Why Apple Earnings Surprise May Not Be Enough

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Apple will produce solid earnings Wednesday, even if it can't match the most optimistic forecasts to the penny. Its core profit will show a company tuned to make money in a way few have managed.

The financial results will provide an updated picture, although they will not answer the most important question facing a much-admired company still worth a half-trillion dollars: How will it cope with the threat of a No. 2 that is steadily gaining on the leader?

The U.S. market is focused on Apple's big-name competitors--Amazon (AMZN), Google (GOOG), and Facebook (FB), all of which have cutting-edge technology aimed at shaping the future. Still a big factor is Microsoft (MSFT) and its new Windows 8, as is Research in Motion (RIM), whose Blackberry is widely used but in a steep decline. However, the U.S. market may not where the real fight happens.

In the rest of the world, and increasingly in the United States, another name comes up more often: Samsung (SSNLF), already the top technology company by sales, and the most direct threat to Apple. The company is already winning market share and creating a competitive threat to the high-margin prices Apple enjoys as the smartphone innovator that commanded a premium.

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Investors have noticed. When Apple (AAPL) started its decline in September, Samsung began an equally impressive rise. A look at the stock charts shows the fork in the road: While Apple fell by over 25 percent, Samsung gained about that much.

"It is definitely not coincidence. Since then, you have only gotten more evidence of Samsung taking share within the high end of the smartphone market and Apple losing it," says David Cassese, a BlackRock portfolio manager who focuses on the consumer, healthcare, and information-technology sectors.

Iconic Apple's new competition. Apple is so iconic and beloved by its legions of fans that it's viewed by some as a sort of invincible company that always wins unless it beats itself. So most of the focus is on internal issues like product releases, CEO Tim Cook's role in extending the Steve Jobs's string of hits, the company's ability to squeeze costs from the supply chain, and upcoming earnings releases.

If there is competition, Apple's core following, including securities analysts, tend to cast it into another realm of distant "what if's," looking more at future scenarios rather than present-day concerns. Will Google's Motorola become an iPhone killer? Could Amazon's Kindle use the company's "cloud computing" advantage to create an uber-tool in mobile commerce?

But right now, Samsung is showing what a company that sticks to the basics can do. It has been flooding the market with new smartphones at all price ranges, with three dozen released over the past year versus just one for Apple.

It seems Samsung has re-spun an old Steve Jobs mantra, "You can't just ask customers what they want and give that to them." Where Apple responded by repeatedly giving its customers The Next Big Thing, Samsung offers a lot of little ones, and then sees what sticks.

"There has been more innovation coming out of Samsung lately and the market, as it pertains to both stocks [Apple and Samsung], is taking notice," says Cassese. To be fair to Samsung, there has been one Big Thing in the mix along with all of the little phones that barely gets noticed. But even that product, the Galaxy Note, started as a punchline. Considered laughably oversized when it launched as the first major phone-plus-tablet, it has gained ground as such "phablets" catch on.

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"The world's tech pundits couldn't stifle their giggles. Was it a phone? Was it a tablet? Was it a joke?" wrote Slate's Farhad Manjo. Whatever it is, the Note has become a serious success. The Note turned into one of the most successful smartphone product launches ever. Its two versions sold an estimated 20 million units in 2012. It caught on initially with people who did not want to buy both a smartphone and a tablet.

Most importantly, it moved Samsung upstream in the product world. Already, the Korean company had a lead in the number of phones sold in the global market, but mostly with cheaper phones. The Note, and improvements to its Galaxy flagship, have shifted perceptions, as have its advertising spots, cleverly devised to show it as hip and outsider-ish. At the same time, Samsung's manufacturing chops give it the luxury of spinning out new products at a fast and furious pace. By producing lots of different products, customers can decide the future, choosing from an array of phones that look funny but surely think differently.

Samsung has category-leading sales for a vast array of products, but its market capitalization values it at less than half of Apple's total. Profits are growing, and topped $7 billion in the last quarter. That's well below $13 billion for Apple, but the consensus view is that Apple will report an earnings decline of 3 percent this week, Thomson Reuters estimates, though some analysts predict double-digit gains.

The lesson for investors. A strong earnings report could well give a fresh lift to the beaten-down Apple, but if it recovers, its share price may still be capped by The Law of Big Numbers, which basically says growth slows once you hit a market value that investors can no longer afford to bid higher. The stock is likely to remain volatile as it makes a transition from a growth stock to more of a value stock, says Cassese.

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As Apple reached its record-high stock price of just over $700 per share for a total of just over $650 billion in market cap, the ascent to the record valuations may have led to a change of perceptions. Some took it as a signal that it would become the first $1 trillion company. But the market as a whole decided to start taking money out of the stock because its growth potential was shrinking.

Analysts have come up with many reasons for the four-month slide to $500. Mostly, their rationales ignore the size of the elephant in the living room. While its price-to-earnings ratio remains modest at about 11 times earnings, half of the 20 of the Standard & Poor's 500 (SPX), investors still wonder where Apple's next massive growth will come from to justify more gains in the stock price. Its earnings in the past have been lights-out strong, to be sure, and certainly account for Apple's present value. But as always, no matter how stellar the company, past performance is no guarantee of future results.



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