 a share – Wall Street was looking for $38bn and 10.27 a share.
In the June quarter, overall results were strong by industry standards but disappointing for Apple. Net income was up 21% year-on-year to $8.82bn or $9.32 a share, while sales rose 23% to $35bn. Analysts had predicted profit of $10.37 a share on revenue of $37.2bn. Apple’s shares fell by as much as 6% to $565 on the news, with sales growing at the slowest pace for three years.
The company did sell a record 17m iPads in the first full quarter since the latest HD device was released in March, exceeding the 15.4m projected by analysts. CEO Tim Cook also said the company sold 1.3m units of Apple TV, three times the year-ago figure, though he admitted this was “still at a level that we would call it a hobby”, adding: “We continue to pull strings to see where it takes us.” The company sold 4m Macs and 6.8m iPods.
Sales were especially weak in debt-ridden Europe and like other firms such as Nokia, Apple is seeing the Chinese boom fizzling – sales in Asia-Pacific, including China, slipped by 22% from the previous quarter to $7.89bn. Gross margin was 42.8% and will fall to 38.5% in the current period because of product transition and a stronger US dollar.
The Chinese market, now the world’s largest, is increasingly a bellwether for the industry with its rising affluence and its consumers’ conversion to smartphones. Chinese slowdown has been a major negative for Nokia all year, while several firms were hit in Q2 by a slackening of the country’s consumer boom. Apple was among them – having taken a long time to get established in the country’s mobile space, it scored a huge quarter there earlier in the year, but fell back again in the June period, when sales fell to $5.7bn from $7.9bn in the March quarter. Cook indicated that Apple had built up excess inventory during the first months of 2012.
Beijing-based IDC analyst TZ Wong says this is, as elsewhere, a result of the iPhone cycle. "The 4S model is a little bit too long in the tooth when compared to other phones with better specs," he told Bloomberg. "To put it plainly, consumers are getting a little bit tired of the look of the iPhone 4 and the iPhone 4S." Even the new iPad did not generate the same levels of furore as its predecessor when it went on sale in China, and many are questioning whether the country’s users are already moving on to the next big thing. In particular, the Samsung Galaxy S III and the HTC One X are outselling the iPhone in Greater China, while local Huawei and ZTE models are heavily subsidized by carriers.
Gone are the days when Apple could console itself for a lacklustre performance with the fact that everybody else was far behind. The second calendar quarter, and the iPhone transition, will see Samsung extending its lead over its arch-rival according to various calculations, Juniper Research says that Samsung shipped 52.1m smartphones in Q212, twice Apple’s number of 26m (another endorsement of the multi-model strategy, since the Korean firm saw the Galaxy S, Note and Beam families all performing well). However, the Galaxy S III has been the key, and of course Samsung currently interleaves its biggest launches with those of Apple. The S III achieved sales of 10m units in June.
iPhones at the US carriers:
Another key indicator for Apple is always its home market, and particularly the activations by AT&T and Verizon. Both firms saw these slip in the second quarter because of the transition period, though ironically, that boosted their margins because of the lower subsidy bills.
For the second quarter in a row, AT&T’s iPhone activations dropped – the Q2 figure was 3.7m, down 14% sequentially, while Verizon’s number was 2.7m, down 15.6% on Q1. Wells Fargo analyst Maynard Um wrote in a client note: “The two US operators’ activations combined were slightly below our expectations, accounting for 20.3% of our forecasted 31.5m versus the March & December quarters where the two accounted for 21.4% and 32.1%, respectively.”
The Apple handset still accounts for the majority of smartphone activations at AT&T, whose smartphone total was 5.1m, but by a declining margin as the iPhone 4S ages. Verizon sold 5.9m smartphones in the period, with 2.9m Android smartphones to add to its 2.7m iPhones, a balance which is expected to shift once it is able to offer an Apple handset for its rapidly growing LTE network. In the year-ago quarter it had sold 2.3m iPhones, but the figure was 3.2m in Q112, once again illustrating the cyclical pattern.
Overall, AT&T reported a 10% rise in earnings in Q2 on the back of better wireless margins – partly because of the lower Apple subsidy bill - and strong smartphone sales across various brands. Wireless operating margin was 30.3% versus 26.9% a year earlier, which the cellco attributed to “improved operating efficiencies, fewer handset upgrades and further revenue gains from the company's 43m high value smartphone subscribers”.
Group net income for the quarter was $3.9bn, up from $3.6bn a year earlier, on revenues up 0.3% to $31.6 bn, slightly behind Wall Street forecasts. Mobile revenues were up 4.8% year-on-year to $16.4bn, just over half the group total and wireless data revenues were up 18.8% to $6.4bn. AT&T boasted of “record low levels of churn” in both the prepaid and postpaid segments, at 1.18%.
The carrier reported a net increase in mobile subscribers of 1.3m in the quarter to reach 105.2m, including postpaid net adds of 320,000; prepaid net adds of 92,000; connected device net adds of 382,000 and reseller net adds of 472,000.
Verizon Communications saw strong growth in Q2, mainly propelled by the wireless arm. Verizon Wireless posted a 7.3% year-on-year increase in service revenues to $15.8bn, offsetting its parent’s 3.1% decline in fixed line sales. Mobile data revenues were up 18.5% to $6.9bn while postpaid ARPU hit a record $56.13, a rise of 3.7%. Total operating revenue was $18.57bn.
The cellco added 1.2m retail net mobile customers in the quarter, including 888,000 postpaid, bringing its total to 94.2m. Smartphones made up 50% of the postpaid base, up from 47% in the previous quarter. The rise in 4G and data services helped push Verizon Wireless to its highest ever EBITDA margin, at 49%, up from 45.4% a year earlier. The LTE network now covers 230m POPs in 337 markets across the country, or nearly 75% of the population.
Apple tightens control of supply chain:
An important competitive advantage in consumer electronics is control and scale in the supply chain. Once Nokia was the king, now Apple and Samsung battle for the crown as they do for smartphone market share. Apple is in the clear lead and is expected to buy nearly $28bn worth of semiconductors in 2012, up 15% on last year, according to analysts at IHS iSuppli. The research firm says Apple is increasing chip spending at a faster rate than other top buyers, increasing its dominance over the market, and is widening the gap with the number two chip buyer, Samsung, which is set to invest $14.9bn this year, up from $14.8bn in 2011.
"It’s well known that Apple has already conquered the smartphone and tablet segments - but behind the scenes the company is engaging in another kind of conquest: the dominance of the electronics supply chain," said Myson Robles-Bruce, senior analyst at IHS, in a statement. This position enables Apple to dictate terms on pricing and product roadmaps and to have a preferential position if components are in short supply. “For Apple, these benefits translate into competitive advantages, letting it offer more advanced products at lower prices, faster and more reliably than the competition," Robles-Bruce said.
After Apple and Samsung, the biggest chip buyers worldwide are HP, Dell, Sony, Panasonic, Cisco, Canon, Toshiba and Fujitsu, in that order.
Marketing costs send LG Mobile back into red
LG continues to struggle turn its mobile business around, posting a second quarter operating loss in the unit. However, the reason behind the deficit gave some encouragement – rather than incurring losses because it was selling low value devices, like last year, these have come mainly from the increased cost of marketing some high end and potentially high impact products.
Like HTC, another Android supplier struggling to stay visible beneath Samsung’s shadow, LG has pulled out the design stops this year to get itself noticed, majoring on 3D displays and strong video and imaging in its Optimus line. However, there was a trade-off from all this effort to impress consumers. The company said in its statement: “Although cost structure improved due to better product mix from stronger LTE phone sales, operating profit declined as a result of increased marketing expense”.
As the company shifts its balance of handsets away from its traditional featurephone base and towards higher margin offerings, it is seeing a decline in overall volumes, which fell to 13.1m units during the quarter – a transition earlier seen at Motorola Mobility, Sony and HTC. Smartphones are now 44% of that total, up from 36% a year earlier, while featurephone sales are “shrinking”.
For the three months, the handset business recorded an operating loss of KRW59bn ($51.3m), compared with a loss of KRW55m in the year-ago quarter, on revenue of KRW2.29 trillion, down 28.6% year-on-year. The setback came after LG Mobile managed to achieve profitability for two consecutive quarters, after a long series of operating losses.
“Sales figures for phones aren’t rising quickly enough,” Choi Nam Kon of Tongyang Securities told Bloomberg. “That is forcing them to increase spending on marketing and such, so margins keep narrowing. They need to raise sales volume first.”
Looking ahead to Q3, it said it expects competition to intensify, “with competitors launching premium flagship models”, and will retaliate with more LTE handsets plus “marketing efforts and efficient supply chain management” to improve the impact of those launches.
The LG group posted net profit of KRW159bn ($138m), up from KRW109bn a year earlier, but reveuue fell by 10.6% year-on-year to KRW12.86 trillion ($11.18bn). As well as difficulties in the phone division, there was a fall in sales in the home entertainment unit, though profits in that section doubled. LG aims to be the world’s largest vendor of 3D televisions this year.
Wireless Watch: Quarterly setback may force Apple to rethink one-handset strategy
