All analysts and investors agree on one thing: Innovation created Apple (AAPL). But innovation has two forms: revolutionary and evolutionary. Revolutionary innovation is what Steve Jobs did so well. His creations shook up the status quo and produced new markets with his dramatically new, must-have products.
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But he also was expert at the follow-on – i.e., evolutionary innovation. By advancing his creations faster than the competition, particularly with newly created features, he not only generated Apple’s star leadership status, but also kept its high profit margins intact. Additionally, he ensured highest quality and attractive design, resulting in an ardent customer base and making Apple the standard against which all competitive products were judged.
Then the revolutionary innovation ended. (See graph at end of article.) With Steve Jobs’ illness, then death, Apple lost the key ingredient to its ascendency. In spite of the initial rumors that Jobs had left nine earth-shaking creations that would be rolled out, nothing materialized – not even the “I finally cracked it” TV product that Steve announced, via his biography.
Evolutionary innovation can’t win the race
Tim Cook’s Apple has attempted to use evolutionary innovation to keep Apple’s hyper-growth going, without success. Plus, some of the “innovation” is following a competitor’s lead or met with less than enthusiastic reception (e.g., Apple Maps and SIRI). Growth, especially of earnings, has been hit by the natural weight of competition (products and pricing), market saturation and the challenge of replicating previously heady sales and profits before entering growth territory.
And this is where the Wells Fargo analytical downgrade from “outperform” to “market perform” comes into the picture.
Jim Cramer’s response illustrates the problem with much Apple analysis
Jim Cramer (on January 2) criticized Wells Fargo’s downgrade, saying it’s the same stuff that was tossed about in 2013, and clearly that was wrong. In other words, he took on the messenger and not the message. Behind the downgrade was a realistic, growing concern that Apple’s high profit margins might not improve as much as had been expected. In fact, Apple has been dealing with that problem since the stock hit its high in 2012. Back then (March 2012), the quarterly gross profit margin was 47.4% and the net profit margin was 29.7%.
The stock’s decline from that point reflected stagnating earnings per share, even as sales rose – in other words, declining profit margins. The latest profit margins (Sept. 2013) are 37.0% gross and 20.1% net – desirable levels from an absolute standpoint, but at the low end of a downward sloping trend. Importantly, after those last results were reported, Wells Fargo remained positive. As reported in the Street Insider, “Apple (AAPL) Valuation Range Raised at Wells Fargo Post Q4.”
We believe Apple’s current product cycles present a strong cyclical opportunity to benefit not only from unit demand but, more importantly, gross margin benefits. We reiterate our Outperform rating.
Clearly, Wells Fargo didn’t succumb to Cramer’s 2013 vision of Apple naysayers. So, what changed? The answer is the January 2 Street Insider article, “Wells Fargo Downgrades Apple (AAPL) to Market Perform; Sees Pressured GM, Tighter Market Opportunity.”
There are three concerns [Wells Fargo Analyst Maynard] Um notes:
- Gross margin coming under pressure later this year with the iPhone 6 cycle
- Limited amount of market opportunity for existing product segments Apple participates in
- A shift in the balance of power from handset vendors back to wireless providers
The analyst’s other comments present the good aspects of Apple’s outlook, and he maintains his price targets. So, what happened is that increased uncertainty means the hoped for gross profit margin improvement might not occur. In other words, the continuing process of evolutionary innovation only, even if resulting in increased sales, doesn’t guarantee increased profits.
The importance of Samsung’s stock drop for Apple
Coincidentally on January 2, Samsung stock declined significantly, as reported in The Wall Street Journal in “Investors Flee Samsung Electronics.”
Investors fear the world’s largest maker of mobile phones will continue to report slower profit and sales growth in smartphones as competition intensifies and less-expensive devices push down prices.
Some of Samsung’s smartphone competitors have started to reduce prices to gain market share. Google Inc.’s Motorola Mobility unit this week cut its Moto X smartphone to $399 from $550, substantially below Samsung’s Galaxy S4, which costs about $600 without a contract in the U.S.
‘The proportion of less-premium smartphones appears to have increased within the portfolio, squeezing margins,” said Doh Hyun-woo, an analyst at [Mirae Asset Securities].
There’s that word again: “margins.” When the revolutionary innovation is over and the evolutionary innovation is getting long in the tooth, price becomes the primary competitive tool, and that means high profit margins fade. Thus, earnings decline even if unit sales growth compensates for unit price drops. Apple is not immune to these basic forces and trends.
But couldn’t 2014 have some positive surprises?
Of course, but that’s hardly a reason to invest in a stock – because something wonderful might happen. With that in mind, along with the distinction between revolutionary and evolutionary innovation, take a look at this optimistic view of Apple (also on January 2) by the editor of Business Insider in “Get Ready for a Seriously Huge 2014 From Apple — New products and personnel will propel AAPL higher this year.”
… because Apple didn’t produce a brand new category of products, some people think Apple blew it this year.
Apple used 2013 as an opportunity to reset itself. It reorganized the company with [Jony] Ive taking the lead on design. It staffed up for big opportunities, and now it’s ready to attack.
CEO Tim Cook has been promising that 2014 will be a big year. On the company’s most recent earnings call, he said, “We continue to be very confident in Apple’s future and we see significant opportunities ahead of us in both current product categories and new ones.”
In a memo to employees, Cook said, “We have a lot to look forward to in 2014, including some big plans that we think customers are going to love.”
Here, specifically, is what we’re expecting:
- A bigger iPhone
- The iPad Pro
- A better Apple maps
- A new look for Apple’s Mac operating system
Here’s other stuff we’re expecting, but we’re not certain will happen:
- The iWatch
- Changes to the Apple retail stores
- Something with TV
- Refinements to iOS 7
- A Retina iMac
- A Retina MacBook Air
- A 4K monitor
There’s nothing of revolutionary innovation in the listing, unless it’s “something with TV.” In fact, many analysts/investors would cross off some or many of the items above because they will not have an important effect on sales and/or earnings growth.
The bottom line
Apple continues to miss its former essential ingredient: Revolutionary innovation. Through evolutionary innovation, it has been able to grow sales somewhat, but not earnings. The resulting margin erosion, unless halted, can only harm the company’s stock performance. The Samsung news, affecting a large part of Apple’s business is ominous. The rationale behind the Wells Fargo downgrade is likewise worrisome.
What to do? Since we know that stock investors dislike uncertainty, it is probably best to watch and wait. Take the facts as we know them and don’t overlay any unknown, hoped-for good news – especially of the revolutionary innovation type. Then, if Apple should surprise us with a truly dramatic, revolutionary product, we can always jump in. Will the stock rise, meaning we miss out on the gains? Likely not, because all revolutionary products have many doubters until a widespread, positive reception is seen. For Apple without Jobs, that’s probably especially true.
By the way – about that “cheap” price…
I’m reading again about how cheap AAPL is, at 13.8 times 2013 (Sept.) earnings and 12.6 times 2014 estimated earnings. It’s true those are low numbers, however their abnormality should be a warning, not an enticement. When the largest (by market capitalization) company sells on the cheap, it’s not because investors don’t understand it or hate it. Rather, it’s because many see risk, even as others see growth. This logic applies especially in this market, where growth stocks are in demand. Here’s how Apple currently ranks among large technology stocks.
Apple’s revolutionary innovation history
Here’s a graph showing Apple’s major product innovations alongside the stock price. Note that we are now about seven years from iPhone’s introduction and four years from iPad’s.