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Apple is overdue for another breakthrough product

The company's market share may have peaked. It's still a good business, but the only way up is to once again bring the world something bold and innovative.

Apple's new iPhones have not driven the stock price higher in an up market. NASDAQ

Apple is getting pounded. Apparently, investors aren't charmed by the company's new iPhones, with the stock down since the September 10 announcement.

Apple's estimated 2013 price/earnings ratio is a lowly 12, compared with Google's 25, Amazon's 346, and Facebook's 87. At this juncture, Apple is more like the unloved Microsoft, which has about the same price/earnings ratio. Neither company is catching fire with investors, although activist shareholder Carl Icahn is finding Apple's stock price attractive.

While Microsoft's problem is that Windows, especially for mobile devices, isn't taking share from anyone but BlackBerry and feature phone makers, Apple's problem is that the hockey-stick growth for the iPhone and iPad is slowing and pundits want to see a low-cost iPhone to feed the thirst for Apple products in emerging markets.

But Apple is staying the course that was set 30 years ago by Steve Jobs. CEO Tim Cook is simply carrying on the tradition of establishing premium brands and sidestepping the race to the low-margin bottom. Apple will cede market coverage and share over time in exchange for higher gross margin and profit, up to a point.

The formula didn't work so well during Jobs' decade-long absence from the company, but has worked exceedingly well over the last decade. Apple grew from $5.7 billion in revenue and $65 million of net income in 2002 to $156 billion in revenue and $41 billion in net income for 2012, based on pioneering and initially dominating the new smartphone and tablet markets.

According to Canaccord Genuity's Michael Walkley, Apple earned 53 percent of the global operating profits in the smartphone market for the second quarter of 2013, and Samsung consumed the remainder.

The financial and critical success of the Macintosh indicates how the formula works for the more mature part of Apple's business. The Mac operating system has less than 10 percent market share. Yet, according to Asymco's calculations, Apple generated 45 percent of the profit for PCs in the fourth quarter of 2012.

"If this estimate is considered then the operating profits from PC operations imply that Apple generates more profit than all the top 5 PC vendors combined," says Horace Dediu. (April 2013) Asymco/Horace Dediu

Apple could have made a more concerted play for the lower tier of the market than the iPhone 5C, which starts at $549 without a carrier contract. A cheaper iPhone with the same screen as the 5C but with components from the iPhone 4S would have filled the bill without depressing the gross margin below 30 percent, says Bernstein Research's Toni Sacconaghi.

But the company chose to stick with its business model of higher-priced phones harnessed to generous carrier subsidies. Sacconaghi suggests that Apple might be waiting to seal a distribution agreement with China Mobile, which has 740 million subscribers, before introducing a less costly (but not lowest cost) phone and, in the interim, is content to "skim higher price, higher margin customers."

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Cook doesn't seem phased by calls from critics to go low. He maintains that Apple just needs to focus on making the best products, which don't come cheap without a contract, and that the sales will follow. "What we are focused on is the long term. This has always been a secret of Apple," he said in February at the company's annual shareholder meeting.

Apple CEO Tim Cook at WWDC in June.
Apple CEO Tim Cook on stage at WWDC in June 2013. James Martin/CNET

Long-term focus is Cook's way of saying it's not Apple's way to chase market share without financial gain. Apple can succeed with its modest array of established products as a large niche player, extracting a substantial chunk of the profit out of the market even as its market share stalls or declines. Long term also means that Apple must deliver more than operational efficiency and incremental upgrades to franchise products. The company needs to produce more hits, like the iPhone and iPad, to recharge the Apple ecosystem.

It's not an unforeseen consequence of Apple's, or its competitors', business strategy that incrementalism can become a liability. The more conservative approach could turn Apple's BMW of computing into a road-worthy but less compelling Honda, allowing another company to lead the next wave of engineering innovation.

The iPhone 5S is an interesting illustration of Apple's patience, fussiness, and long-term thinking. On the surface, it's another incremental upgrade, now available in champagne gold. It has the same 4-inch screen and battery life as its iPhone 5 predecessor, with a speedier processor, better camera, and new fingerprint scanner. Just what was expected, nothing considered breakthrough that will send droves of Android users into the Apple camp.

But there is far more beneath the hood that is intriguing, with the 64-bit A7 processor and M7 motion co-processor, which can track your movements. But the 5S, as its name reflects, is primarily an interim product, introducing capabilities in the new processors and sensors that won't be fully unleashed until future products ship, such as the rumored iWatch. Nonetheless, for many consumers, both the iPhone 5S and 5C will satisfy the hunger for something new and better from Apple.

Cook and company know that incremental improvements won't prevent Samsung, Google, and others in the Android clan from encroaching on the high ground, the premium slice of the market they are trying to hold. In fact, Apple's market share may have peaked for now. The only way up is to once again bring the world something bold and innovative. The iPhone debuted in 2007 and the iPad in the spring of 2010. Apple is overdue for another breakthrough.