Tim Cook May Need to Confront a New Reality at Apple: Managing Decline

 

Slowing growth is unavoidable for a hot company.

Tim Cook has done a superb job managing the challenges of his first four-plus years as Apple’s @aapl AAPL -1.07% CEO. Now, with Tuesday’s deeply disappointing earnings report, he may need to confront a sharply different long-term challenge: managing declining expectations.

Since taking over from Steve Jobs in 2011, Cook has mostly had to keep the iPhone magic going and wring maximum long-term performance from seemingly insatiable global demand for it. He has done so by introducing compelling new models and going big in new markets, most significantly China. On Tuesday, Apple reminded investors of something important they already knew: No tree grows to the sky.

It was inevitable that one day corporate revenue, and iPhone sales in particular, would decline from the previous quarter. But at Apple it hadn’t happened with regard to overall revenue in 13 years and with regard to iPhone sales in eight years.

Wall Street analysts were prepared for a downturn, but it was worse than they expected, and now the big question is whether it was a blip or the beginning of a new trend line. Cook thus faces the fundamental question of how, or whether, to shape investors’ expectations of Apple’s future performance.

Everyone knows that expectations are the basis of stock valuations, but we sometimes forget how powerful the effect can be. For example, based on number crunching by the EVA Dimensions consulting firm, 55% of Alphabet’s GOOGL 0.05% $471-billion market cap as of year-end 2015 was based on expectations of future profit above and beyond anything the company had ever earned. For Amazon AMZN 2.88% (year-end market cap: $328 billion) the figure was 72%; for Facebook FB -0.02% (year-end market cap: $287 billion) it was 74%. Investors in all three companies are betting on a much, much bigger future.

But for Apple (year-end market cap: $673 billion) the percentage of market cap based on future profits was -1.5%. Investors were already expecting profits to shrink, not grow, and it turns out they underestimated the decline. The stock had been falling before Tuesday’s earnings report was released, and after Apple’s announcement the company immediately lost another $47 billion of market value as investors recalibrated their expectations further downward.So what should Cook tell investors now? Apple’s biggest market, the Americas, is economically weak, and the U.S. is largely smartphone saturated. Its second-biggest market, China, just smacked down Apple by banning its iTunes Movies and iBooks businesses. Are more restrictions ahead? No blockbuster new product category is in the offing until, maybe, the long-rumored iCar in four or five years. Apple announced on Tuesday it would return even more cash to investors than previously disclosed, indicating no plans for major new investments.

Slowing growth is unavoidable for a hot company. If Apple’s market value were to grow for the next 10 years at the same rate as the past 10, it would be about $7.7 trillion, or just shy of the combined GDPs of Germany, France, and Italy. That obviously won’t be happening. Should Cook pivot to tempering expectations? Or should he, like Warren Buffett with Berkshire Hathaway BRK.A 0.48% , say absolutely nothing about future performance and let investors make their own guesses? (It has worked well for Buffett.) Or is an unimagined new blockbuster product, another one of Apple’s famously well-kept secrets, lurking behind the scenes?

Whatever the answer, Tim Cook will have to learn new leadership skills to continue his knockout performance.

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