“Apple has lost its innovative touch.” The justification here is based upon the iPhone 5. The argument put forth that the previous versions of the iPhone offered revolutionary changes but the iPhone 5 is merely an upgrade. Furthermore, as the argument goes, competitors are closing the innovation gap on smartphones. On a literal level, the iPhone 5 is an upgrade. The iPhone 5 sports faster 4G communication connections, the updated iOS6 integrating Facebook and Open Table, improved panoramic photography and a new form factor. At a core level, these are all improvements, albeit some significant, yet they don’t represent a revolutionary new product.
Yet, has anyone else displayed a more innovative touch? Competitors did raise their own bars in August and September with impressive product introductions for the upcoming holiday season. None of these introduced anything revolutionary either, although they also offered significant improvements over their predecessors. Apple is still setting the bar. It remains the benchmark of comparison. And, it sold 5M iPhone 5s in the first weekend, limited only by supply – numbers not touted by the competitors. Whether one classifies the iPhone 5 as “innovative” or merely an “upgrade,” consumers are still clamoring to have the device.
“Senior management shakeup leaves Apple unstable.” On one hand, there was a great deal of backlash in the press for Apple Maps. On the other hand, when Apple addressed the issue internally, there was a great deal of backlash in the press for management shake up. Apple, in some odd way, has become the stock that could do no right. The argument continues that Apple is lost without Jobs. Again, did any of the competitors suddenly produce a Jobs-clone, a marketing guru, a magical presenter? Not yet. The argument implies that Apple can’t be managed well in a post-Jobs world, but no arguments suggest which company is better managed or more innovative than Apple. And it is too early to determine if the management changes will be net positive or net negative to Apple. But what we do know is that product launches are successful and consumer demand for Apple products remains high enough for Apple to grow at least the 8% per year implied by the P/E, seemingly very low compared to 45% growth in revenues and 60% earnings growth achieved in this past FY ending September.
“Margins have to compress due to competitive forces and new products.” Yes, margins should compress with new products, to a point and at introduction. Then with efficiencies of production and economies of scale, margins will improve over the product lifecycle. But competition, to date, has not pushed Apple’s margins down, because Apple does not compete on price. Apple competes on features, an ecosystem and strong brand loyalty. And while many pundits argue that other products have richer features, and whether or not it is true, consumers are still buying Apple. 3 Million iPad Minis were purchased in its first weekend. Take the markets in which Apple competes that are not distorted by distribution channels. Apple has dominant market share in iPods and iPads. Apple is growing its Mac sales while the overall computer industry is declining. And, with a $121 Billion cash war chest, if Apple wanted to drop prices and buy market share, it has the ability to do so. The iPhone category is different as carriers, and their subsidies and marketing, can have influence over consumer purchasing decisions.
Despite expectations of margin compression, most analysts believe margin compression is a near-term issue that will be worked out as the new products mature. And one analyst in particular identifies three sources of gross margin upside, even in the upcoming December quarter. Peter Misek at Jefferies did an impressive “deep dive” into the gross margin issue faced by Apple, with a detailed analysis broken down by each device, its key component costs and cost to build. The combination of yield improvements in the quarter, robust iPhone sales and allowance for the typical conservative gross margin guidance by Apple led to a forecast 40% gross margin during the December quarter, Apple’s Q1FY13, as compared to Apple’s guidance of 36%. Peter forecast gross margin lifting to 42% by the March 2013 quarter, Apple’s Q2FY13, as bottleneck issues at assembly plants and yield issues were worked through.
The proof in the pudding is the December quarter, when the best new products compete for the consumer wallets. Most Apple bulls believe that iPhone sales in the September quarter were depressed in anticipation of a new product release. Certainly, initial sales support that conclusion but hard market share numbers for the December quarter will evidence if, in fact, new products from Apple’s competitors can loosen Apple’s perceived mind share lead in the smartphone market. Likewise, the success of the iPad Mini can be measured against its competition to see if Apple can maintain its market leadership in the tablet market at all screen sizes. Again, Apple is not competing at a “lower price point” but at a different size category.
Yet of all the “Apple is over” articles, not one can argue that the stock is overpriced. As Peter Misek points out, applying a slight premium multiple of 13x (above the S&P’s 12x) to his estimate for Apple FY13, his price target for the stock is $900. Removing cash, Apple is currently trading at about 8x FY13 earnings, yet is growing at 20% or more.
Finally, Apple’s main competitor is Google’s Android ecosystem. If investors believe in the secular growth of tablets mid-term and smartphones near-term, it doesn’t seem like the trade should be sell Apple and buy Google. Google, trading at just 11x FY earnings (excluding cash) is also attractive, given its growth rate and relative to the overall market, like Apple. It stands to reason if investors believe in the secular growth of tablets and smartphones, and acknowledge these two companies dominate the markets, both stocks should be in their portfolios. Both offer attractive PEG ratios for investors and are well positioned for the “long term” (in technology cycles).
Although some may worry that Apple isn’t what it used to be, no one has argued who the New Apple is, or what company is innovating like Apple. No other company has come to the forefront to introduce a new product category like an iPhone, or iPad, or iPod, and many still expect Apple to introduce a new “television” in the next couple of quarters. And, no one is arguing that Apple is an expensive stock, because it trades at an inexpensive valuation. The fundamentals haven’t changed yet.
Maybe the real issue here is stock fatigue. I wrote my first analyst report on Apple in July 2004 when the stock was $16. It has appreciated almost 40 times. Even when it went to $50, portfolio managers would lament that they had missed the run and wanted other ideas. Yet, Apple has kept performing on the fundamentals: growing revenues, expanding margins (after product introductions), new products, and new channels. Perhaps stock watchers are just simply tired of watching Apple stock go up year after year and are chomping at the bit to call "the top."
Investors are fortunate enough to have a large prolific group seeking out the Apple killer and will be certain to report who it is once it’s found. Until then, Apple remains well positioned for the next three to five years, as iPads continue to ramp, iPhones continue to ramp margins, and the company continues to upgrade products. Investors should take advantage of these dips to build a position in Apple at these levels and, if they believe in the secular growth of tablets and smartphones or worry about Google, they should take a good look at Google as well (Google Stronger for Long Term).
