Apple's Problems Could Get Much Worse

By Markets Fool.com

Image source: Apple.

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The incredible growth of the iPhone over the past nine years has finally come to an end, at least for the time being. In April, Apple reported the first ever year-over-year decline in iPhone sales, with the company selling 16% fewer units compared to the same period last year. On an absolute basis, the numbers are impressive: 51.2 million iPhones generating $32.9 billion of revenue. But the slump in sales sent the stock tumbling, despite Apple's massive cash hoard and still-extraordinary profitability.

If one assumes that Apple can maintain its current profits, the stock is outrageously inexpensive. Its net cash represents about 30% of the company's market capitalization at this point, putting the cash-adjusted P/E ratio at just about 7 based on last year's earnings.

But investors making this assumption are discounting the possibility that Apple's earnings could fall severely going forward. If Apple's earnings get cut in half, the stock doesn't look so cheap anymore. That may seem like an unrealistic decline, given the strength of Apple's brand and the popularity of its products. But it actually isn't far-fetched at all.

Fewer, better phones
In 2012, U.S smartphone users upgraded their phones every 22 months on average. The two-year contract, where smartphones were subsidized and sold at a discounted price by the major wireless networks, created an incentive for consumers to buy a new phone every two years. Also driving sales was the fact that smartphones were getting substantially better each year. Gains in performance and quality were meaningful, and two years was enough time to make most phones largely obsolete.

Today, the two-year contract is dead, and smartphones no longer improve dramatically each year. The upgrade cycle is getting longer while developed markets like the U.S. approach saturation. Global smartphone shipments fell 3% year over year during the first quarter, according to Strategy Analytics. Any growth in the smartphone market going forward will come from developing markets like India, where inexpensive Android phones reign supreme. Apple's market share in India currently sits at just 2% thanks to the high price of its products, and the company's attempts to import used iPhones into the country for sale have so far been rejected.

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Apple faces two main problems that have the potential to drive down its profitability. First, competitors are producing flagship-quality phones at much lower prices, and mid-range phones are now of a high enough quality to fit the needs of most smartphone users. Second, due to this increasing quality, the end of two-year contracts, and the lack of major improvements with each new annual iPhone, consumers are upgrading less often.

Already, both of these issues are affecting Apple. The company launched the iPhone SE in April for $399, the cheapest iPhone to date, in an attempt to spur upgrades. But launching a less expensive iPhone runs the risk of pushing average selling prices down, especially considering that the iPhone SE is essentially the innards of the iPhone 6s, minus 3D Touch and some other minor features, inside the body of an iPhone 5s.

In the United States, now that smartphones are no longer subsidized, the $650 price point is less appealing for consumers. With subsidies, the entry-level iPhone was knocked down to just $200, making the difference in price between the iPhone and a mid-range Android smartphone at most $200. Today, with consumers paying the full price, either up front or through installments, the difference can be $400 or more, depending on the phone. It's hard to imagine this change not putting pressure on Apple's average selling price going forward.

Longer upgrade cycles will also put pressure on Apple. In the United States, the smartphone upgrade cycle has reached 29 months, according to Citigroup. This shift was likely a major contributor to Apple's first iPhone sales decline, and there's no reason why the upgrade cycle can't continue to get longer. Apple's phones in particular are high-quality and long-lasting, and without major improvements each year driving users to upgrade, the move to a three-year upgrade cycle isn't out of the question.

That would be a disaster for Apple. If the iPhone average selling price were to fall by 20%, and the upgrade cycle were to increase by 20% in length, iPhone revenue would fall by one-third, all other things being equal. If Apple lost market share as well, the drop would be even larger. I'm not saying these things will happen, but a scenario like this doesn't seem unrealistic. If we reach a point where most consumers hold onto their phones until they stop working, instead of upgrading due to new features, Apple is in serious trouble.

Perhaps the iPhone 7 will prove to be revolutionary device, reversing the company's fortunes and propelling iPhone sales higher. But I'm not holding my breath.

The article Apple's Problems Could Get Much Worse originally appeared on Fool.com.

Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.