Apple: No Innovation, No Problem (For Now)

| About: Apple Inc. (AAPL)
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Apple's (NASDAQ:AAPL) 23% drop over the past two months has been accompanied by numerous explanations. Supply constraints, lower than expected gross margins, and glitches related to the iPhone 5's new Maps app (which is replacing Google (NASDAQ:GOOG) Maps) and the iPhone 5's camera have all been cited as rationales for the share price decline. Yet no single concern has received more airtime than the complaint that Apple's innovation days are over due to the death of its visionary founder, Steve Jobs.

Last week, Jeff Gundlach made one of the more extreme bearish calls on the stock, stating that Apple shares may fall as low as $425. "I'm really struck by this mini iPad thing as if that's any kind of a product innovation," Gundlach told CNBC. "Once you just start changing the size of your products, I really think you're not exactly innovating. I'm wondering if you're going to start coming up with the tootie-frootie mini iPad where it comes out in different colors because that would be absurd as innovation." Gundlach's view on the iPhone 5 seems similar. Similarly, Doug Kass came out against Apple over the past two months, arguing that the company is "losing its first-mover advantage," presumably to Samsung (OTC:SSNLF). While Kass has since reversed course, saying that the stock's decline has made shares attractive again, others have continued to hawk the "end of innovation" thesis. On Tuesday, another Seeking Alpha author argued that the iPhone's sales have already peaked. The iPhone 5 is not very innovative compared to the 4S (so the argument goes), which will quickly lead to a slower replacement cycle, market share loss, and margin contraction.

Perhaps the iPhone 5 should not be called innovative. The major improvements it received (compared to the iPhone 4S) were the following: 1) a larger screen, 2) an LTE modem, 3) a thinner body, 4) a faster processor, and 5) a new version of iOS. However, users of older iPhones can also upgrade to the new iOS 6. None of these upgrades were particularly radical, although the body design does require new manufacturing techniques. Yet they were the upgrades needed to make the iPhone competitive in 2012 and 2013; something Apple's critics seem to overlook. Many (though not all) users prefer a larger screen than the 3.5" size that was standard on earlier versions of the iPhone. Increasing LTE penetration in developed markets had created a selling point for Android devices, particularly at carriers like Verizon (NYSE:VZ). Putting LTE in the iPhone negated that advantage. A thinner and lighter phone will offset the slight increase in screen size, maintaining easy portability. With the iPhone 5, Apple has moved to counter some of Android's obvious advantages, while continuing to offer a best-in-class user experience. It's worth pointing out that even with the iPhone 4S (3.5" screen, non-LTE) at the top of its product lineup, Apple expanded its U.S. smartphone market share to 33.4% for the three months ending in July. Clearly consumers have been willing to sacrifice a little on technical specs in order to get the iPhone experience.

This brings me to my key point: Apple does not need to be innovating all the time to be incredibly successful. Indeed, if the company were constantly making radical changes to its products, Apple would risk alienating its loyal users. Instead, Apple is continually improving its product portfolio. Most of the time this takes the form of step changes (the larger screen and addition of LTE for the iPhone 5; the shrinking of the iPad 2 into a 7.9" iPad mini). To be sure, Apple will probably need a major innovation every 3-4 years to maintain its competitiveness over a longer period of time. Samsung, for instance, seems to be poised to introduce flexible displays in the next year or so. But in the near term, Apple is doing the right thing: giving consumers what they want by making incremental improvements to its existing products.

Apple's relatively low reliance on innovation at this point in its life-cycle is a major part of my investment thesis for the stock. I bought my first Apple shares less than a year ago (I paid $388 in December, 2011). Previously, I had always been wary of the stock's above-market multiple, because I feared that the company would one day release a disappointing product that would damage its reputation, which would subsequently depress sales. Recent events have led me to discount this scenario. In the "Antenna-gate" fiasco (2010), Steve Jobs initially riled up customers (who were upset about dropped calls due to a new antenna design) by telling them, in essence, to hold their phones differently. Eventually, he offered iPhone 4 customers free cases, which seemed to resolve the reception issue. "Siri-gate" (2011) was somewhat lower profile, but still resulted in a number of disappointed customers. Over the past year, Apple has been hit with a variety of lawsuits from consumers who claim that the company deceived them about Siri's capabilities. And the "Maps-gate" episode (2012) has led to a public apology from CEO Tim Cook and a major management shake-up. Yet these "challenges" have had no noticeable effect on iPhone sales, which have increased from less than 40 million in FY10 to more than 125 million in FY12 (and look set to increase again this year, if delivery wait times are any indication).

Today, many market-watchers seem to have forgotten that the iPhone 4S was a relatively disappointing product, given that earlier in 2011, a number of analysts had expected the next iPhone to include an LTE modem. The strong customer reception (iPhone sales up 70% year over year) to what was essentially an iPhone 4 with slightly better internal components and a voice assistant that didn't work very well changed my perception of Apple as an investment opportunity. Moreover, Apple's share price seemed to stagnate even as profit skyrocketed, causing the stock's multiple to fall below the market's earnings multiple.

Apple has a large and loyal group of followers, and there are probably tens or even hundreds of millions of non-users who aspire to eventually own Apple products. As long as Apple remains receptive to customer feedback and introduces improved iPhones and iPads (and Macs) on an annual basis, customers will continue to buy those products. While RIM's (RIMM) Blackberry ecosystem has a similarly loyal user base, there are not enough hardcore Blackberry users today to keep the brand alive long-term unless the new BB10 OS can bring in tens of millions of new users. By contrast, Apple's iOS has already reached critical mass (and it is still gaining perhaps 100 million new users annually). For the iPhone in particular, as the user base grows, replacement demand will drive significant ongoing sales; a recent study showed that 75% of older-generation iPhone users intended to upgrade to the iPhone 5 within the next year. In other words: the majority of iPhone users think the iPhone 5 is "innovative enough." Similarly for the iPad mini: the device was essentially sold out on its opening weekend, with a total of 3 million total iPads sold (most of which were the mini). Even if the iPad mini is just a shrunken iPad 2 at a slightly lower price, consumers want to buy it.

In summary, investors have no reason to be worried about a slowdown in innovation at Apple. The company is making the right amount of progress; providing new products that users want (the iPad mini) and adding desirable features to their existing product lineup (the iPad's retina display, and the iPhone 5's larger display and LTE modem). While these upgrades were not necessarily "innovative" per se, I am confident that they will drive 20-30% sales growth in FY13 through increased adoption and higher replacement rates. An agreement to offer the iPhone 5 through China Mobile (NYSE:CHL), the world's largest wireless carrier, could provide upside to that growth rate.

If Apple's product features are much the same in three years as they are today, the company may be in trouble. Personally, I think that Apple's massive increase in R&D spending will generate substantial future innovation, including new product categories. As detailed in the company's most recent 10-K, R&D spending has nearly doubled over the past two years from $1.8 billion in FY10 to $3.4 billion FY12. Considering that Apple was able to develop the iPhone and iPad in a period when R&D spending was limited to an annual average of less than $1 billion, there is a good chance that Apple pessimists will be surprised by Apple yet again.

Even if that is not the case, Apple shareholders have little to worry about at present. The company should be able to grow profits from its existing product lines to roughly $70/share in 2015 simply by continuing to make desirable improvements to its products. That alone is sufficient to justify a valuation well above Wednesday's closing price of $536.88 (or roughly $410 excluding cash).

Disclosure: I am long AAPL, RIMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.