The case for Apple Part 1 – the iPhone

It’s always a good idea to keep an eye out on all of your investments and the best way to do that is to look at the quarterly earnings that each company releases every few months. These will always give you a good indication on the past performance of the company, industry headwinds and future expectations.

Apple released their Q1 earnings a few days ago and as a long term holder of the stock, I figured it was as good a time as any to do an in-depth analysis of the stock and to see whether I’m still comfortable holding Apple or if it was a good time to sell.

I want to start with a quick run down of the numbers and projections but concentrate more on their product lines. Any weaknesses or strengths there will be instrumental in future earnings which is what I’m mainly concerned about as an investor. I realized this was going to be a long post when I started to get into the thick of things so I’ll probably split this into two or three posts. In this first one – we’ll do a quick run down of the earnings and the talk about their big money maker; the iPhone.

Q1 Earnings and Q2 Projections

The initial market reaction to Apple Q1 earnings has been unfavorable driven by weak Q2 forecasts, signs that iPhone growth is potentially nearing an end and weak computer and iPad sales.

First let’s take a look at the numbers.
  • Q1 EPS: $3.28 versus expectations of $3.23
  • Q1 revenue: $75.9 versus expectations of $76.6 billion
  • Gross margin: 40.1% versus expectations of 39.9%
  • iPhone unit sales: 74.8 versus expectations of 75 million
  • iPhone ASP: $690 versus expectations of $674
  • iPad unit sales: 16.12 million versus expectations of 17.3 million
  • Mac unit sales: 5.31 versus expectations of 5.8 million
  • Q2 revenue guidance: $50-$53 billion versus expectations of $55.7 billion
Let’s do a quick rundown of the earnings first.
I don’t want to bore anyone with too many numbers so I’ll try to keep this brief and to the point.
EPS grew 7% over last year. Apple has about 5% less shares outstanding now than they had at the end of Q1 2015. Adjusting for that, net Income y/y only went up about 2%.
Revenue grew about 2% as well. Apple’s iPhone was the only product that grew against Q1 2015 and it was a very small increase. The iMac sold 4% less units and iPad sales were down 25%. Services and other products grew by 19% and 43% respectively. Services now make up 8% of overall revenue while other products are about 6%. Not a huge chunk of the overall pie but the Mac line of business is only around 9% so these new areas are starting to add up a bit as they grow.
The 2% y/y increase against Q1’15 was driven by a big increase in India(76%), a large increase in Greater China(14%), a slight increase in Europe(4%) and decreases in the Americas and Japan.
The iPhone’s ASP(average selling price) actually went up this quarter as Apple raised prices in some foreign markets to offset currency headwinds.
Speaking of currency headwinds; since Apple does over 60% of their business overseas – the strong dollar has a pretty big impact on their revenue. Apple made sure to point that out during their presentation, a first for them showing a bit of concern about potential market reaction to the slowing growth. If you adjust for the currency differences between 2015 and 2016, y/y revenue growth would have been 8% instead of the 2%.
It’s certainly not a game changer but it does put the revenue picture into perspective as we’re seeing a 5B+ impact due to currency.
The problem is that this impact will likely continue in the near term so it can’t be discounted. Apple made a big deal out of it in this earnings release as it certainly hurt them but they certainly never adjusted for it in prior releases when the dollar was weaker and currency headwinds were a benefit.
We see these issues carrying through into Q2 revenue guidance which is short of expectations by a $2.7B on the high side and will be below Q2’15 which came in at $58B. Apple has also shown in the past that they tend to guide conservatively and I’m not surprised by the soft Q2 numbers here.
That’s it for the quick look at the earnings. I will come back to this later to put the product discussions into perspective against current and projected earnings. I’ll also touch on it again when I go through Apple’s statement of cash flows and balance sheets.
But first – let’s talk about the iPhone – their biggest source of revenue.
The iPhone
Apple goes as the iPhone goes and the flat increase in both revenue and units sold is obviously not going to be taken as a good sign of future prospects. This combined with the lean revenue projection for Q2 has sent the stock tumbling recently.
There’s no denying the fact that Apple sales are slowing. Next quarter, Apple will likely show a quarterly revenue decline for the first time since 2003 and will also probably show a quarterly iPhone unit sale decline for the first time ever.
The main concern here is that the iPhone is reaching a saturation point in the developed countries. Combine that with slowing growth in important emerging markets such as China and you’ve got an issue.
There are certainly other markets like India which is showing solid growth on a % basis but that’s still a tiny fraction of the overall bucket and will continue to be so for the foreseeable future.
If this is peak iPhone then have we really seen Apple at its best or can Apple get back on track and continue to impress in the future? To figure out the answer to that – we need to look at what makes the iPhone desirable and whether or not we’ve reached a point where that desire is satiated.
The iPhone market
First, let’s take a step back and take a look at the worldwide smart phone market and how the iPhone ties into it. As of 2015, iPhones represent about 12-15% of the overall phone market which is expected to more than double in size by 2020 led by primarily by growth in emerging markets like India and China and other smaller countries. IDC is projecting that annual phone shipments will reach 2B/yr by 2019 from a high of 1.5B in 2015. This is projected to be driven by small increases in 2016 and 2017 then a bump in 2018.
These projections may seem bullish but you have to consider the opportunities that are out there in the global market for growth.
China has 93 mobile phone connections/100 citizens. That seems pretty saturated but only 50% of the population used smart phones as of 2015. India has 79 connections/100 citizens but only 26% of the population had smart phones. These two are the biggest target markets out there but there are plenty of other potential markets to expand into that offer similar potential growth. These are not outliers either as even Central and Eastern European countries like Russia, Poland and Turkey sport smart phone penetration rates that represent about 55% of the overall mobile users with prediction showing those numbers rising to the 70% range by 2018.
The main point to take out of this is that there is still a market out there for smart phones – we’re not even close to full penetration in most of the world.
On the opposite of that end is the US. The problem with Apple in the U.S is that the domestic smart phone market has become saturated leading to fewer first-time buyers. The smart phone penetration growth has been quick in the US as evidenced by the great growth in earnings for Apple. In December 2013, only 65% of mobile users owned a smart phone. That number grew to 75% by the end of 2014 and was around 85% by the end of 2015. That means the US as a smart phone market is not going to be driven by first-time buyers in the near future as we reach a full saturation point. There are still certainly people out there that don’t own a smart phone but that number is growing smaller and smaller each year.
There are no actual numbers to support this but it is likely that these late adopters (I included myself here) are also more likely to hold their phone for a longer period of time and might not be as good a source of recurring revenue as the early adopters. If these people are reluctant to switch from a no frills mobile phone to a smart phone with a variety of features, it’s also quite likely that they won’t care about the slight upgrades that a new versions of an iPhone offers. It’s also possible that these no-frills mobile phone owners are less likely to buy a high-end smart phone like an iPhone.
Now this creates potential problems from Apple. The first is that the US is a source of nearly 40% of their revenue and if it is near a peak then future growth rates will certainly be affected unless they can really capitalize on growth in those emerging markets we talked about.
The second is that the US market is already pretty saturated with the iPhone. On top of that, the remaining first time buyers, the long term hold outs might be less likely to want a high-end phone as they’ve been perfectly happy with their old Nokia. If the first time buyer market is shrinking then the natural solution is to either poach second time buyers who don’t own an apple iPhone or make current iPhone owners upgrade more often. Let’s talk about the first strategy before we talk about the second as that will be discussed later.
The current iPhone US market share is about 44% – a pretty sizable chunk when you consider the variety of players in the smart phone market. However, when you compare it by OS(operating system), iPhone is second behind Android which is the primary OS in most competitor’s phones.
If we posit that first time buyers are becoming rarer then the best way to grow market share is to get Android users to convert. At this point the question becomes – is Apple capable of doing that? Apple is aware of the need for this transition in the US market as they’ve recently released an app on the Google store allowing easier conversion from Android to iPhone but how successful will this strategy be in the long term and how many people are actually willing to switch OS?
There was some good information in the Q4 call from Tim Cook where he claimed that over 30% of their iPhone sales were from Android switchers. There were no numbers this quarter but Tim Cook did say that Q1 had the highest level of iPhone switchers by far. This sounds great but is it really as great as Apple makes it out to be?
There are two data points that we have that can shed some light on this. We’re seeing iPhone market share in mature markets remaining relatively constant against Android but shrinking worldwide in recent months. Why is that the case and does it matter and more importantly does it support the case that Apple is poaching Android users?
The simple conclusion is that Apple’s long term strategy of offering a premium product at a premium price has reached a saturation point in certain markets where the price point is simply not affordable or not enticing to first time phone users. This limits their uptake of those users in those markets and will limit their earnings potential in the near-term as late adopters in mature markets go for the cheaper options as do those who can’t afford Apple’s price point in emerging markets. If entry-level users are picking Android then where is Apple getting their growth from if not old Android users?
The available data makes this more of an assumption than a calculated conclusion which isn’t something to bet your life savings but it does offer a viewpoint that can lead an investor to two conclusions.
One is that we’re close to the end of easy growth for any smart phone company in certain markets. This is the case for Apple, or Samsung or anyone and is a relatively obvious conclusion based on the data presented before. There is certainly still room for growth in markets such as the U.S. but the best days of growth are behind us and lower cost phones are better positioned to capture that growth than Apple. Two is that future growth in those markets will come through better products and services designed to lure away customers and tie them to a new platform. The first conclusion is certainly a problem for Apple but I think the second is a strength and we’ll discuss why that is in a second but first let’s talk about the other avenue for growth in mature markets; the existing user.
Besides growth driven by new sales or conversions – there’s also the revenue brought in by current users upgrading and I think that’s another strength apples has in its arsenal. Apple has one of the highest brand loyalties in any industry. They’ve also done an amazing job of making an entire integrated Apple universe that can effectively tie a user to Apple products much better than any Android device has so far.
The problem is Apple can’t simply thrive on the existing iPhone user as not everyone is an iPhone fanatic that upgrades with every cycle. As an investor, I need to make sure that they don’t leave the emerging markets and even first-time buyers behind because as I’ve said before – those are the new growth markets that have potential beyond anything the U.S. offers. The problem is that I think we’re at a point in the smart phone cycle where Apple is doing exactly that.
That is at least in the short-term. I’m not surprised by the reduction in projected revenue in the near term.
The aforementioned strategy of offering a premium product at a premium price might have been very successful in the U.S. where the middle class is strong and can afford an expensive smart phone but it might not be as successful at the start in emerging economies where the middle class is more limited and less likely to start off with a premium product.
To top that off, the current macroeconomic climate sees the economies of the important emerging markets slowing and currency issues will make the products even more expensive. Does that mean that the iPhone is done growing and will become second fiddle to Android in the near future or can Apple get past it and return to iPhone revenue/unit growth in the future?
I think the question is complicated and the outlook isn’t overly amazing in the short term but I still firmly believe that in the long term – the iPhone can continue to be a success.
And in order to figure out why – we need to talk about the smartphone ecosystem as a whole and the iPhone as a product and see what it offers that others do not.
The Smartphone World
Sometimes, I hear this general opinion of Apple or the other smart phone carriers as a one trick pony that will die out when the next fad arises. People bring up Sony and their Walkman or the Blackberry.
True, both were replaced by better, cooler products and really sunk the fortunes of the respective companies so why can’t the Apple be next?
In my mind – these comparisons make little sense.
It’s true that Apple makes a large portion of their revenue from their flagship product as do most technology companies but is the comparisons of the iPhone to a Blackberry or Walkman fair? Is the technology going to be phased out as soon as the next big thing comes along?
To answer that question – we need to look at the differences between technologies that die out and the smart phone.
Sony made the Walkman/Discman/MP3 player as a device with a specific function; listening to music. The Blackberry was made for email, old school mobile phones were there to make calls.
The iPhone is not a function specific device.
It is the next iteration of a computing device that as of right now doesn’t really have anything above it on the tech tree. A computing device is one that can do pretty much everything with the right hardware and software. Unlike those devices we talked about that eventually died out – the smart phone is almost infinitely expandable. Get the right software and the right hardware and you can do pretty much anything a computer could do in the palm of your hand.
Now the next question to ask is what will replace computing devices and I don’t think we have the answer to that question yet nor do I think we’ll have it anytime soon.
The personal computer in its many iterations is so ubiquitous that I have a hard time imagining it being replaced.
If you look at the history of computing devices, you’ll notice one important thing and it’s that they’ve been around forever and have shown no sign of disappearing from our lives.
We’ve certainly gone through a number of versions – starting with computers the size of an entire building, down to entire floors, down to entire rooms, down to our desktops, our laptops, then our tablets and finally our pockets.
Compare your smartphone to a desktop you paid $2500 for 20 years ago and you’ll find a much more powerful machine that does more functions and is mobile to boot.
Now I’m certainly not comparing the iPhone or any Android machine to a top of the line desktop PC today – we still have a long way to go in that regard but technology is an amazing thing – don’t be surprised if the phone you buy five years from now is more powerful than a brand new laptop you can buy today.
The point I’m making here is that smartphones are just another evolution of a computer, a technological achievement that’s been around for decades and won’t be going anywhere anytime soon. It will certainly evolve into something else eventually. Who knows what it might be; whether smaller wearables, implants or something else entirely but for now the smart phone is the top of the technological spectrum when it comes to computing devices.
Think about how many other devices the phone has replaced in recent years. It can be a clock, a music player, a video player, an internet browser, an email client, a map, a gaming device and countless other things. It’s a computer in your pocket. There are limitations to what it can do just like there were limitations to what a laptop could do and what a desktop could do and what a computer the size of an entire room could do.
The idea that the phone we see in front of us today is peak technology is nonsense but so is the idea that the iPhone will be around forever and generating income forever. That’s now what I’m trying to say here. I know that the phone as any other computing device will evolve and get better. The question is whether Apple is position in such a way that it can be a leader in that evolution and we can discuss that later. The fact that they’re at the forefront of the Desktop, Laptop, smart phone and now wearables space certainly makes me feel better about that question.
The iPhone Experience
At this point, I’m pretty comfortable that the smart phone isn’t going away anytime soon and the hardware and software are improving. However, I think we’re starting to reach a point much like the desktop and laptop did where incremental upgrades just aren’t all that impressive anymore.
Going from a Nokia to an iPhone 5s was a pretty big upgrade for me, it was a whole new world; a computer in my hands at any time, 24 hour access to the internet and a multitude of apps.
But now that I’m here – why should I upgrade? To me it’s not worth it. In fact, the iPhone 5S does pretty much all I want it to do – it’s fast enough, has enough memory and runs all my apps and internet well enough. Sure the iPhone 6s will be faster, offer even better performance, a better camera and new features but if I’m already at a point where it’s fast enough and performs well enough and I don’t need higher quality pictures – what’s my impetus to upgrade? I probably won’t upgrade unless my phone breaks because the 5s does all I need it to do.
So the question is – am I alone in this type of mentality or is it going to be more commonplace in the future.
If Q1 2016 sales are any indication then I’m probably a minority. While the iPhone barely shipped any more units than Q1 2015, you have to consider the comparison in relation to the Apple upgrade cycle.
The numerical updates 3g to 4, 4 to 5, 5 to 6, etc. are often seen as a bigger upgrade than the s versions which are just side upgrades. You can certainly question whether or not that’s the case as a lot of these updates just seem like window dressing to me but the truth is that the 5 to the 6 had one of the biggest upgrades in recent memory when it came to the bigger screen along with the usual updates like a faster processor and better camera.
Apple sold almost 50% more phones in that quarter than the quarter before. It was an insane sales number and driven partially by the big change in screen size as well as some other upgrades and the maturation and growth in some of the more important markets we discussed.
Then the 6s comes out – same screen size – some minor updates – absolutely 0 interest in it personally. And it sells more than the 6 in the first quarter. Now it is true that the 6 launched a bit later in China for the 6(Oct. 17) so the sales number may have been potentially understated as evidenced by a very strong Q2 in 2015 which will likely beat 2016.
Does this mean that Apple’s revenue is capped now and that any future growth is going to be hard to come by or can they recover from this miss?
To figure that out, let’s go back and look at first quarters of the 5 and 5s. The 5 sold 29% more units than the predecessor while the 5s only improved those numbers by about 6% over the 5. The point is that’s always been the Apple cycle and will always continue to be the Apple cycle.
Now look at the Q1 unit sales and consider the following.
  • It’s an s upgrade which has historically sold a lot less than a numerical update
  • Apple is facing very tough economic conditions in most of Apple’s growth markets including China and India as well as Europe.
  • Apple is facing tough currency headwinds. In order to reduce these – they’ve adjusted the ASP of their phones in certain markets up as evidenced by the ASP of $690 and still maintained growth in emerging markets.
Now if you look at it through that lens – do the sales really look that bad? ASP is up on an s model refresh in a challenging economy and unit sales actually improve! I don’t think that’s too bad but what’s more important is what this means for future sales.
The issues we discussed before still remain and how can Apple face these and continue to grow revenue. If the US market is getting saturated and the low-cost options are more attractive to the emerging markets – the obvious solution is to poach Android users and get existing users to upgrade.
Is either of these options likely? I think so and I’ll tell you why.
First – let’s cover the issue of existing users and the potential for upgrades there. The 6 and 6s were record sellers but the adoption rate on existing users is only about 45%. That means that over 55% of existing iPhone users are on a 5s or below. Now Apple doesn’t break out figures for US or emerging market customers so it’s possible that a lot of these older users are in emerging markets where cheaper phones sell at a hotter rate. However, even if that’s the case – there’s plenty of opportunity for current user conversions to either the newest models or the older models as the get cheaper and fall down the Apple price tree.
We are certainly not at point here where everyone is already on the latest and greatest model but we might be reaching a point where upgrades are less and less common.
There are two reasons for this and one is the death of 2 year phone contracts. If you bought your phone a few years ago, you probably bought your phone at a subsidized price of $0-$199 depending on model with a 2 year carrier contract. These are much less common now and while carriers have tried to make this less apparent by spreading the cost out across 24 months within the users bill – it’s still an obvious issue as the upfront cost seems much higher. Apple themselves have gotten on the train with the Apple upgrade program which works by spreading the cost of the new phone into monthly payments.
The second reason is one I mentioned before and that’s because phones are simply getting to a point where phones are already good enough so any updates aren’t all that impressive. A phone from 2014 can run things almost as well as a phone from 2016. It may be a tad bit slower and be missing a feature or two and have a smaller screen but it’s relatively similar – all things considered. True must have features haven’t really been a yearly thing with Apple or any phone makers beyond the bigger screen of the 6 which attracted some users. I’m not sure what the upgrade cycle is for the average user but I could certainly see it get longer and longer as the iPhone numbers grow.
I think both of these are real issues and will weigh on results going forward. The market is very pessimistic about the upgrade cycle and will continue to be so until it sees the numbers grow again.
The Q1 unit sales while disappointing to the market were still quite impressive when you consider all the headwinds we talked about – any unit sales increase on an s line model with weak macroeconomic data was a big win. I’m optimistic about the iPhone’s future even with the projected Q2 sales drop.
This data shows me that Apple can maintain solid sales figures on a side grade. In my mind this also goes to show strength against Android in the more mature markets. If first time buyers aren’t there anymore or gravitating towards Android then growth in those mature markets will have to come from poaching Android users which certainly seems to be happening according to Tim Cook.
Now obviously Tim Cook will tout victory over his main OS competitor but can there be any truth to the belief that Apple can win over Android users in the long run?
I think so and this is why.
It’s because Apple is in a very unique position when it comes to the smart phone market and that allows it to have tighter control of its product, produce a premium product, have better control of user experience and thus have a stronger hold on long-term market share than Android.
There is no other company in the smart phone space that shares its position. Samsung is great at hardware but what else? The other entrants into the space like Huawei are similar to Samsung. Microsoft tried both ends but never gained a footing and has seemingly given up on the windows phone. Google tried their hand at both ends of the spectrum but is really only keen on the software side with their OS although they have spoken about getting more control over their Nexus line.
The problem here is that Android is a sum of its parts and while that may include some excellent phones and a more open OS that some users love – it can also include a lot of terrible phones and terrible user experiences.
I think that’s the main competitive advantage Apple has when it comes to the smartphone market over Android. With an iPhone, you get a curated experience that is going to be the same no matter what phone you get – whether it is an older iPhone model or a newer one. Apple has complete control over their OS and Hardware. On the other hand, you have Android that offers a variety of user experiences depending on the phone and brand you buy.
There are certainly conversations every day about which OS is better and while some love Android and all you can do with it – some prefer the simplicity and look of iOS but it’s not just the OS that matters to the overall user experience. It’s the whole package.
In the end – Apple is the only smart phone maker that controls the whole package and as an investor, that’s a big deal for me.
They have a unique strategy of being the high-end, high-cost producer in a very saturated market and have done an amazing job with it so far.

The other key point is that if you like Apple’s software – you have to buy Apple. If you like Android, there’s plenty of hardware producers out there who share the software.

That’s why I think Apple is best positioned in this environment for the long term.
The problem is that this strategy isn’t going to be amazing in the short-term as the market matures in the US and some European countries.
Apple simply doesn’t have a price point that is as attractive as Android in emerging markets but as the market matures around the world – Apple is best positioned to start taking back market share by curating an overall experience that isn’t as commonplace with Android phones. I think Apple knows this and that’s why they’ve stuck to their strategy and will continue to do so despite the market sentiment.
There have been calls to introduce cheaper phones to attract the emerging markets but Apple also doesn’t want to poach their existing customer base that may want a cheaper phone but doesn’t want to leave the Apple ecosystem.
Could they introduce a cheaper phone and grow market share in emerging markets right away at the expense of margin? I think so but I don’t think that’s their long-term plan. I think their plan will be to let those users experience what cheap phones can do and then eventually lure them into the premium experience of an iPhone as the emerging markets middle class grows.
Their product refresh cycle has room for improvement too. For example, as an investor, I hoped the mid-year refresh would be a 6s mini(6s with a smaller screen) which I think would appeal to those looking for a smaller screen but not wanting the innards of an older phone but that doesn’t look to be the case. That doesn’t seem to be the case but it certainly could be in the future allowing for expansion of sales as well.
At the end of the day – Apple controls 90%+ of the smart phone industry earnings. This is insane in this day and age especially when you consider the depth of the smart phone market.
I think iPhone unit sales will be slower in the short term but I think we’ll return to unit sale growth with the release of the 7 and see a small sales boost boost mid-year smaller screen refresh.
Often times – the market’s search for growth can overshadow perfectly reasonable numbers and make them seem worse than they are. I think iPhone unit sales are reaching a point where growth in the s cycle will be hard to come by and may even start shrinking but the new refresh will certainly bring back growth with new features that users want.
Even if growth is limited in the near term, the iPhone is still one of the best businesses in the world as it continues to sell a ton of units at an excellent profit margin. The iPhone business is the one I bought into a few years ago when I saw what it offered against Android and I still think highly of it today. Growth has slowed and might be muted in the near term – but my long term belief that the iPhone is a cash machine and will continue to be so for a while with the potential for a return to growth as soon as the 7 gets released in a year’s time.
In the long term – I think unit sales growth will be harder to come by than it has in past years simply because of the maturing markets and potential for an extended upgrade cycle but I still think we’re far from peak iPhone here. There might be some undulation in growth in given years but Apple still makes one of the products out there and is at the forefront of technological breakthroughs in the smart phone industry. Is there potential for a phone maker to unseat Apple with a high end product at a lower price? Of course but that’s something to keep an eye on as an investor. I don’t think it’s happened yet and I’m not expecting anything to change in the near term on that front. Google is most likely to come up with something to challenge Apple but that hasn’t materialized yet.

I believe we’ll see the upgrade cycle extend and shrink depending on what new models offer. Battery life is probably the next big change that will come down the pipeline that will improve smart phone sales. Domestic growth will come more through luring users and user retention both things that Apple excels at while emerging growth will limit potential growth in the short term due to price point but should be a boon in the long term as the middle class matures in those countries.

The iPhone has been a constant growth machine in the past few years and I think that’s over in terms of constant growth. That doesn’t mean unit sales will start to fall of a cliff but shrinkage during the s cycle and slower growth overall isn’t unexpected. The worries that it’ll go bust don’t bother me. If anything, the iPhone going forward will be boom or snore. And as an investor, I’ll take a profitable snore any day. 
Now that we’ve covered the iPhone – we can talk about the other products in Apple’s arsenal. Yes, they do make other things! Is there something out there that can help Apple when iPhone sales lag or is everything in their arsenal peaking as evidenced by drops in the Mac and iPad lines?
In the end – while I still like the iPhone business – if the rest of the business is doomed to failure then there might be no reason to invest in the company. I’ll cover those topics and then look at the financial statements of the company in the next part.
How do you feel about the iPhone business? Are you worried about the slowing sales and see it as a sign of future revenue reduction or do you just see this as a maturation of a product line in a slowing economy that can return to growth with a new release. 

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