Apple Explained, Part 1: In Steve We Trust
Part One: In Steve We Trust
Before we begin this week's Apple Trader column I'd like to request that we all bow our heads in a moment of silence for our fallen IRAs and trading accounts and most of all for our poor brethren who bought on margin and are no longer here with us today. May the almighty dollar rest their souls. Amen.
We'll start today's Apple Trader sermon with a parable of perception. Below, you'll see a nice little bunny I've drawn...
Or is this rather oddly sketched bunny really a duck looking off to the upper right of the page? Once your mind sees a bunny, it's hard to shift to a duck. But when you finally see the duck, you can no longer see the bunny. The shift in perception happens in an instance.
In fact, the picture is of both a duck and a bunny, but the mind's eye can perceive only one identity at a time. What does a lousy cognitively shifting duck/bunny have to do with price of Apples on the Nasdaq? Everything.
A Story of Two Apples
On Thursday during market hours Apple's stock was in rally mode after what in retrospect seems a minor downtrend. Walter Mossberg, the highly respected "personal technology" columnist for the Wall Street Journal, wrote an in depth review: "Apple's Design Delight: The Cube is Beautiful, Silent and Powerful".
The first line of the article begins thus, "Apple has done it again. The company that has long stood for style and innovation in a sea of industrial, me-too computers has now introduced a top-of-the-line, powerful machine that is simply the most gorgeous personal computer I've ever seen or used. And I've seen most of them." Normally, Mr. Mossberg isn't the gushy type.
On Thursday during market hours Steve Jobs was a hero. Analysts and pundits claimed Apple had completed its come back several quarters ago and was marching on Wintel strongholds. Mac OS X beta was available and it was insanely great. Apple was the leader of the PC pack in mind and soul share. It seemed only a matter of time before market share followed.
Then the sky cracked open and Apple phase shifted in a blink of the eye into a lemon. Cupertino, with one 429-word press release, wrenched 50% off the market capitalization of Apple that's about $20 million per word.
The panic that ensued among Apple investors on Friday isn't rational. But it's not exactly irrational either, in the sense that the natural human reaction to these types of situations is rather predictable. There is even a physiological basis for it as I've tried to show with the bunny and duck demonstration.
Investors' perception of Apple phase-shifted from the image of a lovely cash cow to that of a fraudulent dog in less than an hour. Within 120 minutes of the fateful news release lynch mobs were fully assembled online. Wired.com egged them on, actually quoting irate investors hurdling invectives at Apple, "A speed bump? That sonofabitch Jobs said this is a speed bump?" The AAPL stock boards were over run with foul mouth short traders, applebashers and hecklers of all stripes. Ah, the niceties of info age culture. It was like being paraded through a medieval city as a prisoner in chains.
A few stunned investors e-mailed me with naive questions indicating that the online trading boom has brought many newbies to the stock market who never RTM. One guy asked how AAPL could be worth 50% more on Thursday than Friday since the company had actually not lost a single asset. For the record: The real or book value of a corporation is always a fraction of its going stock price (market value). The trading price is based on what people perceive the future of the company is worth, not the actual physical value of the corporation's assets. Once again, cognition is the name of the game. Is it a bunny or a duck?
OK, Enough BS, What the Heck Went Wrong?
It's simple. Fred Anderson said that Apple will miss earnings by as much as 30% this quarter due to unexpectedly slow sales. Revenues will be off by about 10%. If the earnings shortfall continues in the current range, Apple could see total earnings over the next year roughly 70 to 100% below what investors signed on for when they bought the stock. That's not a speed bump as Steve Jobs disingenuously labels it. From a risk management point of view it's a washed out road. Fred gave three reasons for Apple's fall from grace.
Reason Number One: "We experienced lower than expected September sales due to a business slowdown in all geographies."
The world economy is slowing. The US economy is slowing. Mr. Greenspan and the geriatric crew of the Federal Reserve have been fighting inflation a phantom enemy from the Industrial Age past by raising the sword of interest rates higher and higher. Meanwhile, a real dragon, in the form of soaring energy prices, has snuck up behind them and threatens to slay their precious economy. Higher oil prices, like higher interest rates, slow growth. The Feds hadn't planned on mixing their prescriptions. The worst case scenario is global recession. But, more likely we are just going to get a good old fashion October market scare and the economy will bounce back thanks to the magic of ever increasing productivity due to never-ending high-tech innovation and global competition like never before. You gotta love it.
Apple has another problem. The low euro to dollar exchange rate makes the purchasing price of a Mac in Europe about 30% higher than it was last year at this time. Although Mr. Anderson didn't attempt to pass off Apple's demand problem on the weak euro, it must be depressing sales in Europe. This may be the first time in personal computer history that PC consumers anywhere are paying more per megahertz now than one year ago.
For the record, Apple isn't the only big multinational corporation to notice unusual softness in consumer demand. The list is long and respectable. It includes Dell, Intel, McDonald's, Alcoa, Dupont and many others.
Reason Number Two. " Second, our Education sales, which normally peak during September, were lower than expected."
Can't blame macro-economic conditions of this one. US schools are ramping up their use of technology in the classroom. No one is really sure how to use IT in schools. Studies show kids learn better from teachers than cathode ray tubes, but it's the politically correct and historically inevitable thing to do. So why can't Apple literally own this market?
Teachers have been e-mailing me for years with complaints about Apple's lack of attention to their needs. One teacher recently wrote, " Apple networking experts are scarce and no active training program exists. Long ago, Apple should have created a regimen for training people in schools to set up and manage Macs and PCs connected to Apple servers. For schools that have Apple servers, supporting this technology is based on subscribing to mailing lists and reading manuals." He goes on to say, "Apple pretends that Macs only get networked to other Macs and Apple servers. Even if that were true, I still don't see dedicated support for modern networking/security issues in schools. Their new security product, Macintosh Manager (which has replaced At Ease), is a total nightmare!" Of course, the Wintel solutions are no picnics either, but this is Apple's home turf and they're losing it.
Just as important, Apple's product release timetable ignores the educational purchasing cycle, forcing harried teachers to haggle with their guilelessly slow administrations to rush order Macs late in the summer, only to see their orders arrive after the first day of school.
Finally, Apple Inside sales is an entrenched bureaucracy with a totally disorganized, even arbitrary managerial system that enervates the often heroic efforts individual sales people valiantly attempt in the name of Apple. The man in charge is Mitch Mandich, VP of Worldwide Sales. This guy has been an ersatz hero for years now because the insanely great Mac products sold themselves creating a feedback loop of rising demand. Mr. Mandich was a great channel slasher, a regular jack-the-ripper, but it may be time to think different.
Apple is hitting its first "speed bump" in demand since pre-iMac days. These are the type conditions that test the readiness of Mandich's sales infrastructure and it has been found to be insufficient for the challenge. After three years of riding a high demand, constrained supply gravy train, Apple Inside sales is ill prepared for the long uphill haul ahead.
Reason Number Three: "Our Power Mac G4 Cube is off to a slower than expected start, resulting in revenues below expectations."
Forecasts for Cube sales this quarter were in the 150,000 unit range. Now, it looks like that number will be closer to 40,000. It's almost impossible to accurately predict how popular a new product, especially a paradigm-buster, will be with consumers. In perfect 20/20 hindsight it's easy to see that Apple has created a marketing paradox with the Cube. It's a sleek, high-price sculpture that best appeals to sophisticated and well-heeled digital age gurus, like Walter Mossberg. But the niche Apple hopes to fill in their product lineup with the Cube is decisively more bourgeois. If Apple had from the start targeted the patrician user, sales forecasts would be in line with today's actual sales. Until Cube prices drop and some details are worked out (Cube has no CD-RW option), the Cube will have more in common with the 20th Anniversary Mac than Performas.
Nevertheless, just because the Cube isn't a stunning success with K-Mart shopper doesn't mean it isn't a stunning achievement or that it won't eventually be a successful product in Apple's lineup. Once again, cognitive expectations mar what is in reality a pretty picture.
The Cube conundrum is so vast and central a topic to Apple's culture it deserves its own in-depth article. The only thing that has to be said now is that Apple must move rapidly to neutralize the hairline seam issue or Cube sales are going to plummet faster than Goodyear tire sales by Christmas.
And now, the Kicker: "We are currently reevaluating our plans going forward, and will provide lower growth targets for next quarter and the next fiscal year when we announce our final results on October 18."
Missing earnings by thirty percent is pretty bad, by itself worth a 25% sell-off in the stock price. But the fact that Mr. Anderson expects the problems to last well into the future guaranteed capitulation by even the most Mac faithful investors and set off the Friday panic.
Waiting for the other shoe to drop
For unknown reasons Apple waited till the last day of the quarter to issue the earnings warning. Mutual funds, which own 60-something percent of all outstanding shares of AAPL, dumped the stock in panicked after hour selling so they wouldn't have to show they were holding a loser in their portfolios. That may not be a very noble reaction, but it is very human one.
Worse, Apple held no conference call with analysts to explain in more than one-liners what the heck is really going on. Instead they're going to let us stew in our juices for 18 more days. Apple has to be more forth coming with the public and the analysts.
For instance, Apple's press release announcing the earnings shortfall does nothing to elaborate on why they estimate revenues will be $1.8 - $1.9 billion this quarter with only $0.33 per share earnings, when last quarter they also made $1.8 billion in revenues, but earned $0.45 per share. One recent investor (now ex-investor) asks, "Is the real deal that their margins are so much lower because of the old products in the pipeline?" Who knows? Apple's not talking.
Normally, when a corporation drops a warning flare with minimal explanation it means there is more bad news ahead. Fund managers have seen this type of behavior before and believe it's far better to wash one hand's quickly of such messes rather than languish in a cat and mouse game with a management that isn't on the up and up.
The gaggle of gratuitous downgrades from almost all brokerage firms covering Apple seems rather punitive. The analysts are royally pissed off at Steve Jobs, who told them to toss their silly metrics and just "trust me on this" during the recent MacWorld. Those who did got burned.
One shouldn't shed too many tears for the financial analysts. It must be an eye opener for retail investors to watch the spectacle of a dozen bumbling clowns rushing to cut their ratings on Apple after the fact. These guys supposively get paid the big bucks for figuring out what is going on in advance, not for alerting their clients of yesterday's big sell-off.
On Thursday AAPL was a "Buy" or a "Strong Buy" or an "Accumulate" at $53 1/2 with price targets of $70 to $90, the next day not an analyst on Wall Street would touch the stock at $25 3/4. It begs the question: If Apple is a "Buy" at $53, why isn't it a "Steal" at $25? Of course, the analysts will tell you things have change, Apple is now a duck, not a bunny.
Perhaps the analysts' half-wit antics in this debacle will help retail investors realize that analysts aren't here to help just anyone divine a stock's future. Their loyalties are with their paying clients, although in this case it appears their paying got chewed-up as well. Every guidance analysts utter in public must always be held suspect.
Who are we going to trust now?
Apple's management must have spotted a negative 30% sales shortfall bearing down on them like a freight train weeks ago and choked. How else can one explain why they waited to the last eve of the quarter then nuked their own market capitalization? Cupertino's insular corporate culture must have been in denial over the lousy sales figures till the very last moment, hoping to pull it out with education sales in the last couple of weeks. When Mandich let them down, they panicked and screwed up the warning process.
Who knows what goes on behind closed boardroom doors? The worst case speculation is that Chief Jobs is so scary and so autocratic that his management vassals had to yield to Job's own rough style of handling this episode. Mr. Jobs, a multimillionaire many times over thanks to the financial markets, is oddly disdainful of Wall Street's ways.
Whatever the reason for the bungled earnings warning with no conference call, it will be a long while before Apple's management regains the trust of many professional and retail investors. Once bit, twice shy.
Your comments are welcomed.