Apple Inc. Investors Should Keep Their Eyes On The Ball

Investors who focus on Apple Inc. (NASDAQ:AAPL)’s fundamentals could have a big advantage over the rest of the market.

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WASHINGTON, DC — It’s no secret that Apple (NASDAQ: AAPL.US) is one of those battleground stocks where bulls and bears have dug in on both sides and are holding their ground. Many people have strong feelings about Apple’s products — either they love their iPhones and iPads, or they think Apple gadgets are dated and overpriced — and this usually determines whether they like Apple stock.

Obviously, Apple’s competitive positioning (particularly vis-a-vis Android phone and tablet vendors) is very important to valuing Apple stock. However, what ultimately matters is how much profit Apple will earn, both now and in the long run.

Products like the iPad arouse strong emotions in many investors. (Photo: Apple)

Unfortunately, many investors seem to be getting blown off course, focusing on statistics that have no clear relationship to earnings. Instead, long-term investors should tune out the noise and focus on Apple’s potential for earnings growth — since that will determine whether Apple is a good or bad investment.

The market share argument

One common source of “noise” is the periodic release of market share statistics. Many Apple bears harp on the company’s falling market share in the smartphone and tablet markets. However, Apple’s falling market share is not nearly as important as many people assume.

The problem with evaluating Apple based on market share is that it only really competes at the high end of the smartphone and tablet markets. Both markets have been booming in the past few years, but the vast majority of the growth is at the low end of the market.

A proliferation of smartphones and tablets priced in the $100-$200 range (unsubsidized) have led to big gains in unit sales for vendors that participate in the low end of the market. However, these devices are priced at or very close to cost, whereas Apple earns a healthy margin on every iPhone and iPad sale.

iPhone sales are still growing, even if Apple’s market share is falling. (Photo: Apple.)

The result is that Apple is missing out on a lot of sales volume but not much profit. Thus, Apple’s falling market share isn’t necessarily a problem.

Some bears argue that Android could gain a competitive advantage from its high market share by becoming the preferred platform for developers. However, people don’t buy $200 smartphones so they can save hundreds of dollars to spend on apps! Most app spending comes from people with high-end smartphones. Thus, iOS remains a huge cash cow for mobile developers — Apple paid out a whopping $2 billion to developers in the December quarter.

In summary, market share is a bad yardstick for measuring Apple’s success. Apple investors can be perfectly happy in an environment where Android vendors are posting big gains in sales and market share — as long as Apple’s revenue keeps growing and margins remain roughly stable.

The “best in the bunch” argument

At the other end of the spectrum, some Apple bulls focus too much on the profitability gap between Apple and many Android device manufacturers. While it’s true that Apple is much more profitable than most of its competitors, this can provide false comfort to Apple investors — because the key fact is that Apple’s profitability is falling.

For example, it’s true that Android tablet vendors have boosted sales primarily by introducing cheaper and cheaper devices. While unit sales have skyrocketed, most Android tablets are sold at breakeven or very close to it. This makes the Android tablet market fairly unattractive from an investment perspective.

However, the fact that Android tablet manufacturers have terrible profit margins isn’t necessarily good for Apple. The availability of very capable Android tablets for very low prices has clearly had an impact on iPad sales and profitability. Total iPad revenue grew just 3% in Apple’s most recent fiscal year because of a steep drop in the average selling price and a slowdown in unit sales growth.

Android tablets are disrupting iPad sales, even if they aren’t generating much profit. (Photo: Apple.)

There’s no prize for being the best company in an industry with declining profitability. Apple may be better off than most potential competitors, but that didn’t prevent it from registering a double-digit earnings decline in FY13.

Block out the noise

Apple doesn’t need to fight tooth and nail with low-end Android vendors for smartphone and tablet market share to produce a good return for long-term investors. In fact, Apple is better off continuing to focus its efforts on the upper half of the market.

That said, Apple investors shouldn’t be satisfied with the recent trend of stagnant to declining earnings. In that context, the fact that Apple is still far more profitable than other device manufacturers is irrelevant.

So what should Apple investors be looking for? First, Apple needs to be able to grow iPhone and iPad sales — even a high single-digit rate would be acceptable — while keeping margins roughly steady. By this metric, the iPhone seems to be successful, but the iPad is falling short.

Second, Apple needs to diversify its revenue base by introducing new products that will catch on with consumers. CEO Tim Cook has repeatedly promised in the past year that Apple will introduce new product lines before the end of 2014. Now investors just have to wait to see what Apple has developed, and whether it will be successful.

Foolish bottom line

Apple bears correctly recognise that the company is not in as strong a position today as it was even two years ago. However, the problem is not that Apple is losing market share, but that it has been forced to sacrifice some of its profit margin to remain competitive.

Meanwhile, Apple bulls wisely ignore the market share statistics but gloss over the fact that Apple’s earnings are well below 2012 levels. Clearly, something is wrong, and pointing out that Apple is still the most profitable mobile device manufacturer is beside the point. Investors who can tune out this noise and focus on Apple’s fundamentals will have a big advantage over the rest of the market.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Both Adam and The Motley Fool own shares in Apple.

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