MORGAN STANLEY: This Time It's Different For Apple

Morgan Stanley analyst Katy Huberty has a massive report on Apple in which she tells investors to buy shares ahead of what is shaping up to be a giant fall.

She says, "this cycle is different" for Apple. Huberty is referring to Apple's product cycle, which is expected to include two new iPhone models with larger screens, and a new wearable device, which most people are calling the iWatch.

Most investors are looking at the iPhone 5 product cycle for comparisons to this year. After all, that was the last time Apple release a major design change (including a bigger a screen) for the iPhone. But, things are different this time, and Apple's shares are poised for a big break out as a result, says Huberty.

Here are the 8 reasons this time is different, per Huberty.

1. Institutional ownership of Apple shares is significantly lower than it was in 2012.

"Apple ownership, measured as its average weighting in the portfolios of the top 100 holders, peaked at 4.5% in the September 2012 quarter, and then troughed at 1.9% in the June 2013 quarter," says Huberty. Apple is currently at 2.3%, which is 2009 levels.

It's also lower than Apple's S&P 500 weighting which is 3.4%. Huberty says other technology companies are more heavily weighted in shareholder portfolios versus their weighting in the S&P 500. As a result, Huberty says, "we see room for investors, particularly managers of large long-only funds, to increase their Apple positions."

Morgan StanleyInvestors are increasing ownership of Apple, but still have a ways to go

2. Apple has significantly increased its cash return to shareholders.

When the iPhone 5 came out, Apple had a $2 billion dividend, and no share repurchases, for a total yield of .5%. This fiscal year, Huberty estimates Apple will have a total yield of 8.5% from $11 billion in dividends, and $31 billion in share repurchases. Since starting its share repurchase, Apple has lowered its share count by 9%.

As the yield increases, and the share count lowers, the stock price should increase.

3. Analysts are increasing, and will continue to increase, their estimates for Apple's business.

Apple's stock peaked on the day the iPhone 5 was released. From there, it fell hard. One the main culprits for the decline was a realization that Apple's business was not as hot as everyone thought. Starting in October, analysts began trimming their EPS estimates. As they cut back on their estimates for Apple's earnings, the stock fell.

This time, Huberty thinks the opposite will happen. Analysts have been increasing their estimates, but many of them don't have the iWatch built into their models. She thinks Apple could sell 60 million iWatches in its first year on the market. When the iWatch comes out, she believes analysts will jack their estimates and the stock will follow those estimate increases.

Getty / Ian GavanAngela Ahrendts

4. Apple has a stacked line up of new executives and new hires.

In 2012, Apple's executive class was basically the same group that had been there for a while, with a few holes here and there. Today, it has a mix of new executives, and older executives in new roles. Consider the following changes:

• New head of retail, Angela Ahrendts, formerly CEO of Burberry.
• New CFO Luca Maestri, formerly CFO of Xerox.
• Scott Forstall, formerly in charge of iOS, is out, replaced by Jony Ive and Craig Federighi.
• Kevin Lynch, the CTO of Adobe, is now at Apple, reportedly working on iWatch software.
• Paul Deneve, was Yves Saint Laurent, and is now working on "Special Projects".
• Dr. Dre, Jimmy Iovine, and Ian Rogers are now a part of Apple through the Beats acquisition.
• There are multiple people from Nike working on projects at Apple.
• Dan Riccio was promoted to run hardware engineering.

Basically, what we have here is some fresh blood. And we have a team that Tim Cook put in place to execute his strategy for the company.

5. Apple has increased R&D spending.

R&D spending doesn't necessarily mean much. For instance, Microsoft outspends Apple when it comes to R&D, and we've seen how that's worked out for the two companies. But, as you can see in this chart, there is reason to believe that the increase in R&D spending will lead to a new product.

Morgan StanleyR&D spending suggests something big is coming

6. Apple's going crazy with M&A.

Sure, everyone is focused on the big $3 billion purchase of Beats. But, Apple has made a number of smaller acquisitions. Since the release of the iPhone 5, Apple has made 29 acquisitions.

In the first three quarters of fiscal 2014, Apple spend $898 million buying companies. Over a two year span, from 2010-2012, Apple spent $820 million on acquisitions. Presumably, Apple infusion of talent and product will bolster whatever it's releasing this fall and in the years to come.

7. Gross margin seems to be stable now.

After the iPhone came out, Apple's sky high gross margins crashed going to 37%, down from a record high of 47.4%. As the margin collapsed, investors feared it would never end. However, Apple's margins have stabilized, and Huberty believes they will survive this product cycle. Benedict EvansMargins fell, but are stable and even ticking up a little

Here's what happened with the iPhone 5, per Huberty: "In September 2012, Apple introduced the iPhone 5 with a new form factor, which increased warranty expenses and suffered severe supply constraints initially, all hurting its gross margins. In October, the company also introduced the new iPad Mini and lowered the price of the 2nd-generation 9.7" iPad by $100, both of which we believe was margin dilutive to the company at low- to mid-20s gross margins."

Since then, Apple has raised the price of the iPad Mini with a retina display. It rolled out the 5C at a high price, which protected the margin. She believes Apple may raise pricing for the iPhone 6, and if not, its mix of components should protect the margin.

Further, she thinks the iWatch will have something like a 40% margin, which will help Apple.

8. Online services have matured into a real business for Apple, and there's room for much bigger things.

Apple's app business is booming right now, which is offsetting the decline in iTunes revenue. Apple has hired the Beats team to fix its iTunes problem and compete with Spotify.

Here are some charts from Ben Schachter at Macquarie Research that shows app store sales and growth:

MacquarieMacquarie

Huberty thinks Apple can increase revenue from users from software and services: "We estimate Apple currently generates about $1 of revenue per month per user. For comparison, streaming content apps like Beats Music, Spotify, and Netflix cost $8-10 per month. Each additional $1 per month per user would add five points of revenue growth and $0.57 of EPS annually."

Other possibilities for the future include using the fingerprint scanner, a wireless technology called NFC, and iBeacons to create a new mobile shopping service.

In conclusion...

You can see what Huberty thinks it's going to be different this time. As a parting shot, here is a look at what Apple's stock has done historically after a new iPhone launches. The stock collapsed during the Great Recession, and during the iPhone 5 launch. Otherwise, it's always been up.

So, in a way, things will be different, but really the same as they've always been.

Morgan Stanley