Apple AAPL Earnings Preview

   

Apple (AAPL), one of the most iconic technology companies in the planet, has performed extremely in the past year but now faces incredible challenges. The main problem: It has executed so well that it has created a level of expectations that may be too lofty in an increasingly competitive environment.

While I’ve been positive on the company and stock for years, I’ve never been more concerned about its prospects. Let’s explore the situation, starting with a bit of background.

Over the past three decades, Apple has revolutionized three industries: personal computing with its Macs, the music industry with iTunes, and the cell phone industry with the iPhone. Now the iPad aims to create a new class of mobile devices for consuming media in places where the large screens of a television or desktop are inconvenient and a phone is too small. 

Near term, a lot of the investment choices about Apple are going to rest on the success of iPad since it is the company’s marginal new product, and skeptics have wondered if there really a need for a device between the smart phone and the PC. So far, customers have answered the question with a resounding yes. The iPad blew out estimates and sold 450,000 units on the first week with a device on which one can surf the web, write docs and enjoy music, video, and games in a large format. 

Apple iPad – Seeing is Believing

I tried the device at a local Apple store and was blown away by its screen, as it provided a much richer photo and video experience than I anticipated. I went in very skeptical, but came away thinking it might be the best way to consume news and photos that I have seen. The richness and depth of the colors are intensely deep and lifelike — much different than either a computer or TV flat screen monitor, or in the case of photos, paper. 

A key problem with the iPad is its weight; it’s pretty heavy to hold in your hands for an extended period. The natural place to use the iPad will be a couch or armchair where you can rest it on your knees and interact with the screen at arm’s length. Not coincidentally, there is no other device that really fits this role. It will probably be very popular on plne flights, and in fact I bet that people who do not have to use a notebook computer for actual work while traveling will discover that this device will be a great substitute: smaller and lighter, but perfect for light work and entertainment.

Apple has tried to capitalize on its success with iPhone until now by forcing developers to develop applications that only run on its operating system. Software giant Adobe Systems (ADBE) recently released Creative Suite 5, which is a design program with a cross-platform compiler. This software would allow a developer such as Netflix to easily develop an application for the iPhone operating system that also easily ports to Google’s Android phone operating system, or any other smart phone OS. 

Because it is the apps that make the iPhone/iPad, Apple has shut out content built with cross-compilers, and that has shut out all Adobe products, including the super-popular format called Flash which forms the basis for 90% of the videos seen on the web. Chief exec Steve Jobs claims that applications that can run on multiple platforms are substandard because they do not fully utilize all Apple’s coding tools. Yet this argument disguises Apple’s real motive: The firm aims to benefit from its first-mover advantage by disallowing any software that can be run on competitors’ platforms. It’s very anti-customer — I couldn’t see any New York Times videos when browsing to the NYTimes.com website on the iPad, which was irritating — but creates a business moat.

AAPL Closed System May Cause Trouble

While this seems smart on some level, it is very short-sighted. A closed system discourages developer innovation and is likely to fail in the long run. Apple ran into this same problem in the 1980s. It developed an excellent operating system for personal computers but focused too much on controlling all the details. Microsoft gave individuals the power to customize their computer. People like choice, and in time Windows become the dominant operating system by a 9 to 1 margin. 

Apple may be making the same mistake by requiring applications to be made specifically for the iPhone/iPad platform. Android is free and allows developers incredible flexibility to develop applications. Unlike Apple, Google doesn’t take a large cut of developers’ revenue, letting them generate far more profit, and that incentivizes them to create new Android applications. Moreover, the Google (GOOG) mobile phone OS can be found on Verizon (VZ), Sprint (S), AT&T (T), and T-mobile platforms, while iPhone is exclusively offered by AT&T. 

Whichever company is able to become the dominant smartphone platform — whether through a closed or open system — stands to profit on the same scale as Microsoft did with its Windows OS. This is a really important battle.

As Apple’s revenue streams are shifting from desktop computing to mobile devices, holding the leadership position is crucial. Nearly 50% of Apple’s total revenue will come from sales of the iPhone/Pad and surrounding software and accessories by 2011. At present, it’s around 27%, with the rest coming from desktop and laptop computers. So the stakes are high.

Apple is also facing challenges on the mobile advertising front, a huge potential revenue stream that no company has been able to dominate so far. Google recently acquired adMob, a mobile advertising firm that launched the first web based ads for the iPhone and also has the capability to launch ads from applications. With the introduction of new smartphones from Palm, Nokia, Blackberry and the Android complex, Google plans to use adMob’s first mover advantage to generate tremendous growth in mobile advertising through web- and app-based advertisements. 

Apple Looks to Ad Sales

However, Apple is fighting back. Last week, Jobs unveiled iAd — a new technology aimed at combining the emotion of television and the interactivity of internet ads. Theoretically, iAd will create a richer content experience by using the HTML5 protocol instead of Flash. Adobe Flash is the most widely used animation product with market penetration over 80% but is somewhat buggy and hogs a lot of system memory. People will be interested in clicking on iAds because they do not close the open app. 

Apple decided to take a real gamble with iAd by stating, at least initially, that it plans to grab a much higher percentage of ad revenues than analysts believe it deserves, around 40%. While that’s good for Apple’s P&L, it is another act that reduces incentives for developers to produce innovative advertisements for the iPhone/iPad line. Google demands a much smaller cut of ad revenues, and plans to make up the difference on volume. 

This ad differential will become an important battleground, as the Apple vs. Google battle escalates in coming years. Ad views on Android devices doubled from November 2009 to February 2010, according to reports in large part because they’re sold by so many carriers who consider them their hottest devices. Over the same time period, iPhone ad views reportedly dropped by a third as it is tied only to AT&T.

Apple will also face increased competition for its iPad as rivals enter the “slate” computing market. That’s the term du jour for the slew of iPad-type devices on track to be released in the next six months by Google, Nokia, Microsoft, Hewlett Packard and others. Until now, Apple has always made the coolest devices — slick, beautiful and fast — but it will be exceedingly hard to maintain that edge. So many much-desired pieces were left off the iPad — including a camera, a USB port and Flash capability — that it really left itself open to competition this time.

iPad Faces Off With WePad

We won’t have to wait too long to see a rival at the door. This week, a German company called Neofoni introduced its iPad competitor, called the WePad, that has a bigger screen, a webcam, and two USB ports that allow connection to PCs, a mouse and cameras. The Wepad also runs on open source Linux , which is compatible with Google’s Android OS and all flash applications. The device hits stores in July and offers nearly all the features of the iPad except for apps unique to the Apple platform. You can bet Linux developers will swarm this device with iPhone-like apps if they think it can get traction.

In short, Apple is in fascinating position: Absolutely dominant and absolutely vulnerable. Its apps, devices and marketing are the best, but its partner reimbursement system does not motivate developers and runs the risk of stifling innovation for Apple products. Google’s open source Android operating system is very flexible and will gain market share quickly, especially with its ability to operate on many different platforms, and even it will be pressured by competitors like a WePad running Linux.

As an Apple shareholder, I hope that the company can find a path soon toward competing with Google and the others in the open market rather than on its closed track because history has proven repeatedly that open ultimately wins.

Despite all these challenges in the long term, let me now add that in the short term Apple’s prospects remain very good. Analysts expect Apple to earn $14 a share in 2011, resulting in a P/E of about 17, which is very low for a high-quality, high-growth company. Moreover analysts have consistently underestimated Apple’s sales and earnings, so the forward PE is actually more like 14. 

Assuming earnings are underestimated by 20%, as usual, due to higher iPad and iPhone sales, and then applying an industry average multiple of 17, Apple should be priced at $330 by next year. But with tremendous competitive challenges lying ahead, it will have to summon all its magic now to get there. It’s a buy on any weakness following the earnings report.

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Article printed from InvestorPlace Media, http://investorplace.com/2010/04/apple-aapl-earnings-preview-ipad-iphone/.

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