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Apple’s Uncharacteristically Sloppy Execution

Posted on Tuesday, Jul 22nd 2008

Apple (AAPL) reported a strong Q3 yesterday that again topped analyst estimates, but its forecast missed estimates. Along with activation and other service issues for the new 3G iPhone and concerns over Steve Jobs’ health, the weak forecast has led to shares falling 11% in after-hours trading to about $149. This is the first time Apple has looked sloppy.

For Q4, Apple expects revenue of $7.8 billion and EPS of $1 versus analyst estimates of $1.24 EPS on revenue of $8.3 billion. Gross margin is expected to decrease from 34.8% in Q3 to about 31.5%. A new accounting system for the 3G iPhone, “future product transition” and the impact of back-to-school promotions are behind this sequential decline.

In the first weekend after launching the 3G iPhone on July 11, Apple sold 1 million 3G iPhones, with many stores reporting stockouts. This compares with sales of 6.4 million first-generation iPhones in the first year of their release, adding 717,000 from Q3. By all indications, the 3G iPhone will do better, although the inventory shortfall will prevent them from doing as well as they could have. This is another situation that feels sloppy to me. Apple has released the 3G iPhone in so many markets, including numerous international markets, without working out the supply-side details – inventory, logistics, tracking, supply chain – very uncharacteristic lack of attention to operational details.

According to iSuppli, Apple is spending $174.33 on components plus $50 in IP royalties per unit while the unsubsidized price is $399/$499 for the 8GB/16GB device. That gives a 44% and 50% margin for each 8GB and 16GB 3G iPhone sold, respectively, although AT&T is selling the phone at a $200 discount against 2-year service contracts. Without an AT&T contract or subsidy, AT&T is selling the iPhone at $599 for the 8GB model and $699 for 16GB. That would imply a gross margin of 62% for the 8GB model and 64% for the 16GB model (at an additional cost of $23 for the 16GB chip). Apple gets an estimated $300 per iPhone in subsidy from AT&T. All in all, the margin numbers across the board look quite healthy.

However, Q4 sales will not be significantly affected by this high margin or by high iPhone sales due to the new accounting method in which iPhone revenue is going to be distributed over two years. This deferred revenue stance will make future revenues predictable, but both current revenue and EPS lower.

As for Q3, revenue was up 38% y-o-y to $7.46 billion, driven by 43% growth in Mac revenue. Net income was $1.07 billion, or $1.19 per diluted share, versus $818 million, or $.92 per diluted share in Q3 2007. Analysts estimated EPS of $1.08 on revenue of $7.36 billion.

Apple generated $1.33 billion in cash during the quarter, ending with a $20.8 billion reserve. Operating expenses were $1.21 billion and gross margin was 34.8%, down from 36.9% last year.

Apple shipped 2.5 million Macs which accounted for 61% of revenue. The updated iMac helped drive 49% growth in desktop sales while portable sales were up 37% due to demand for the MacBook Air as well as MacBooks and MacBook Pros. Gartner and IDC placed Apple in the No.3 spot in the US market, behind HP and Dell, for the second quarter. IDC says Apple has 7.8% share, sharing the spot with Acer, while Gartner puts the figure at 8.5%. Either way, Apple is becoming a force in the US computer market, something that HP and Dell, as well as Microsoft would need to battle in the years to come.

Music products and services accounted for 33% of revenue. Apple sold 11 million iPods in the quarter, up 12% y-o-y and 4% q-o-q, driven by sales of iPod Shuffle and iPod Touch. However, due to lower ASPs courtesy of price reductions, iPod revenue grew just 7%.

International revenue accounted for 42% of revenue. Revenue from Europe grew 43% and from Japan 40%. Asia-Pacific had y-o-y growth of 53% in the Mac business. Apple opened its first store in Australia and last weekend its first store in Beijing, and the company is planning to open stores in Switzerland and Germany in Q4.

There has not yet been any hint from Apple about how it will use its $278 million acquisition of microprocessor design company PA Semi. We have to wait also to see how Apple plans to use its $20.8 billion cash reserve. There is no lack of ambition in the ever-hungry Jobs, but perhaps he ought to acknowledge that he needs help in dealing with the growing pains of his beloved company from people who don’t shy away from the dirty details of operations.

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Apple has looked a bit sloppy recently. What can Apple do to improve operations?

Apple has been growing fast and aggressively, both in its’ currents markets and branching into new ones. Most of the sloppiness came recently around the time of the iPhone 3G launch. Apple just had the single largest sales launch of any consumer electronics device ever, selling 1 million iPhone 3Gs in one weekend. Considering that each and every phone had to be activated was enough to cause problems that would have made any company fall to its’ knees.

That herculean challenge wasn’t enough for Apple. They also upgraded the iPhone OSX software to 2.0, launched the iPhone AppStore, upgraded itunes for all iPhones, ipods, Macs and PCs, and transitioned .mac to MobileMe. That, frankly seems insane. It would have been easier to handle so much if spread over a week or two.

Apple already has Tim Cook as operations chief. He’s one of the best COOs in the business. He’s had Apple executing flawlessly for years. What can he and Jobs do to improve the execution, that has stumbled of late and not lived up to the excellence that Apple is known for.

Apple had enough iPhones on hand to be the largest CE launch ever. During the conference call, they reported that they can ramp up iPhone 3G production very quickly. Their iPhone availability on launch was decent. The minimal loss in potential sales from running out of supply is more than made up in the “I want it but can’t get it” marketing hype.

Given the drastic cut in price, and increase in capability, Apple management knew that they would sell through their stock-on-hand in short order. Apple held back some stock in order to insure opening weekend shortages. That the shortage of product is increasing is a sign that there is sustained demand for the iPhone beyond even Apple’s wildest dreams. There are factory floors in Asia that are at the moment being reconfigured to crank out more iphones as quickly as possible. With all the upcoming geographic launches, Apple will need all the stock of iPhones they can get their hands on. Based on Apple management’s confidence that they reach their 10 million goal for calendar 2008 means that they were already planning to make at least 7 million or more iPhone 3G in the next several months. From the looks of things, they will need many more than that to satisfy demand.

So, I won’t fault the availability of the iPhone. They will continue to have stock throughout the remainder of the year, with stock selling out frequently at many locations. As we approach Christmas, it will become increasingly harder to find an iPhone as the holiday demand for iphones will blow away anyone’s ability to crank them out. Cook is probably trying to maximize production of iPhones as you read this.

That they’ve already sold the most of any product on launch, and can’t make them fast enough is a powerful marketing draw. Knocking Apple operationally because of strong demand is short-sighted. Apple has a proven ability to get millions of desired gadgets into the hands of millions of eager buyers all around the world, usually with a build quality that makes other manufacturers blush.

What I didn’t like so much is that so many upgrades, transitions, and launches were timed to happen simultaneously with the launch of iPhone 3G, that it pushed past Apple’s ability to get it all done without major issues.

That their activation servers could not handle the opening weekend load was inexcusable. That they didn’t transition .mac to MobileMe a week or more before the iPhone is equally enigmatic.

That there would be issues is easy to predict. Having so many launches and transitions and upgrades simultaneously, degrades the company’s ability to quickly and efficiently deal with the issues that do crop up. Launching iPhone 2.0 and the AppStore together with iphone 3G makes some sense, but the iTunes upgrade should have been put through several days earlier. It would have been easier to enable the iPhone AppStore on launch day on an already upgraded iTunes. Having everyone upgrading at once, using up precious server resources that could have gone to phone activation was less than optimal. All those software items should have been gotten out of the way to lighten the load on the servers on iPhone launch day.

All the software should have been working for any Apple employee logging in from an Apple IP address in Cupertino the whole week prior to launch. We all knew enough about the products that whatever little leaked out in the days leading up to the launch would have been of little consequence. That many of the reported issues would have been resolved prior to public launch would have yielded much better PR results.

I am confident that most issues will be dealt with swiftly and will only be a memory in short order. The reality is that the products, both hardware and software are truly amazing, as is the ecosystem that all the parts fit together to create.

They can’t cut back on products or stretch their timetable much. Doing so would have a material impact on numbers, and therefore their fundamentals and stock price.

Plus, they still have so much left to do. They have more products to develop, update, launch, more businesses to branch into, etc. The longer they drag out the current projects, the longer it will take to accomplish all they have in their pipeline.

I would think that their product pipeline is both broad and deep. Apple is only held back by the limit of their resources, that being the staff time of their engineers, developers, and designers. They will not advance any prototype into production unless 1) they can do it well and 2) there is ready and willing market for that product.

You also reported the numbers from Apple’s 3Q results, which were amazing. Any CFO would have loved to be reporting these numbers and would have gladly given up a limb to trade places with Oppenheimer.

To recap. Apple is having trouble with execution. In part because they are having so much success in the marketplace and are just trying to keep up with demand. In part because they are actually creating real products that real people want to own, and this process takes time.

But beyond that, they need to try to avoid missteps. They already have a great COO, so Jobs already has the help of an execution and operations master. What can Apple do to improve their execution?

Apple has grown close to 50% yoy for every quarter for the last several years. From the looks of it, they will continue at close to that pace of growth for at least the next several years. What issues do Cook and Jobs have to be mindful as they lead a company that is growing so fast, and is already so large?

Rarely are companies both as large as Apple and growing at the rate that Apple is growing. Their largest challenges going forward will be of an operational nature. Luckily Cook is the man for the job.

Jobs doesn’t do any of the operational lifting. That’s what they have employees for. Tim Cook is responsible for all those operations.

Jobs was just responsible for insisting on timing everything to launch, upgrade and transition at the same time. There is a method to that madness, but operationally it is just plain madness. Unfortunately Cook is left making sure it all happens. What should Apple do to avoid those operational gaffes?

I would have had one new software item a day (iTunes, MobileMe, AppStore,etc.) almost like fireworks leading up to iPhone launch day. Or even if one insists on doing it Jobs-style, and launching them all simultaneously; all the software should have been turned on and working internally at Apple for all employees for at least one week. There were no secrets to leak, as the world already had a pretty good idea of what was going to be delivered.

I suspect that they just barely got everything done in time, or as it turned out almost everything. Some people laugh when Apple’s Joswiak says that they didn’t get to cut and paste, because they didn’t get that far down their list yet. Looking back at all the launch issues, makes that statement ring true to me.

It sounds like Apple is stretched to the breaking point creating amazing products with great market reception. They probably can’t hire and train engineers and developers in the Apple way fast enough.

Apple’s been a little sloppy lately.
What can they do?
What are the ramifications in the Valley?
What does that mean for their stock?
What does that mean for their products?

You asked some questions. Do you have any answers?

Realtosh Wednesday, July 23, 2008 at 12:29 PM PT

One more thing.

Apple was not working on iPhone 100%. They had and have many folks working on refreshes for all of their lines (iPods, Macs, laptops) plus they have some new goody coming out. Almost certainly some Internet device that uses much of what they’ve developed for iPhone — touch interface, compact OSX, Safari browser, AppStore distribution platform, etc.

Some may call it a Tablet. I’m not sure of its’ form factor, but it will likely be larger than an iPhone and smaller than a Mac. They will do all to keep a lid on costs, so you likely won’t see any physical keyboards, or hinges. So it won’t look like a traditional laptop. It won’t be like the super expensive Windows tablets that have crazy hinges that filp around and double as laptops.

The design will be simple and elegant. The form factor will be easy to lug around or throw in a small bag and take with you whether on the train, bus or even on a plane on vacation. You’ll have access to entertainment (music, TV, movies) games, Internet, email, Exchange, VPN, etc.

It will cost less than traditional laptops, at least Apple’s laptops, and will seems much more advanced and much more portable than laptops.

The costs of touch screen technology and solid state memory will crush margins, which is what is getting everyone’s tale in a spin.

Be prepared for what will feel like another revolution, and it’s coming at the end of the next (current) quarter, just in time for holiday shopping.

Realtosh Wednesday, July 23, 2008 at 12:47 PM PT

Sramana,

Why are smart phone so expensive in India?

The iPhone just went on sale on Friday, and is over 3 times as expensive as in the US and western Europe. Apparently, it’s not an Apple only thing, as other high-end smart phones from Nokia and others are just as expensive.

Why do Indian carriers not subsidize phone prices? Why can’t they recover their up-front subsidies?

Does Indian have any kind of credit scoring system that would hold people accountable for their accounts?

Realtosh Saturday, August 23, 2008 at 10:23 AM PT

I think the Indian wireless carrier business is very different from the US. The ARPUs are much lower. That’s probably what’s preventing those carriers to offer subsidies …

Sramana Mitra Saturday, August 23, 2008 at 4:52 PM PT

Are you saying that the carriers don’t offer subsidy because they don’t have to?

They don’t subsidize the expensive phones because there are so many low priced phone on the market without subsidy?

Was the Reliant phone subsidy a successful project. If so why was it discontinued and why don’t others follow suit. I read that many people bought their subsidized phones and threw them away. It is not so easy to do so in the US without getting a bill with termination charges, that would follow you.

Is there a developed financial system with credit scoring in India that approaches what is available in the uS and western Europe?

Realtosh Sunday, August 24, 2008 at 7:18 AM PT