Apple's Not in the Clear, But There's Still Hope

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Apple is one of the biggest success stories of this generation. Can anybody really believe that Apple was a $10 stock as recently as 2004? Apple has gone from a struggling PC maker to a company that redefined mobile. It continues to hold significant profit share in the smartphone and tablet worlds, while at the same time is well-known for providing truly best-in-class PCs -- Apple keeps gaining share and is likely to keep doing so with its new MacBook Pro launches. However, despite a quarterly "beat" on the top and bottom lines, and despite guidance that was solidly ahead of sell-side expectations, the stock didn't budge. What gives?

The sentiment has turned as of late
First off, while the stock didn't rally on the earnings report, it was clear that investors were pricing in a pretty healthy quarter and guidance. It was no secret that the iPhone 5s would sell in droves and, frankly, the new iPad Air and updated iPad Mini look to be simply the best tablets on the market today. But, at the most recent closing price of $524.90, the stock is already up an eye-popping 36% off of its April lows. Certainly a far cry from the $705 top, but this isn't 52-week-low territory.

So, if everybody was buying expecting a "great" quarter and then that quarter came as expected, what is there to drive meaningful upside? Well, not much. In fact, it could be argued that while the quarter was wonderful relative to expectations, it was unhealthy when taken at a broader view.

Profits down year over year; Samsung growth troubling
While Apple's buyback program has certainly mitigated the effect of declining net income on earnings per share, it is difficult to escape the fact that Apple's profitability did, indeed, decline on a year-over-year basis. Note that part of this is due to heightened research and development spending -- which is good, since R&D is the lifeblood of any tech company -- but gross profits were actually down 3.6%. It's very difficult to reward a company with a "high" multiple when its business -- built largely on three product lines -- begins to show very slow top-line growth with the bottom line headed in the wrong direction.

More worrisome, while Apple earned a cool $7.5 billion in net income during the quarter, it's hard to ignore that rival Samsung Electronics  turned in a whopping $7.74 billion -- not bad for a company that makes "cheap plastic phones," eh? But more seriously, the faster Samsung's profitability continues to skyrocket, the more it can spend in R&D and marketing, and the more it can extend its reach. And, thanks to the fact that Samsung in-sources plenty of the high-cost parts for its phones, it will have precisely zero problems engaging in, and winning, any price war in any tier of the mobile market.

At the very least, Apple would be wise to stop sourcing its iPhone/iPad parts at Samsung, if possible. For instance, it would be a shock to not see Taiwan Semiconductor get the orders for the next-generation "A" chips in order to try to cut off Samsung's logic foundry profits.

There's still hope, though
Despite this negativity, not all is lost. Apple's iPhone 5s backlog is sizable, and Tim Cook hinted on the call that during the course of 2014 Apple would begin to participate in device categories that it currently doesn't play in today. For example, this could very well mean larger phones, cheaper phones, convertible tablets, and so on.

Apple's brand is clearly very strong, and whenever the company chooses to compete in a given market/price point, it is very quick to win over the hearts and wallets of consumers. Could a bigger iPhone take back even more share from Samsung? Probably! Not to mention that next year, the iPhone and Mac lines are due for brand new industrial designs, which could further spur sales simply by virtue of being "new."

Also be aware that Cook hinted pretty strongly at perhaps an even more aggressive capital allocation strategy to be announced next year, so that could at the very least continue to attract more conservative, income/value-oriented investors.

Foolish bottom line
Apple is a superb company that really does create best-in-class products in whatever categories it happens to play in -- there's no doubt about that. The problem now isn't about the company's business necessarily falling off of a cliff, but there are very legitimate concerns that competitive pressure will continue to mount and that the growth engine may fail to get restarted. Apple is a solid company, and 2014 may prove to be a blockbuster. But for now, it's tough to see what could drive meaningful upside to the shares over the next several years.

Is Apple over? Or is it readying its next act?
Apple has a history of cranking out revolutionary products... and then creatively destroying them with something better. Read about the future of Apple in the free report, "Apple Will Destroy Its Greatest Product." Can Apple really disrupt its own iPhones and iPads? Find out by clicking here.

The article Apple's Not in the Clear, But There's Still Hope originally appeared on

Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of 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.

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