Apple’s Terrible No Good Very Bad Earnings Warning

Wednesday, 2 January 2019

“Letter From Tim Cook to Apple Investors”, published this afternoon on Apple’s Newsroom:

Today we are revising our guidance for Apple’s fiscal 2019 first quarter, which ended on December 29. We now expect the following:

  • Revenue of approximately $84 billion
  • Gross margin of approximately 38 percent
  • Operating expenses of approximately $8.7 billion
  • Other income/(expense) of approximately $550 million
  • Tax rate of approximately 16.5 percent before discrete items

Apple’s initial guidance for the just-closed quarter, issued two months ago:

  • Revenue between $89 billion and $93 billion
  • Gross margin between 38 percent and 38.5 percent
  • Operating expenses between $8.7 billion and $8.8 billion
  • Other income/(expense) of $300 million
  • Tax rate of approximately 16.5 percent before discrete items

I’m sure Cook had to reissue all aspects of their adjusted guidance for legal reasons, but the only one that is off is revenue, and it’s off by a lot: $7 billion from the middle of Apple’s projected range, and $5 billion from the lower bound.

This is bad news, pure and simple, and for Apple, truly extraordinary. The last time Apple issued an earnings warning was in June 2002 — which is so long ago that it predates Daring Fireball by two months.

Cook:

While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China. In fact, most of our revenue shortfall to our guidance, and over 100 percent of our year-over-year worldwide revenue decline, occurred in Greater China across iPhone, Mac and iPad.

China’s economy began to slow in the second half of 2018. The government-reported GDP growth during the September quarter was the second lowest in the last 25 years.

It’s easy to say “OK, it’s just China”, except that China is Apple’s only hope for iPhone sales growth. The truth seems obvious: Apple reached peak iPhone unit sales a few years ago, and now that they’ve peaked, when something goes wrong in a major market like China, it’s going to result in an overall decline in sales.

We believe the economic environment in China has been further impacted by rising trade tensions with the United States.

Translation: Donald Trump.

While Greater China and other emerging markets accounted for the vast majority of the year-over-year iPhone revenue decline, in some developed markets, iPhone upgrades also were not as strong as we thought they would be. While macroeconomic challenges in some markets were a key contributor to this trend, we believe there are other factors broadly impacting our iPhone performance, including consumers adapting to a world with fewer carrier subsidies, US dollar strength-related price increases, and some customers taking advantage of significantly reduced pricing for iPhone battery replacements.

That’s an eye-catching admission — it sure makes it sound like the old way of handling battery degradation (throttling performance to keep the iPhone working at all, but not informing the user what was happening or why) was intended to drive people to buy new phones. I don’t think it was, but it effectively became a side effect Apple was happy with until it blew up into a controversy. Cook is even making this same point in an interview on CNBC now. I think that’s the wrong way to play it — Apple should be proud that you can get two or three extra years of great performance from an older iPhone with a relatively inexpensive battery replacement, not pointing fingers at the program as a reason for slower sales this quarter.

The problem iPhone sales face is not a lack of innovation. But I’m sure the interwebs are already full of arguments that this is the reason. People have been arguing that year-over-year iPhones weren’t innovative enough every single year since the iPhone 3G, with the possible exception of the iPhone 4 in 2010, which introduced an obviously amazing retina display and an all-new vastly superior industrial design. Except instead of complaining about “innovation” with the iPhone 4, the same critics just made a mountain out of the antennagate molehill.

iPhone sales have effectively peaked for two reasons. First, Apple ran out of new markets to conquer years ago. The iPhone is effectively available worldwide. The astounding go-go growth of the iPhone in the early years was largely about their steady expansion into new countries around the world. Matt Richman put the insane growth of the iPhone in the early years into perspective seven years ago:

In 2009, Apple sold more iPhones than it did in 2007 and 2008 combined. In 2010, Apple sold more iPhones than it did in 2007, 2008, and 2009 combined. Last year, Apple sold 93.1 million iPhones, slightly more than it did in in 2007, 2008, 2009, and 2010 combined. The pattern continued.

But there’s a limit on the number of people in the world who (a) want an iPhone and (b) can afford one, and the iPhone reached that 3-4 years ago. A bad economy in China significantly shrinks the number of people worldwide who can afford one. They’re much in the position Microsoft got to with Windows and PCs — they’re no longer an upstart growth company and are now a massively profitable blue chip.

The other factor is that the modern — that is to say post-iPhone — smartphone market is 11 years old. It’s maturing, and in a mature market people replace devices less frequently. In the same way MacBooks last for 4-5 years or more for many (most?) people, iPhones now last 3-4 years easily. Durable hardware with future-proof chip performance, combined with Apple’s redoubled effort to make sure iOS 12 runs well on older hardware — these are good things for users and for the long-term reputation of the iPhone, but by definition they lengthen upgrade cycles.

Apple could not have picked a worse quarter in which to stop reporting iPhone unit sale numbers. They should have picked a quarter when sales were higher than expected, or at least in line with expectations. Picking a quarter in which iPhone sales fell short will only fuel the notion that they’ve stopped reporting unit sales because they have something to hide. Given how far short iPhone revenue is for this quarter, even I find myself wondering if that’s why they’re changing this policy now. It’s un-Apple-like to make a long-term change for short-term reasons, but you can’t ignore the optics on the timing.

I called “bullshit” (literally the word I used on my latest podcast) on the last two months of “iPhone sales are slower than Apple expected” stories and clearly I was wrong. I still think most of the reports were bullshit — particularly the ones based on reports from Asian suppliers — just bullshit that happened to turn out right for once, like a stopped watch getting the time right twice a day.

One analyst who definitely got it right, though, was Rod Hall at Goldman Sachs. His research note downgrading Apple back on November 20 looks remarkably prescient today.