What's Ailing Apple?

Barclays Capital has addressed the reasons it believes shares of Apple Inc. (NASDAQ: AAPL) have underperformed the sector since February. Apple stock has fallen 3.82 percent between February 1 and June 24.

In addition to market/sector weakness, we attribute a large degree of the concerns to be centered on iPhone specific issues. This year, Apple is flat year-to-date versus the IT Hardware Index at up 2 percent and the S&P 500 at up 2 percent, but since its peak in February of almost $365, shares are down 9 percent versus down 5 percent for the NASDAQ and a flat performance for the S&P 500, said Ben Reitzes, an analyst at Barclays Capital.

Reitzes said his reasons for the recent underperformance of Apple stock likely range from:

-- iPhone 5 or 4S timing: Concerns around the timing of the next iPhone and whether a major upgrade even comes at all this year, making street iPhone estimates too high and resulting in near-term share losses to Android-based phones (Reitzes believes iPhone sales rebound by December quarter and this impact is largely in the stock)

-- Smartphone Health: Concerns about Apple getting caught in the smartphone hiccup -- in terms of builds and a deceleration in demand -- an anticipation of lack of near-term upside at leaders like Apple after disappointments at Research In Motion Ltd. (NASDAQ: RIMM) and Nokia Corporation (NYSE: NOK), (Reitzes believes the market is still strong, just adjusting among leaders/laggards and adjusting to technology – should be catalyzed by 4G next year).

-- Pricing: Concerns that above two reasons mean Apple has to inevitably lower prices for iPhones or even introduce a low-end, de-featured model that dilutes margins (Reitzes is modelling price cuts and still get good Apple numbers…).

-- HTML 5 & the “Disintermediation issue”: Concerns the adoption of HTML 5 by developers could conceivably allow developers to make apps in the browser and disintermediate the app store (the app store is a clear differentiator for Apple but the usability of the iPhone is only enhanced by more sites embracing HTML 5 -- so Apple needs some of this to happen but should make sure the App store still has leading content, like games and special business apps).

-- Technical Breakdown? It has been observed that Apple shares have broken down on a technical basis (Reitzes doesn't focus on technical analysis and believes shares follow fundamentals over the long term).

-- Executive departures: Retail Chief Ron Johnson is leaving Apple to become the CEO of J.C. Penney Co., Inc. (NYSE: JCP). While his departure seems to be amicable and linked to a solid opportunity at the right age and stage of his career -- he is considered a top talent and a significant loss (Apple execs have accumulated significant wealth and Reitzes thinks Ron needed to take this opportunity now if he ever wanted to be a CEO on his own).

-- Sell-side ebullience: Concerns that ebullient sell-side estimates are finally catching up with Apple not just for the iPhone but even for the iPad with some estimates calling for well over 8 million units in the current quarter, which may prove difficult to beat (yes, some estimates out there are way too high, in Reitzes' opinion -- but in the end he thinks fundamentals will prevail).

-- No Next Big Thing: One of the most attractive things about investing in the Apple story since about 2005 has been that it was pretty easy to envision the Next Big Thing -- i.e., phones or a big iPod Touch were easy guesses. Reitzes didn't know how the specifications would look or all the details, but you get the idea. Now there are camps that think the next big thing is an integrated TV system -- and some who think there isn’t anything.

Reitzes thinks the next big thing is really a combination of China (the next US or bigger?) and increasing the utility of the iPhone with 4G connectivity – creating the next mega upgrade cycle (fuelling 200 million units/year-like volumes over time). He believes Apple is laying the foundation for this type of cycle to start in mid-calendar 2012 with new partners in China and new iPhone products. He is hesitant to say it is TVs given the issues of having cable companies involved. Perhaps TVs running iOS & Apple TV software are coming in the near future, but he just can't nail down the impact and is uneasy about anointing TVs as the next big thing.

-- Cash return: Shareholders' frustration with Apple's cash distribution strategy or lack thereof (Reitzes would like to see a dividend and a dividend growth policy, but aren't expecting one).

-- Steve Jobs: The regular and ongoing concerns around the potential impact of a change in leadership should CEO and visionary, Steve Jobs, need to step down (Reitzes rarely get questions on this issue anymore and believes that investors have learned a lot about Tim Cook -- he wish Steve well).

Of all these issues, we want to focus on the iPhone mostly in this report given the segment accounts for over 60 percent of Apple’s profits and tend to be the biggest driver of the share price. Valuation, while very compelling, just doesn’t seem to get the same audience of late, said Reitzes.

Perhaps it is the fact that Apple is still the second largest company in the S&P 500 with a market cap of $300 billion, which makes it well owned -- and the fact that Apple is not expected to change its cash strategy, which could arguably expand the investor base.

As a result, Reitzes believes the iPhone issue is likely to be the major driver of incremental flows into the stock, with interest from the traditional investor base. Of note, he really doesn't get many questions anymore about potential succession issues should Steve Jobs need to take permanent leave.

The brokerage lowered its 2011 third quarter iPhone unit estimate to 16.4 million from 16.6 million, its fourth quarter estimate to 16.4 million from 19.1 million, and its 2012 first quarter estimate to 23.8 million from 25.4 million. The brokerage reduced its fiscal 2011 iPhone unit estimate to 67.7 million from 70.5 million, while maintaining its 2012 estimate of 92.5 million.

Apple stock declined 3.81 percent from $345.03 close of February 1 regular trade to $326.35 close of June 24 regular trade. The stock traded between $235.56 and $364.90 during the past 52 weeks.

Shares of the Cupertino, California-headquartered Apple closed Friday's regular trading session down 1.47 percent at $326.35 on the NASDAQ Stock Market.