Apple's (AAPL) 2013 Worldwide Developer's Conference is set to begin on June 10, and more than ever before, investors will be watching to see what CEO Tim Cook and his deputies reveal to developers, and by extension, consumers and investors. In our view, Apple's executives will deliver for all constituencies. Although new iDevices are unlikely to be unveiled at WWDC, Apple is set to reveal details regarding both iOS 7 and OS X 10.9, and rumors are swirling that iRadio will also be unveiled. In our view, a WWDC-induced selloff should be seen as a buying opportunity, for we believe that at Apple, innovation is alive and well, that the company's market position remains strong, and that investor (and sell-side) psychology will eventually swing away from present pessimism.
Innovation: A Style Uniquely Apple
For some time, we have argued that at Apple, innovation is alive and well. Many investors, analysts, and pundits have come to the belief that Apple is no longer innovating, that the company's "magic" has disappeared. The truth is likely far different. In 2007, Apple introduced the iPhone, in 2010, the iPad. And in 2013, Apple has the potential to introduce a new product category, most likely either a TV or watch, based on the seemingly omnipresent rumor mill. A new iPhone (and possibly a new iPad) are due as well, which will put Apple in a strong position for the 2013 holiday season. However, to truly understand that innovation is alive and well at Apple, investors should turn to what is likely the most obvious source: Apple's financial statements.
In its latest quarter (Q2 2013), Apple spent $1.119 billion on research & development, a 33% surge from a year ago; R&D matching the 33% increase for all of fiscal 2013 to date. Unlike many of its technology peers, namely Google (GOOG) and Microsoft (MSFT), Apple does not spend money on R&D for the sake of spending money. Apple's R&D efforts are almost wholly devoted to commercially viable projects. This stands in stark contrast to the R&D practices of Google and Microsoft. Google thinks nothing of spending $300 million on a project such as Google Wallet, even though only Sprint (S) allows the application to be installed on smartphones (the three other major domestic carriers block Google Wallet), and the service loses money on every single transaction, according to the project's former chief. And Microsoft, as has been well documented, has spent billions on research projects that have never seen the light of day, or have been felled by internal conflict. Apple, however, is far more focused. At Apple, a 33% increase in R&D expenditures is tied to the development of new products destined for the market, not R&D spending for the sake of spending. We believe that WWDC will lay the groundwork for an innovative second half of 2013, and that Tim Cook and his lieutenants will not disappoint.
Market Position: A Return to Grace in the Eyes of Observers
Apple's 2013 slide has been due in large part to concerns that the company is losing control of the smartphone and tablet market to Samsung (GM:SSNLF). As shares of Apple have fallen, Samsung has risen, driven by surging optimism over the company's Galaxy line. However, in recent days, there has been a turn in sentiment. On Friday, Samsung shed $12 billion in market capitalization, as multiple analysts, both in the United States and South Korea, have cut price targets and earnings estimates, citing slowing Galaxy S IV sales, including a slowdown in South Korea. The prospects of a refreshed iPhone, including a potential lower-level model geared towards emerging markets, along with Apple's rumored iPhone trade-in program, have been cited as direct reasons for this turn in sentiment.
As sentiment sours on Samsung, there is evidence to suggest that Apple's iPhone business is set to beat consensus estimates for Q3 2013. In late May, Morgan Stanley noted that its research indicates that Q3 iPhone sales will reach 31 million units, well above the 27 million consensus estimate. These above consensus estimates are corroborated by Jefferies' Peter Misek, who noted on June 7 that Q3 sell-through is set to be 30 million. Misek's note contains seemingly contradictory conclusions; he argues that iPhone sales are slowing (even though his 30 million estimate is well above consensus), but that this slowdown gives him increased confidence in a September launch for the iPhone 5S (evidence by Q3 build plans of 40-45 million units). Given that delays in the launch of the iPhone 5S (the tentative name for the successor to the iPhone 5) have been a source of great consternation for analysts, increased confidence in a September launch should be a bullish sign. However, in keeping with the latest trend within the sell-side community, Peter Misek appears to be extracting only bearish conclusions from the data points available. However, the rising prominence of this trend is best exemplified by research not from Jefferies and Peter Misek, but from Canaccord Genuity, which we will discuss below.
Observer Psychology: Overcoming a Desire for Failure
Given Apple's prominence in the consumer culture, both here in the United States and internationally, the company's renaissance after 1997, and the role of Steve Jobs, likely the most famous CEO in history, Apple occupies a special place in the minds of many investors. That mindset has, in the past, manifested itself in the sell-side community as well, with industry observers often referring to Apple as a "Wall Street darling." Now, however, the pendulum has swung the other way. Apple has become something of a Wall Street pariah, and multiple analysts are laying forth arguments that Apple's best days are behind it, despite having little meaningful information as to what is truly going on inside Apple. In our view, there has been a surge in a desire to see Apple stumble and fail, not because of any particular animosity towards Apple, but because of a belief that no company can be as successful as Apple has been for so long. It is as if Apple must fall from grace, because if it does not, the efficiency of the market will come into doubt. However, with Apple, the markets have rarely been efficient. In early 1997, investors headed for the exits, unaware that fortunes could be minted if they had been buying shares of Apple instead of selling. In 2007, when the iPhone was first released, few on Wall Street could have imagined the impact that it would have on Apple's stock price. And such market inefficiency is present today as well. As Tim Cook said on Apple's Q1 2013 conference call:
"I know there has been lots of rumors about order cuts and so forth and so let me just take a moment to make a comment on these, I don't want to comment on any particular rumor because I would spend my life doing that but I would suggest it's good to question the accuracy of any kind of rumor about build plans and also stress that even if a particular data point were factual it would be impossible to accurately interpret the data point as to what it meant for our overall business because the supply chain is very complex and we obviously have multiple sources for things, yields might vary, supply performance can vary. The beginning inventory positions can vary, I mean there is just an inordinate long list of things that would make any single data point not a great proxy for what's going on."
We do not believe that any Apple analyst has a true grasp of the state of Apple's supply chain. We agree with CEO Tim Cook that a single data point regarding component cuts at one supplier can truly be converted into a factual assessment of the health Apple's iPhone business (or the company's health overall). This is especially true if that data point is flawed from the beginning, something that we believe is perfectly exemplified by a recent report from Canaccord Genuity. The firm conducted a survey of the domestic smartphone sales landscape, targeting the retail arms of AT&T (T), Verizon (VZ), T-Mobile (TMUS) and Sprint. The firm concluded that the Samsung Galaxy S IV has stolen the sales crown from the iPhone at all but AT&T, surely a sign that Samsung is surging ahead of Apple when it comes to control of the smartphone market in terms of market share, and even eventually profit share. We however, do not think that this is an accurate conclusion, particularly because Canaccord's survey failed to include Apple stores, which almost certainly account for a large proportion of iPhone sales. How can a survey of iPhone sales be accurate if it fails to take into account sales generated at Apple stores? Further highlighting the error of this report is the fact that Canaccord itself inserted a disclaimer into the report noting that its survey excluded Apple stores, essentially guaranteeing that the results would be favorable to Samsung. The fact that Apple's retail stores were omitted, which evidence suggests account for around 15% of domestic iPhone sales (figures as of 2012, and may not reflect current trends), is a material oversight. On its own, Canaccord's survey is not that meaningful. But, it serves to highlight a recent trend regarding observer psychology when it comes to Apple. Observers are looking for ways to frame Apple as a company falling from grace, extrapolating such a conclusion even when the data fails to support it. However, we believe that the 2nd half of 2013 will go a long way towards breaking this mindset. Apple must recapture control of the narrative regarding the company, and WWDC will likely mark the beginning of this counter-offensive. Should shares of Apple fall on the back of a perceived soft slate of innovative features and products, we believe that investors should add to or initiate positions in Apple. On its own, WWDC 2013 is not about launches of new iPhones and iPads. Rather, it is about positioning Apple and its developers, who are crucial to its long-term success, for a strong holiday season. And we believe that Apple will be successful in delivering a strong showing at WWDC 2013, to the benefit of developers, consumers, and investors.