Apple (AAPL) delivered another quarter of workmanlike growth after markets closed Tuesday. Will it be enough to start wooing back fund managers who’ve grown restless with the iPhone maker’s lack of innovation in recent years?
Once upon a time (2012), 46 actively managed mutual funds had at least 9% of their portfolios invested in AAPL stock. Today, only four fund managers have loaded up, suggesting the bloom is definitely off the rose.
When will fund managers return? That difficult to answer, because it depends on a complex arrangement of factors. What I do know is that AAPL stock is worth owning, despite skepticism from growth investors. Here’s why:
How Much Growth is Enough?
Five years ago this quarter, Apple delivered $8.3 billion in revenue and $1.7 billion in operating income. Today, it has $37.4 billion in revenue with $10.3 billion in operating income, which works out to annualized growth of 35% and 43% respectively. Clearly Apple’s growth has slowed considerably, but not enough to keep AAPL stock from testing its all-time high of $100.72.
But it hasn’t stopped altogether and it certainly can be reignited.
Take the iPod — probably Apple’s most truly original product — for example. It required huge investments by Apple in physical infrastructure, research and development, and some very talented employees in order to bring it to market. As McKinsey points out in its 2013 report Innovation Matters: Reviving the Growth Engine, “the iPod transformed the ways in which people sell, find, purchase, and share music.”
It won’t be easy, but Apple already has these three very important ingredients in-house; any money required should it need to add to any of them obviously isn’t an issue. Tim Cook might not be Steve Jobs, but he is certainly smart enough to know that an engine requires fuel.
Growth investors need to be realistic about Apple stock.
You can’t expect a company that’s generating $180 billion in annual revenue to grow top-line sales by 35% year-over-year as if it were one-fifth the size — it’s just not possible. Sure, you can move your money into stocks you believe can sustain 25% year-over-year revenue growth for the next 5-10 years, but those are few and far between.
When you consider that Apple has sold more than 350 million iPods over the last 13 years, it only takes one great product to set the engine afire. While we don’t know how successful either the iWatch or iTV will be once they’re released, but we can be pretty sure that Apple will manage to sell a bunch of them.
AAPL Stock: What’s It Going to Take
I expect Apple to grow revenue by 5% in 2014 with operating income anywhere between a 3.6% increase and a 2.6% decrease year-over-year. Two years ago, operating income was $55 billion. This year, it will be lucky to hit $50 billion. Gross and operating margins are lower today than they’ve been in several years. With R&D running about 30% higher than in 2013, operating margins aren’t going higher.
That puts added pressure on the company to improve its gross margins above 40%. It’s not happening in 2014, but it could pull this off in 2015 with the introduction of the iWatch. Watches have much higher gross margins than even the iPhone, which at one point topped 60%. The watch market’s not nearly as big as the smartphone market, but last year Citigroup (C) analyst John Chen suggested it could be a “$6 billion opportunity” for the company. Most importantly, it could easily replace the revenue and profits provided by the iPod, which is on its last legs, and definitely act as a catalyst for AAPL stock.
I see growth investors coming back to AAPL stock when it can consistently deliver gross margins of 40% or more while also growing top-line revenue by double digits. If the iWatch and iTV along with a bigger iPhone 6 are all well-received, it’s a certainty that growth investors will return to the flock.
But until this happens, I doubt many growth investors are going to back up the truck … and that’s a shame because the big gains are always made by getting in ahead of the curve. Value investors, you don’t want to make the same mistake. Buy while the valuation is still reasonable.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.