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Editor Commentary
Should You Buy Apple's Stock Along with the New iPhone?
StockPicks Editor
Tuesday, June 10, 2008
Apple (AAPL)
Apple is widely expected to introduce a second-generation version of its iPhone later today during a keynote speech by Steve Jobs at the company-sponsored Worldwide Developer's Conference. Everywhere you look, there seems to be intense speculation about the features that the iPhone 2.0 will carry. Nobody generates hype quite like Apple and Steve Jobs, they have the formula down pat -- keynote address at a major conference, drop a few hints here and there in the days preceding the event, guard secrets about the product in a fanatical manner and then finally, coyly introduce it. Surprisingly, this never gets to seem old for most people. Apple is sure to get a lot of press over the next few days, but should you be impressed and push the stock higher?
Stock Analysis
From a business standpoint, the iPhone will become increasingly important to Apple. The iPhone only made up about 5% of Apple's revenues last quarter, but iPod sales are not rising as meteorically as they used to. In fact, they were virtually flat last quarter, rising only 1%. So, if Apple wants to keep growing, the iPhone will have to pick up a lot of the iPod's slack. The company also has its line of Macintosh computers to rely on and those have been selling better than expected in recent quarters (especially in Q1 of this year when Apple blew away analyst expectations, heavily in part due to Mac sales), but the Mac has traditionally always done much better when there is some other fancy product to pull people into the Apple stores, something compelling enough to generate a trickle-down effect that the Mac can feed of. The iPod has been this product for much of this decade and now that it is losing steam in a saturated market, the iPhone is going to have to take its place.
So is the iPhone up to the task? The first generation iPhone has performed well; it's been good but not great. It definitely hasn't done as well internationally as hoped. Overall, Apple has sold about 5 million phones since the launch in late June of last year out of which only 350,000 were sold in Europe. The biggest complaint about the iPhone has been that it does not use the fastest data transfer network out there -- i.e. the 3G network. This impedes the speed with which one can browse the internet and use other web services. It is almost guaranteed that Apple will address this by making sure that iPhone 2.0 is capable of running on 3G networks. There isn't as strong a consensus about the other enhancements to the device. However, the most commonly mentioned improvements to the iPhone include a GPS chip, video-conferencing, built-in instant messaging and ability to download songs from the iTunes store via a cell-phone network (currently, this can only be done when connected to a Wi-Fi wireless network).
So it's safe to assume that the new iPhone will be impressive but that doesn't make Apple's stock an automatic buy - at this point at least. Apple is trading at fairly expensive levels. The stock was trading around $200 at the beginning of the year, then it had a tough first 2 months in '08 (as did most of the stock market) on recession fears and a consumer spending slowdown. It fell all the way down to $119.69 in March but has since rebounded (along with a number of big-cap tech stocks) and is now trading in the $182-$185 range. The P/E stands at ~37. Can Apple justify this valuation? To do so, it's going to have to make the iPhone a bona-fide blockbuster. There are a number of obstacles to prevent that from happening. First of all, the iPhone is available only to AT&T customers. The exclusive agreement with AT&T (which is no longer the largest wireless carrier in the United States after Verizon's acquisition of Alltel last week) still has another 4 years to run. This effectively caps the sales potential of the iPhone. Secondly, the corporate and business sector is a huge chunk of the smart phone market. To be taken seriously, the iPhone is going to have to make dents here and penetrate business and IT users. But Apple has never been able to sell to businesses en masse - it's not in the company's DNA. Will that ever change?
Cost is another issue. The iPhone right now prices out a lot of users and it is widely expected that the new iPhone will be cheaper because AT&T will subsidize part of the cost. Apple is entering a slippery slope here. Until now, Apple has played the wireless business on its own terms but by allowing AT&T to subsidize the iPhone, it is admitting that its original strategy did not work and it's giving the wireless provider more leverage. This leverage could be exploited to Apple's detriment down the road. Let's say Apple allows AT&T to subsidize the iPhone by a $100 now. What is to stop AT&T from asking Apple to let it subsidize it by $200-300 in the future? AT&T can always point to increased sales that a subsidy brings as justification. In the end, AT&T will probably make the cash it laid out in subsidies back (thanks to the fat margins on data services that iPhone customers make heavy use of) but Apple could risk watching its flagship product lose the cache that comes with a heavy-price tag and become a commodity (i.e. the RAZR part 2).
One of the reasons the iPod is such a success is because it has numerous price points (e.g. the nano, the touch etc.). Can Apple replicate that model with the iPhone? Who knows? After all, the moment the 3G iPhone hits the market, the current model which runs on the GSM standard becomes inferior because it runs on a slower network. This rarely happened with the iPod (i.e. the introduction of a new model never made the old ones inferior in a fundamental manner). After the current buzz around the iPhone 2.0 dies down, the stock will probably pull back, once the weak consumer spending environment becomes the central issue around Apple again, and that would be a better time to get in, if at all.
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