Monday, November 07, 2011

Apple: For What It’s Worth, Part II

“All I said was I liked the pen…”
—Jerry Seinfeld, “The Astronaut Pen”

 We considered naming this follow-up to last month’s “Apple: For What It’s Worth” column after a different song than the Stephen Stills classic—something more current, more relevant and just plain zippier…something, say, by the Arctic Monkeys (which, as long-time readers know, is the adopted house band for this virtual column).
 And the Monkeys’ “D is for Dangerous” would have certainly fit, because, as it turned out, we were treading on dangerous turf merely by pointing out one interesting bit of data regarding Apple that was not going—as all things Apple have been going—“up and to the right,” to use one of Wall Street’s Finest favorite expressions.
 Specifically, we highlighted the fascinating, abrupt slowdown in last quarter’s sales growth at Apple’s retail stores, along with the (literally unprecedented, for Apple) year-over-year decline in profits from those stores, plus the fact that not one of Wall Street’s Finest asked a question about either of those facts on the subsequent earnings call (no surprise there, really).
 Turns out we probably should have stuck with the good stuff—like pointing out that our August 2010 prediction, reported here, that iPad sales could hit 50 million a year shortly (at a time when Wall Street’s Finest were saying 15-20 million for 2012), looks on target: the 2011 calendar year number should be 40 million; 2012 north of 50 million.
 But we did not point out the great iPad sales, because, after all, everybody knows how well the iPad is doing—although there’s something interesting in the Amazon.com tablet rankings…well, never mind about that—and the modest blemish of a shortfall in the retail channel seemed far more interesting from an analytic point of view: we’d never seen numbers shift so quickly at a high-quality retailer.
 The reaction here was swift and, in most cases, harsh—mainly along the lines of “Everybody knows Apple missed sales because everybody was waiting for the new iPhone and Tim Cook said so and you don’t get it and who are you to say Apple is falling apart…”
 The whole thing called to mind the Seinfeld “Astronaut Pen” episode, when Jerry admires his father’s neighbor’s pen, “the kind the astronauts use” so the neighbor gives Jerry the pen but regrets it so much he later claims Jerry stole the pen, which causes a fistfight at a banquet given in Jerry’s father’s honor, and when Jerry is pushed to the microphone by his mother to calm things down, he finally pleads, “All I said was I like the pen…”
 And all we said was, “Apple’s retail stores seem to be losing their mojo.”  That’s all.

 For the record, we’re big fans of the Apple stores—although initially, when the company began rolling them out in 2001, we would have put money on their being doomed to failure.  Running a good retailer is a lot harder than it looks, and Dell had already been taking share from brick-and-mortar operators by going the opposite route—selling direct.  In those days, the disintermediation of the Best Buys of the world seemed like a forgone conclusion.
 But Apple’s retail stores are, in no way, shape or form, comparable to the Best Buys of the world.
 Apple zeroed in on the customer experience like no other retailer since Nordstrom (see a really excellent history here), and as the product set grew from Macs to iPods to iPhones, and as Windows users became reacquainted with the Apple brand thanks to those non-computer products, the stores became Apple’s best weapon in shifting computer market share away from Microsoft: they provided fed-up but hesitant Windows PC users the ability to get comfortable with Macs in an environment that offered terrific, low-key help with no sales pressure.
 Contrast the experience at an Apple store, where even grey-hairs wander inside to browse, check their emails or ask for help, with the experience at a Best Buy, whose business model has become so dependent on selling extended warrantees that a mildly non-tech-savvy consumer wouldn’t go inside to ask for help if they were being held hostage by a crazed gunman in the parking lot:

Best Buy Sales Salesperson:  “Welcome to Best Buy!   How may I help you?”
Hostage:  “I’m being held hostage by this crazed gunman.” Best Buy Sales Salesperson:  “Do you need an extended warranty on anything?”
Hostage: “No, I need you to call the police.”
Best Buy Salesperson:  “I can’t help you there, but perhaps that crazed gunman next to you needs an extended warranty on his sawed-off shotgun?”
Crazed Gunman:  “You sell extended warrantees on sawed-off shotguns?”
Best Buy Salesperson: “Certainly, it’s all part of our slogan, ‘Customer Centricity’!”
Hostage: “What do warrantees on sawed-off shotguns have to do with ‘Customer Centricity’?”
Best Buy Salesperson:  “‘Customer Centricity’ is about carefully listening to the customer’s needs, evaluating the most relevant options to deal with those needs, and then selling him or her an extended warranty.”
Hostage: “I don’t need an extended warranty.  I need the police.”
Best Buy Salesperson: “I can’t help you there, but I can explain the fake benefits of our extended shotgun warranty, which covers any make or model shotgun except those that have been fired, handled, pointed, dropped, dismantled, aimed, loaded, touched, looked at, rented, borrowed, purchased—”
Crazed Gunman, turning gun on himself: “I can’t take this anymore.”
Hostage, grabbing the gun: “Me first.”

 Not for nothing Apple stores as small as 4,500 square feet of selling space with a handful of young, mild-mannered Apple enthusiasts outsell Best Buy stores with 45,000 square feet of fire-breathing, warranty-selling salespersons on the prowl.
How then to explain the sudden, one-quarter fall-off in sales growth at those stores?  There are three reasonable explanations:
 For starters, Apple has been warning for some time that extending its iPhone sales to telecom carriers around the world would affect the growth in Apple’s own retail store sales.  And indeed, most iPhone users we know bought theirs at Verizon or AT&T, not directly with Apple.  However, this channel saturation has been going on for a couple of years and wouldn’t explain the fall-off from a +36% sales gain to a mere 1% sales gain in one quarter’s time.
 Second, as readers noted (and as spelled out in this chart-happy piece here), Apple’s sales were coming up against very tough comparisons thanks to the timing of past product launches when the iPhone 4S glitch occurred. While this is a reasonable mathematical explanation for part of the slower sales growth, it does not explain the sudden drop in profits: after all, difficult sales comparisons on their own don’t tend to lead to significant profit declines for retailers.
 Third, as we noted in “For What It’s Worth”—and as many readers reminded us—Apple’s iPhone sales were stunted by as much as $1.5 billion last quarter as customers waited for the “iPhone 5” (expected by many to be the first LTE iPhone) which didn’t hit stores until October as the iPhone 4S.  Indeed, we know several people who waited, and now own the 4S.
 Still the impact on the retail stores from the delay does not alter the picture as much some might have thought.  Apple’s retail stores comprise a bit more than 10% of total Apple sales, and it is a good bet that the stores sell a lower mix of iPhones (after all, you can buy an iPhone or iPad at Verizon and AT&T, but not a Mac).
 Therefore, of the $1.5 billion in theoretical “lost sales” from consumers holding off for the iPhone 4S, a maximum of $150 million might have come through the stores.  Add those deferred 4S sales back to the reported sales, and the meager 0.8% increase in year/year retail store sales becomes a 5% gain—which is, still, a significant fall-off from the 36% of the previous quarter.
 Furthermore, the unheard-of 26% decline in store profits in the quarter would have only been reduced to a 15% drop, adjusting for the lost 4S profits. That’s still a record profit decline at the retail stores—even worse than the 12.8% drop during the heart of the financial crisis.

 So, yes, we know Apple’s iPhone sales were up against difficult comparisons; yes we know Apple’s stores do volume that any retailer would kill for; yes we know Apple has the biggest share of smartphone gross profits; yes we know Apple is taking market share like you dream about; yes we know the retail stores are a small minority of the company’s overall sales; yes we know Apple is still growing faster than any peer, whatever the @%#@# some lousy #%$##@#@ says.  (Indeed, we’ve had fun over the years highlighting Microsoft’s failed efforts to dent the iPhone juggernaut, here.)
 But to a retail analyst, any abrupt slowdown—for whatever reason—matters.  After all, no retailer—except, maybe, Sears—plans for a decline in profits.  And we’d bet the decline in profits—as well as the flattening out of visitors to the Apple stores—was not in the company’s budget.
 As for the current quarter, nobody should expect a further year/year slowdown in Apple retail store sales.  For one thing, the 4S is making up for the lost sales right now; for another, there was the “buy one for Steve” mantra of many Apple faithful—including Apple co-founder Steve Wozniak, who was first in line at his local Apple store to buy a 4S as a show of support following Jobs’ October 5th death.
 Furthermore, Apple just opened two more stores in China, and those are among the most productive retail stores in the world, for any retailer (estimates run well north of a quarter-billion in sales each, annually).
 And if Apple, as expected, adds China Telecom to the mix…well, the retail store numbers should pick up, and pick up a lot.
 So expect nothing but positive updates on Apple in these virtual pages, like the fact that in the last week of October of 2011, the iPad held 2 of the Top 10 tablet spots at Amazon.com, compared with 6 of the Top 10 tablet spots in the last week of October 2010.
 Oh, wait a minute—that’s not actually positive, is it?
 Nevermind...

Author “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”
(eBooks on Investing, 2011)    Available now at Amazon.com


© 2011 NotMakingThisUp, LLC
                                                             
The content contained in this blog represents only the opinions of Mr. Matthews.   Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.  This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever.  Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored.  The content herein is intended solely for the entertainment of the reader, and the author.

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14 comments:

Anonymous said...

So a 15 percent drop is still better than Best Buy?

Benedict Evans said...

Apple discloses Mac unit sales for retail ('CPU'). And since they also give total CPU sales and total Mac Revenue, you can estimate a Mac ASP and hence back out a pretty good guess at the percentage of retail revenue that comes from iPhones versus Macs. On my numbers, maybe 60%. I have some (lots, actually) of charts on this, but the bottom line is that Mac retail sales have been steady -to-increasing and non-mac have not - fewer visits per store, lower revenue per visit, lower non-mac per store sales...

On the other hand, you don't know what proportion of people are going into the stores to browse and then buying from a MNO shop, especially as distribution expands.

Anonymous said...

Apple stores have more than one function!

Not just retail sales.

It is a gathering place to get help with Apple's products, a window into its products, a place where one get Apple's products fixed, etc. etc.

It is place to attract people who in the long-term become become Apple's customers and keep them coming back!

fivetonsflax said...

I bought my iPhone at an AT&T store in SoHo, New York. Why? The Apple store's entire allocation was being bought out daily for resale in China. I literally could not get a handset there unless I was willing to spend the night on line.

wsf said...

Well said.

And props for using "comprise" correctly.

Anonymous said...

On the iphone at different carrier issue- maybe the drop off in sales is due to launches with INTERNATIONAL carriers, since my understanding was alot of iphones were being sold in the US for grey market export/unlocking and used in other countries..... presumably these sales were at apple stores, not from the US carriers who had agreements with Apple.

Anonymous said...

I would add the effect of some very good android and windows phones becoming available compared to the aging iPhone 4 which has been on sale for about 16 to 18 months on ATT and 6 months on Verizon and STILL Apple is not shipping a 4G LTE phone.

Speed sells.

Anonymous said...

You need to set foot in an Apple Store and realize how crowded they are.

And you need to realize Apple has already done all it can to maximize sales per square foot. It sells nearly two times more per sq. foot than the number 2 retailer, Tiffany & Co.

Then you need to actually listen to the conference call and read the 10k.

It was stated in a number of ways that Apple would be opening larger stores and expanding existing stores.

The conclusion is that Apple retail has hit a physical limit on how much they can sell per square foot. Their next move is to grow the stores.

So you can calm down now. You're not seeing something that everyone else is missing. People just realize there is a simple explanation.

Jeff Matthews said...

Anonymous:

Apple stores are always the most crowded in the mall, but hitting physical limits on store sizes does not cause sales growth to stall in a 90 day window, nor does it cause profitability to decline.

Relax, it's one data point.

JM

Kim Rampling said...

Would it have anything to do with the pace of new store openings?

New South Wales in Australia now has 7 Apple stores out of a total 13 in Australia.

Six of those NSW stores are in the greater Sydney area, of which the current projected population for 2010 is 4.5 million.

Same store cannibalization perhaps?

Bob Schriver said...

Business Week pointed out that the hour by hour real time data from the retail stores helps drive production forecasts adding to Apples supply chain advantages over it's competitors. While you wouldn't build that much retail infrastructure purely as a market research / market monitoring utility, it doesn't hurt. Bob

Anonymous said...

Hi Jeff - if you look at Apple's fiscal Q4 of 2008 (in its 10-K) you'll see that retail segment EBIT was $301mm, a big drop from 2007's $405mm. So there is precedent for this sort of a drop. Q4 2008 margin fell to 17.5% vs. Q3 2008 20.6%, Q2 2008 23%, and Q1 2008 23.8%. Retail segment Q4 2009 EBIT margin also dropped (16.9%) vs. other quarters in 2009. (This did not happen, however, in Q4 of 2010.) I wonder if there is some sort of one-off that takes place in Q4 relating to store worker compensation or other event that depresses retail margins (most of the time) in Q4?

You have a precedent at Apple for the "tough comps" argument relating to the retail segment. If you looking at Q2 of 2009 sales growth was -5%, vs. retail segment sales growth of 111% in Q2 of 2008 - but I'll grant you that the weak macro was probably also a contributor in that quarter.

Anonymous said...

Hi Jeff (part 2) - another thing I noticed from the 10-K: Apple opened 30 stores in Q4, more than in any quarter since Q4 of 2008. Pre-opening expenses associated with these stores may explain part of the margin hit in the quarter.

Jeff Matthews said...

Anonymous: recall that Apple began deferring some revenue on the iPhone to account for software upgrades, and this was changed back after FY09. Not sure if this affected the comparison in Q4 '08...but recall that Q4 of 2008 was when the financial crisis hit.

Your observation that pre-opening expenses for 30 new stores could well have accounted for a slug of the profit drop in 4Q11 may be right.

Cheers,
JM