Apple Inc. (NASDAQ:AAPL) never wants to make low end products according to analysts at Barclays. However, Apple will need to convince investors that 35% margins will be the floor. Earlier we covered part of the new report from Barclays regarding the company's ecosystem, which the analysts believe is solid and has room to grow. However, Barclays has slightly lowered their price target on the tech giant. Below we look at the margin issue and price target math.
Can Apple Make an Argument for 35-40% Gross Margins Long Term?
Barclays believes that margins are the biggest concern for investors. While Apple Inc. (NASDAQ:AAPL) understands the market concerns, they do not believe that management is ready to give a long-term target. However, it doesn’t seem to them that Apple "ever wants to make low-end products" – and will always strive for premium devices that offer a more complete experience.
For the stock to work, they believe that Apple Inc. (NASDAQ:AAPL) eventually needs to convince investors that 35% is a floor for gross margins – in order to justify EPS in the $40 range even in tough years. Each point in margin equates to about $1.50 in EPS based on FY13 revenues – so this point really matters.
Looking at the big picture, since Tim Cook came to Apple Inc. (NASDAQ:AAPL) the company has developed an excellence in manufacturing that helped it keep industry leading margins. Apple effectively delegates the production and manufacturing of its devices to a wide variety of supply chain partners.
Everything from the casing of a MacBook to small connectors in an iPod is outsourced to a highly developed and closely managed chain of production. Apple’s size gives it significant market power allowing the company to extract margins, pricing advantages and economies of scale out of suppliers. This advantage may be sustainable.
Recently investors have become very concerned that the rise of Android will pressure margins into the lower 30% range vs. the 38% range currently. The concern is that Apple could face the same fate as RIM and Nokia – and "some cracks are already showing". Apple is still performing much better than other handset and IT Hardware companies in terms of
Management needs to continue to address the nature of its suppliers and its recent investments in tooling can assuage concerns. Also, some basic views around product mix and scale would be warranted as well. Investors need to be reassured that movements to the low-end of markets don’t necessarily mean margin destruction. A history lesson of how Apple Inc. (NASDAQ:AAPL) averted that fate after the release of the iPod nano and Shuffle and/or the release of the Macbook is warranted.
Given lower estimates, Barclay's price target for Apple Inc. (NASDAQ:AAPL) is now $530 based on 11x reduced FY14 EPS estimate of $48.92. The target represents a discount to the market (S&P 500 trading for 14x 2013 EPS). They believe that given competition and slower growth potential, this type of valuation is realistic.
Furtheremore, the analysts "believe sentiment appears to be approaching a bottom" – while citing the biggest risk as the sustainability of margins. Apple Inc. (NASDAQ:AAPL) is a “platform” company like Amazon, Google and Facebook – and has the ability to reaccelerate its growth with innovation.
Sentiment for Apple Inc. (NASDAQ:AAPL) could improve if the company can get investors more excited with new products later this year. Barclays will be watching carefully whether the company can successfully develop new services that re-energize customers and the investor base. The prior target of $575 was based upon 11.5x on prior FY14 EPS estimate of $50.