What's eating Apple?

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A year ago, Brian White, an analyst at Topeka Capital Markets, published a note forecasting Apple (NasdaqGS: AAPL - news) shares would reach $1,111 (£726).

White's prediction stole headlines and was certainly not dismissed by a Wall Street firmly under Apple's spell. The same week saw a raft of other banks, including Goldman Sachs (NYSE: GS-PB - news) , raise their price targets on a company that could do no wrong.

For the next six months, White's expectation that investors would be fearful of "missing the next leg up in the stock" was spot on. Shares in the iPhone and iPad maker marched higher over the summer, reaching a record $705.07 on September 21.

The computer maker that Steve Jobs had co-founded in a garage in 1976 and then rescued from the brink of bankruptcy in 1997, was now judged by financial markets to be the most valuable in the world.

No longer. Apple shares have fallen 44pc since reaching their September record in one of the most spectacular collapses in Wall Street history.

It is a decline that has not been marked by scandal, a catastrophic economic event or even a sustained shareholder rebellion. Instead there is "the sense that the success the company has had with the iPhone and the iPad is starting to wane," says Colin Gillis, a technology analyst at BGC Partners (Dusseldorf: P2H.DU - news) in New York.

When future historians write Apple's story, White's $1,111 price target may be seen as the frenzied peak of Apple fever. But, right now, Tim Cook, Apple's chief executive, is confident the next chapter in the company's history will be its strongest.

It is why the conversation he will have with Wall Street analysts on Tuesday after Apple reports its latest results will be the most important he has had since taking over from Jobs in the summer of 2011.

"We believe it is very important for management to hone its message and take control of the narrative," says Ben Reitzes, an analyst at Barclays (LSE: BARC.L - news) .

That is easier said than done because Apple is fighting battles on three fronts. In Western markets such as Britain and the US, there is the fear that iPhones e_SEnD still Apple's bestselling product are losing their ability to wow consumers as each new version brings small innovations rather than a captivating revolution.

Meanwhile, in faster-growing emerging economies such as China, Apple faces calls to produce a cheaper phone to capture more of a market that accounted for 12pc of its sales in the last quarter of 2012.

Finally, with Apple shares slumping, Cook and the rest of his board are under intense pressure to return to shareholders more of the $137bn of cash the company has amassed.

Many of the headaches Apple now faces are down to its success over the last decade, when the iPod, the iPhone and the iPad brought revolutionary change to the music, phone and personal computer industries.

Rapid sales growth, of course, is easier to achieve when your starting number is zero. It is worth noting that Apple, which sold 47.8m iPhones in the three months before Christmas, had only sold a million of the devices in total by September 2007.

Profit margins are also more readily fattened when competitors are still lacing up their boots and it is only your products that are bewitching the public.

Apple's gross margin peaked at 44.7pc in the final quarter of 2011 and had dropped to 38.6pc by the final three months of 2012.

The last 12 months has seen Samsung make a concerted effort to wrest away the "must-have device" mantle, which Apple made its own when Jobs was at the helm. The South Korean company's share of the smartphone market reached 29pc in the fourth quarter compared with 21pc for Apple. At the same time, Samsung, Google (NasdaqGS: GOOG - news) and Amazon have all stepped up efforts to aggressively undercut Apple's pricing for both smartphone and tablets.

Although last year's giddy rise in Apple's shares suggests otherwise, investors claim they understand the challenges that the company's success has brought it. Indeed, Tony Sacconaghi, an analyst at Sanford Bernstein, pointed out earlier this year that had Apple sustained its sales growth for another five years, its annual revenue would have matched the gross domestic product of Australia. None of which does anything to relieve the scr*utiny on Cook when he faces Wall Street this week. Apple is expected to report profits of $9.5bn for the first three months of this year in what would be its first annual decline in income in a decade. The company has already said that sales will be between $41bn and $43bn, which would be the weakest annual growth since 2009.

While no one expects Cook to provide a comprehensive set of answers on Tuesday, there is an appetite for Apple's management to address more fully than before the set of challenges now facing them.

The almost legendary secrecy that has been a hallmark of the company is tolerable, it seems, when profit and sales growth are rising. But now some see it as perverse. "The silence is deafening from the company on products, on the dividend," says Gillis.

If diagnosing Apple's afflictions is relatively straightforward, there are a variety of prescriptions on offer for how the Silicon Valley company can quicken sales growth and turn the share price around. And the strongest consensus is that, three years on from the introduction of the iPad, Apple is in urgent need of a new product that will make consumers fall in love with it again. Speculation has so far centred on what has been dubbed an iWatch, which would see Apple push into the expanding field of "wearable computing".

According to reports, Apple has scores of engineers developing a device that would do some of the things a smartphone currently does. Though it may sound like the idea has been plucked from a 1950s science fiction novel, experts are predicting that the next stage of mobile computing will see the emergence of new devices with more specialised functions.

"The watch is a great extension of the iPhone and the iPad" says Carolina Milanesi, an analyst who covers Apple at technology research firm Gartner (NYSE: IT - news) .

"I do believe that wearable computing is the next big thing." Consumers, she says, could use a watch to look at maps, to check sites such as Twitter and also to make payments.

There is also a hope that Apple may yet make a major push into television. Late last year, Cook described the experience of turning on a television as like stepping back in time 30 years and that TV remains an "area of intense interest".

Its current television product e_SEnD a set-top box that allows users to stream onto their TVs programmes and films they have purchased on iTunes e_SEnD has so far underwhelmed consumers. Just 2m were sold in the final quarter of last year.

"Apple is chasing the upgrade treadmill on phones," argues Gillis. "The best way to get out of that cycle is to introduce new revenues, so let's get a watch, let's get a TV."

Not everyone agrees that Apple needs to depart from the iPad and the iPhone which e_SEnD in product terms e_SEnD have become the Californian company's extremely lucrative knitting.

"We're not concerned about what's next," said Mark Moskowitz, an analyst at JP Morgan (Other OTC: JPYYY - news) . "We think Apple can drive meaningful growth with its existing product portfolio." Analysts at Barclays estimate that Apple will sell 151m iPhones this year, up 21pc from last, while iPad sales will grow 46pc to 84.9m. White of Topeka remains a bull but has lowered his price target to $888.

Even Apple's supporters, though, admit that the company has made some rare missteps over the last year, including the botched introduction of a new mapping service on the iPhone in September.

There is also concern that Apple's failure to produce a 5" phone e_SEnD a part of the smartphone market that is now enjoying faster growth e_SEnD will prove costly. These sorts of mistakes are adding weight to the view that, with its share price heading south, Apple will need to start sharing more information about its business with investors.

Reitzes, for example, believes Apple should start releasing data showing how loyal its customer base is. He estimates that recurring revenue e_SEnD or that generated from existing customers e_SEnD is about 40pc of Apple's total.

Whether Apple decides to start releasing more data or not, one area that investors will press for more information on next week is China.

Apple has so far enjoyed stunning success in a country in which the iPhone has become a coveted status symbol. Sales in the Greater China (HKSE: 0431.HK - news) region soared 67pc to $6.83bn in the final three months of last year, as Apple opened more of its stores and the iPhone became available in more retailers.

Cook has done little to disguise his ambitions for a market which he said could eventually eclipse America as the company's biggest.

However, a month into the second quarter of the year, China is presenting two headaches for Apple. The first is the need to quell the recent spate of attacks on its "after-sales" services by authorities in Beijing. Apple is not the first Western company to be the target of such public criticism, but any escalation will rattle Wall Street given China's importance both as a market and as a centre of production for the company.

More critically, investors want to know if Apple intends to make a cheaper phone that might allow it to win over more customers in China and other emerging economies that are going to be critical to its growth. "They are at a crossroads on whether they should optimise for market share or for profit," explains Al Hilwa, an analyst at technology research firm IDC.

Apple's success in delivering new products will shape how it handles its third challenge: what to do with its $137bn cash pile.

Signs Apple fever is waning has intensified the calls to return the cash, as investors worry they can no longer rely on the rapid price appreciation that marked the shares until September. Although Cook relented last year and introduced a dividend of $2.65 a share, investors want more.

David Einhorn, a billionaire Wall Street hedge fund manager, took Apple to court in February as part of a high-profile campaign to keep the company's policy under scrutiny.

When it last reported results in January, Apple said it was considering lifting the dividend further and expanding its $10bn share buy-back programme. Should Apple's growth continue to slow, then its transformation from a company that Wall Street looked to for lightning growth, to one that provides a reliable income through a dividend, will surely accelerate.

"It would be a more mature tech company with a decent dividend yield," says Gillis.

Even if Cook does raise the dividend next week, a future of slower growth is not one that the Alabama native will want to accept.

"People think you can snap your fingers and all these issues are sorted," says Peter Misek, an analyst at Jefferies. "In 15 years of doing this, I've never seen a company turn around a product line-up in less than 12 to 24 months." Apple knows the clock, or the iWatch, is ticking.