In his open letter of apology to iPhone customers (who were upset that Apple [AAPL] lowered the price of the iPhone from $599 to $399 in less than three month after the launch of the original iPhone in 2007) , Steve Jobs wrote “…the technology road is bumpy.” Describing Apple’s rise from less than $100 billion company to the world’s first and only $700 billion company since the era of the iPhone, “bumpy” is the right word, too.
Most of the up and downs could be attributed to the overall stock market. Apple’s fundamentals (sales and earnings) had been growing stronger every quarter. Since the introduction of iPhone, Apple had not seen one quarter of decline of earnings per share (compared with same quarter one year earlier), even during times of the great recession. That changed in the December quarter of 2012, when Apple’s earnings per share (EPS) declined 0.4 percent. It was a none-linear drop. For the preceding four quarters, the growth rate were 116%, 92%, 20% and 23%. The EPS continued to slide for the following three quarters, at -18%, -22% and -8%. Although most analysts were caught by surprise, the market sensed this almost three months earlier. Since middle September of 2012, the stock had dropped 40% from its then all-time high of $100 before the gloomy earning report.
Even today, I still could not figure out exactly why Apple’s earnings had dropped. That December quarter of 2012 was supposed to deliver the biggest boost to Apple’s top line and bottom line. The company just launched iPhone 5 with two important upgrades: size and speed. The screen size increased for the first time since the launch of original iPhone in 2007, and it would run the faster 4G network. iPhone 5 was also much thinner than previous generations. There was a much bigger user base waiting for upgrades. Just when all the stars were aligned, the earnings disappointed. It was not from the top line, sales continued to grow at 18% for the December quarter. The decline of EPS was due to lowered gross margin. In March of 2012, the gross march reached all time high at 47%. In the December quarter, it dropped to below 39%. Even gross margin would normally drop when Apple introduced a new generation of iPhones, the magnitude of drop was unprecedented. Investors were concerned that Apple’s dramatic rise was officially over, and even worse, decline of the empire officially started. Then you have everything aligned to explain why Apple declined and why Apple should. Samsung was eating Apple’s share and Tim Cook was no Steve Jobs. The decline of gross margin was often a first sign of weakness at competition or saturation of an industry, and Apple just delivered a dramatic decline of margin. However, if people looked deeper, this decline of margin was different from the other situations like PC or Televisions. It is not coming from price cut, but from rise of cost. In other words, it was more a production issue than demand issue. Apple did not cut the iPhone price due to weak demand or lower priced Android phones. It was just that iPhone 5 cost more to produce. The average selling price of iPhone actually increased during that December quarter. The gross margin finally improved with the sale of iPhone 5s one year later. The sale of iPhone 6 and 6 plus of last December eventually brought Apple’s gross margin back to around 40%.
With hindsight, if an investor saw the decline of gross margin during December quarter of 2012 as a random production issue, he could have picked a lot low hanging Apples at 50% discount from previous peak, and enjoyed a ride of more than 100% return after. Unfortunately, during Apple’s fall that winter, the panic spread faster than the flu. Every investor I talked, average Joe or professional, thought Apple’s glory was over.
Now Apple is at another peak, not just measured by its own history, but by history of corporate America. Apple has become the first and only $700 billion company. The road ahead would surely be bumpier. The trouble might be gross margin again, or something totally unexpected. There are “known unknowns”, and certainly “unknown unknowns.”
