Few earnings reports are as anticipated as that of Apple's (AAPL), and few earnings reports draw as much commentary as that of Apple's. The company is set to report its Q2 2013 earnings after the close of trading on April 23, and we suspect that CEO Tim Cook will be put under enormous pressure on the conference call to lay out the company's future plans. And with Tim Cook likely to reveal little in the way of truly eye-opening information, investors must turn elsewhere. In particular, we believe that Apple's R&D expenses will serve to pinpoint to investors what is going on at Apple. But first, we wish to discuss certain aspects of analyst and media coverage of Apple, factors that have served to cast a pall over the company.
Apple's Coverage: An Inability to Find the Middle Ground
When it comes to coverage of Apple, we believe that Netflix (NFLX) can serve as an apt comparison. While critics of Netflix are likely to recoil in horror at the thought of such a terrible company being compared to Apple, we believe that the comparison is valid for the reasons below. Analysts and the media heaped praise upon Netflix throughout 2010 and 2011, and a stream of price target increases and positive media coverage helped send shares of Netflix towards $300. However, when Netflix stumbled (this article is not meant to be elicit a discussion of Netflix's fundamental performance), coverage of the company quickly turned negative. Price targets and positive coverage decreased dramatically, with many analysts rapidly reversing their bullish stance and warning of tough times ahead. Shares of Netflix fell rapidly, and fell to near $50 in September 2012, before rebounding to nearly $165 as of this writing.
Where is the comparison with Apple in all of this? The comparison lies in the inability of company observers to find the middle ground. With Netflix, analysts and the media were either heralding it as an unprecedented revolution in media distribution and consumption, or deriding it as an under-capitalized company with a weak competitive position. There was little talk of Netflix as a steadily growing media company that, through a slate of original programming, geographic expansion, and a growing content library is poised to capture a large portion of the global streaming market. And we believe that Apple has been exposed to the same issue. When Tim Cook first became CEO, and when the iPhone 5 was released, there were few, if any, industry observes that had something negative to say about Apple. Price targets were increasing across Wall Street, and the media's coverage was broadly positive. Now, in 2013, the landscape is far different. Many analysts have slashed their price targets, and many reporters are implying that Apple's best days are behind it. We will admit that the competitive landscape has shifted. Apple's leadership in the smartphone and tablet market is no longer something that can be accepted with ironclad certainty. But to argue that the company's best days are behind it is absurd. A recent article from the Wall Street Journal discussing rumors that Apple will begin producing the next version of the iPhone this quarter illustrates this issue quite well. The article included quotes from Strategy Analytics, which argued that Apple must become more like Samsung and launch products faster if it wishes to "cope" with the new realities of the smartphone markets. The article further talks of sagging investor confidence in Apple, and notes a view among analysts that truly disruptive innovation is years away. But, the Journal's article ends with a set of data points that, despite the obvious questions they raise regarding the validity of negative Apple headlines, elicits no discussion from reporters. The following table breaks down data regarding the global handset market from Strategy Analytics, the same firm that believes that Apple must become more like Samsung.
Global Handset Industry, 2012 vs. 2011
All Others (Implied)
2012 Handset Shipment Share
2011 Handset Shipment Share
2012 Handset Profit Share
2011 Handset Profit Share
As the table above shows, Apple's share of global handset profits rose to 66% in 2012. While it is true that Samsung has been growing its share of global profits at a faster rate than Apple in 2012, the company has not been stealing share from Apple in 2012. Rather, Samsung has been taking share from an array of other handset manufacturers, whose collective share of global handset profits fell to around 1%, down from nearly 20% in 2011. Apple also expanded its share of global handset shipments to 8.6% in 2012, growing shipment share by over 43%, versus 19.05% for Samsung. The smartphone market has, in essence, become a duopoly, at least when it comes to profits. And Samsung's growing prominence (the company sells 40% of Android units) has become a source of concern for Google (GOOG), with sources close to the companies reporting that Samsung wants a greater share of the advertising revenue that its Android smartphones generate. In 2012, Apple and Samsung essentially captured all of the industry's profits, a trend that is set to continue in 2013. Estimates from Canaccord Genuity call for Apple to capture 69% of the global handset profits, and for Samsung to capture 34% (that is down sequentially from Apple's 72% profit share in calendar Q4 2012, a seasonally strong quarter for iOS sales), with other companies posting aggregate losses for 2013.
In our view, coverage of Apple has swung too far to the negative. And while it may have been unnecessary to heap effusive praise on Apple when the iPhone 5 was launched, we also believe that it is unnecessary to heap effusive criticism on Apple, when the company's share of industry profits, the only true metric that matters in the long-term, is growing. And Android has started to lose market share in the United States. According to comScore, in the 3 months ended in February 2013, Android's share of the United States smartphone market fell to 51.7%, down from 53.7% in the three months ended November 2012. Apple's share increased from 35% to 38.9%. Of the 10.4 million new smartphone users in the United States during that period, 85% of new users chose iOS devices (as a frame of reference, the iPhone 5 launched in the United States on September 21, 2012).
These statistics are not meant to diminish the potential of the threat posed by Samsung and Android. Rather, they are meant to show that Apple's current situation is far less negative than many headlines would suggest. Coverage of Apple has swung from highly positive to highly negative, and this has served to cloud perceptions of the company. And in light of the company's upcoming Q2 2013 earnings report, this is an important fact to keep in mind.
Q2 2013 Earnings Preview: R&D and Capital Deployment
For Q2 2013, consensus forecasts call for Apple to post EPS of $10.13 on revenues of $42.7 billion. Should Apple post these results, it would imply 8.97% growth in revenues, but a 17.64% drop in EPS, driven by lower gross and operating margins due in large part to the iPad Mini. CEO Tim Cook and CFO Peter Oppenheimer will likely be put under enormous pressure to explain how Apple will return to EPS growth. Admittedly, Apple's sterling reputation during earnings season has been marred as of late. But, in our view, Apple's prospects for long-term EPS growth are brighter than they appear. As evidence, we offer Apple's growing R&D expenditures.
Unlike some technology companies [Microsoft (MSFT)], Apple's R&D expenditures are geared towards commercializing new products, both through incremental updates (such as iPhone 4 to iPhone 4S) and through new categories (such as the iPad). Under CFO Peter Oppenheimer (who we believe is one of Apple's most underappreciated executives), Apple has been able to strike a proper balance between innovation and the need to control profligate spending. As we showed in our last article regarding Apple, the company's R&D expenses soared by 43.5% in its latest quarter (when adjusting for the impact of an extra week in the prior year period), and its guidance for this quarter implies continued growth in R&D spending. Apple is not a company that simply spends money on R&D for the sake of spending it. When Apple increases its R&D spending, especially by such large percentages, we believe that investors should take note. At these spending levels, Apple is likely doing more than simply investing in incremental updates to its existing product lines. New rumors, courtesy of Daring Fireball and John Gruber, report that Apple has pulled engineers from Mac OS X 10.9 to work on iOS 7, and (in yet another example of Apple's secrecy), engineers working on iOS 7 have had their iPhones fitted with polarizing screens to block third-party observers from seeing its "apparently rather significant system-wide UI overhaul."
Part of the dilemma regarding Apple (at least from an investor perspective) is that unlike many companies, Apple wishes to say as little as possible about its product pipeline. Executives of pharmaceutical companies, for example, never miss an opportunity to tout their pipeline, and most technology companies are quick to highlight the latest versions of their products. Not Apple. We believe that there are few things that CEO Tim Cook and his executive team would like more than to be able to develop new products in absolute silence, with no commentary from the media, analysts, or investors. However, that is unlikely to happen, and in the absence of concrete information from Apple, these 3 constituencies are often left to create their own conclusions about Apple's future. And with no guidance from Cupertino, these conclusions have turned increasingly negative over the last few months. However, we do not share such pessimism. In our view, Apple's R&D expenses are a crucial "tell" regarding its product roadmap, and believe that investors should focus on Apple's Q2 2013 R&D expense just as much as they focus on its headline results. Something is happening in Cupertino, and with Apple's R&D now surpassing $1 billion, it is highly likely that the company is developing more than simply new iPhones and iPads.
Apple's capital deployment plans have come under increasing scrutiny as its stock price has fallen, and with $144.75 per share in cash & investments (34.2% of its market capitalization as of this writing), many investors are clamoring for the company to return more of that capital to shareholders. Apple's shares yield 2.5% as of this writing, and consensus forecasts (per Bloomberg) call for Apple to boost its quarterly dividend to $4.14, an increase of 56.24%. Sources familiar with Apple's thinking have said that the company is deliberating on how best to return additional capital to investors, with the focus turning to increasing its dividend and/or buying back additional shares. And Apple itself has confirmed that it is in "active discussions" over what to do regarding its growing pile of cash & investments. If Apple is to make an announcement regarding its capital deployment plans, its Q2 2013 earnings release and conference call seems like a sensible forum to do so. However, unlike many investors who are clamoring for Apple to increase its return of capital, we are sanguine about such a move. On the one hand, increased dividends (as well as buybacks) are not a negative development. On the other hand, we believe that one of Apple's best managerial qualities is the fact that it does not bend to shareholder whims. Unlike countless other companies, who frame everything through the prism of shareholder interest, Apple has always believed in the idea that if it runs its business well, its share price will take care of itself. That was true under Steve Jobs, and it remains true under Tim Cook. While we do believe that an increase in the dividend is possible when the company announces Q2 earnings, we believe that investors should not expect anything on the scale that Apple's level of cash & investments implies that it is capable of. Apple will grow its dividends and buybacks, if it chooses to do so, at whatever pace its management team is comfortable with, not the pace that its shareholders wish it would.
Investors who wish to add to or initiate positions in Apple should do so, in our view. Shares of Apple are near their 52-week lows, despite what we see as a good long-term competitive position, something that is backed up by several data points. However, we believe that any increase in an investor's holdings of Apple should be done with discipline. Our strategy for increasing our position in Apple is to buy 50% of our desired increase ahead of the company's earnings, something that we will likely do this week, and buy another 50% after Apple's Q2 2013 earnings are released. If Apple posts a weak quarter, shares will likely sell off, despite the steep sell-off that has already occurred in anticipation of such a quarter, even if it has served to push Apple's forward multiple (based on consensus estimates) to just 9.5x estimated 2013 EPS of $44.56 as of this writing. And if Apple rallies after posting a good quarter, shares are still far cheaper than their historical averages, with its shares trading at a discount of over 30% to the S&P 500. Apple's long-term prospects have been clouded by an inability of industry observers to find a middle ground when it comes to covering the company, and while competition has increased, we believe that Apple's best days are ahead of it. And with R&D expenses soaring, it is clear that something is happening in the "orchards" of California's leading fruit company. And we believe that in the long run, it will be far better to invest in that fruit company, for its harvests are set to be bountiful in the years to come.