By ROLFE WINKLER
Whether Apple's AAPL -0.47% share-price plunge is justified comes down to one question: Is the iPhone maker a hardware or a software company? Right now, it is more the latter. And that is why the 22% drop in the shares since their September peak creates an opportunity for investors.
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Hardware's history is ugly, thanks to rapid advances in technology. Sony's 6758.TO +1.35% once-popular Walkman was made obsolete, its televisions commoditized. Neither scale nor manufacturing expertise protected Dell or Hewlett-Packard HPQ +1.14% in personal computers. The iPhone helped cause the share-price collapses of Nokia NOK1V.HE +6.43% and Research In Motion RIM.T -0.17% . The collective market capitalization of these five companies is just $75 billion today, according to FactSet. Apple's is seven times larger.
And that is largely due to the secret sauce inside the iPhone, which isn't really a handset so much as a computer with software that makes calls—and plays music, offers games, gives directions, takes photos, provides Web access and more. Wrapped in a svelte yet sturdy hardware shell stamped with Apple's powerful brand, the iPhone 5 commands an average price well above $600 when excluding the subsidies some wireless carriers provide to customers. And the iPhone's gross profit margins are huge: about 50% for the fiscal year ending next September, estimates analyst Rob Cihra of Evercore.
Nokia's gross margins approached 40% in 2003, according to FactSet, but are now around 26%. For BlackBerry maker RIM, they are expected to fall below 30% for the year through February, down from a peak of 55% in 2006.
Just as their handsome margins were targeted by rivals, competitors naturally want a share of Apple's profit pool.
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Luckily for Apple investors, the firm's software protects a sizable portion of its profits. Inside the iPhone is a mobile "walled garden" for which developers tailor their apps.
It is possible down the road that technology will enable all apps to be delivered over the Web, at which point smartphones may morph into low-margin boxes that merely distribute others' software—like PCs. But that is a long way off. For instance, Facebook Chief Executive Mark Zuckerberg has said his company's biggest mistake was building its mobile apps with Web technology rather than using the code specific to platforms like Apple's. It has since reversed course.
The more immediate risk for Apple is that rival walled gardens catch up and undercut its ability to charge a premium for devices. Smartphones running Google's GOOG +0.07% Android system outsold iPhones by more than 3-to-1 in the year through September, according to Strategy Analytics, though part of that is due to the range of low-end phones running Android.
It is hard to say how much of a premium Apple gets for the iPhone 5 relative to comparable Android devices. But if it is 15%, say, and the premium disappeared, Apple's gross profit from selling iPhones in fiscal 2014 could be nearly 30% lower than Evercore's Mr. Cihra's current forecast, assuming no offsetting cost reductions. And earnings per share could amount to about $46 instead of $60.
While lower profits are a risk, lower volume growth for Apple looks like a certainty on the present course. The iPhone is now offered by most of the world's wireless carriers. After T-Mobile USA, announced Wednesday, and China Mobile, 0941.HK -0.79% perhaps next year, there won't be many high value wireless subscribers left to target.
The next leg of growth for the iPhone may be a more affordable device for lower-value subscribers. Apple decided to offer cheaper versions of its first mobile blockbuster, the iPod. And it has launched an iPad Mini. Such moves make sense when you consider that the ultimate power of Apple's business model is luring more users into its walled garden.
Already, the company has probably sold plenty of additional iPhones, thanks to its previous decision to offer cheaper iPods that got more users to put their music in iTunes. A cheap iPhone might draw millions of additional wireless subscribers into Apple's mobile environment.
In the end, these users tend to buy a new Apple device every few years to upgrade to the latest hardware and software. So any short-run hit to profitability from users opting for cheaper devices should be offset by new users that buy Apple devices every few years. The risk remains that rival products eat into Apple's price premium and its profit margins. Even Microsoft MSFT -1.03% finally has a respectable mobile operating system. But even if Apple faces tougher competition, its stock isn't very expensive.
A pessimistic earnings forecast of $46 a share for fiscal 2014 still means a nicely profitable business. Importantly, it also implies a share price multiple of just nine times—after subtracting the huge cash pile on Apple's balance sheet.
The handset business used to be hit-driven, with the sexiest device gobbling up the market only to disappear after a more popular handset appeared. The genius of the iPhone was to break this trend. Its proprietary software and revolutionary design has encouraged users to stick with newer versions of the device.
As long as Apple can keep its software leading edge—and avoid more mistakes like the maps fiasco that frustrated users—its recurring business should keep generating big returns for shareholders.
