The Exchange

Amid a wall of pessimism, it’s not hard to see a bullish case for Apple

The Exchange

It's put up or shut up time for Apple

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It's put up or shut up time for Apple

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Update: Apple's iPhone renaissance got an early start. The company just reported sales of almost 44 million iPhones in the first quarter, about 6 million more than Wall Street expected, helping drive revenue and profits higher than expected, as well. Shares of Apple jumped 8% to over $566 in after hours trading.

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Apple (AAPL) grew from the edge of bankruptcy to become the most valuable company in the U.S. stock market by making highly profitable devices for fast-growing markets, whether it was iPods, iPhones, or  at least at the start  iPads.

Lately, it’s been all stagnation and shrinkage for Apple and its investors. At $528.60 on Wednesday, Apple shares remain 25% below their September 2012 all-time high of $705.07 while, over the same period, rivals such as Google (GOOGL) and Microsoft (MSFT) have posted big gains.

And while almost everything you read about Apple now is pessimistic at best, there’s a simple and straightforward bullish case for the company, one that doesn’t rely on a bolt-from-the-blue acquisition or game-changing new product. To get the stock going again, Apple CEO Tim Cook needs to get back to what the company does best, aiming some of its highly profitable devices at faster-growing market segments. And with larger screen iPhones on tap later this year, iteration   not innovation   will be enough. Truly low-priced phones and tablets for emerging markets would help, too.

The core problem

The core problem over the past year has been the slowing growth in Apple’s two biggest lines of business, the iPhone and iPad. Last year Apple sold 153 million iPhones, up just 13% from 2012, according to IDC, while the overall market grew 38%. And Apple sold 70 million iPads, up 15% as the market grew 68%, according to Gartner. And while Apple makes a lot more profit on each sale than most of its rivals, its overall profits shrank last year.

Analysts expect more of the same in the first quarter report, due out after the bell Wednesday. Most think Apple’s overall revenue will shrink from a year ago, the first time that’s happened in more than 10 years.

Most commentators seem to think the only way out for Apple is via some huge surprise – a new product in a whole new category, a massive acquisition or a share buyback exceeding the GDP of Finland. Tuesday on Twitter (TWTR), venture capitalist Marc Andreessen said Apple should buy Twitter and Dropbox, while investor Howard Lindzon preferred an Apple-Netflix (NFLX) combo. Others hope Apple can make a splash in the television, payments or health and fitness markets.

But much of Apple’s past success came from simply refining existing good products into world-beating great products. It wasn't the original iPhone that powered Apple stock to its all-time highs, after all, but tweaks and iterations.

The day before Apple introduced the iPhone 4 on June 7, 2010, Apple’s stock stood at $255.96. By the end of the month, shares had slumped to $251.53. But phone sales exploded, and the day before the updated iPhone 4S was introduced on September 12, 2011, shares had risen to $377.48, an almost 50% gain. It was a year later that the stock famously topped $700.

The reasons were twofold – Apple jumped on a massively rising tide of high-end smartphone sales and the 4/4S cycle was incredibly profitable. Early iPad sales also looked to be following a similar trajectory.

Shaky times

But since then, like a shaky surfer in rough waves, Apple has fallen off the fastest-rising tides of lower-priced devices and larger-screened phones. There’s a lot of talk about the smartphone market reaching a saturation point, but it’s really just at the high end. Smartphone sales grew at 40% rates the past two years and reached 1 billion last year. But almost all the growth was in the two categories Apple has ignored.

It’s not like Apple execs don’t know this. A 2013 internal presentation released as evidence in Apple’s patent lawsuit against Samsung made the problem perfectly clear. Labeled “Consumers want what we don’t have,” the chart showed that the market for phones costing less than $300 grew by 159 million units in 2012, and the market for costlier phones with screens larger than 4 inches grew by 91 million. The rest of the market, where the iPhone battles, shrank by 22 million units.

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Strategy Analytics analyst Ken Hyers says the trend continued in 2013, as sales of phones with screens over 5 inches grew five times faster than sales of smaller-screened phones.

“They really did miss the boat as consumer demand shifted towards larger devices,” Hyers says. “That has cost them customers and market share, particularly in Asia, where larger smartphones and phablets are particularly popular.”

And it's increasingly clear Apple is going to fix this issue this year. Reports from Reuters, Bloomberg, the Wall Street Journal and others all point to iPhones with bigger screens coming with the next upgrade. Apple has been much better about keeping secrets around its pricing moves, so it's harder to tell if the company will also address the low-end of the market this year. A high profit, low price device would be another win.

The tablet market may be a more complicated problem for Apple to solve. Cheap tablets perform most of the tasks people currently want to do with their tablets at half the price of an iPad. Apple's advertising has emphasized how much more can be accomplished with iPads and iPhones, but consumers aren't following the company's lead.

But, at least with the iPhone, all signs are that Apple will address its gaping problems in the fall. And with expectations low and the stock trading at a depressed valuation, this could be enough to turn things around.

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