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Since Apple (AAPL) released its latest version of the iPhone on September 21st, the stock has been down around 22%. And since the beginning of November, when the iPad mini was released, the stock has been down more than 8%. Is this a temporary pullback that will allow hesitant investors, myself included, to finally jump in, or is there a more fundamental reason for the drop in stock price?

According to Harvard Business Review, the ecosystem is the most important mechanism by which technology firms must provide solutions, and Apple is supposed to have the very best. Ron Adner, in the HBR blog states:

The innovation game is changing. Delivering great products is no longer sufficient for success. And as the Fire's limited memory, ho-hum processor, and lack of camera demonstrate, great products may not even be necessary. Rather, what matters is delivering great solutions ... and the firms seizing the lead are those that can best align ecosystems of offers and partners."

Since tech experts always laud the Apple ecosystem as the key to its success, we thought we would look a bit closer and determine for ourselves if Apple's ecosystem is truly a strength, or if it is becoming increasingly more of a liability.

Defining an Ecosystem

According to Wikipedia, an ecosystem is:

a community of living organisms (plants, animals and microbes) in conjunction with the nonliving components of their environment (things like air, water and mineral soil), interacting as a system. These components are regarded as linked together through nutrient cycles and energy flows.

However, let's rewrite this paragraph to make it more consistent with the type of ecosystem that many technology companies, including Apple, Google (GOOG), and Microsoft (MSFT) are trying to create:

A community of people in conjunction with the electronic components of their environment (PC's, Laptops, Smartphones, TVs, digital music players, etc.) interacting as a system. These components are regarded as linked together through individual preferences and information flows.

Now we can get into further analysis regarding ecosystems and whether the Apple ecosystem will continue to serve as a strength against competitors. Or if the technology ecosystem, unlike the natural ecosystem that we live in, will require too many resources to maintain in balance. Can it continue to be a strength or will it become a crutch that may allow for the smallest opening for a competitor to take advantage of.

An Example of A Strong Ecosystem - Apple

While we don't give it much thought, a strong ecosystem must have certain components to 'capture' our attention and 'retain' our interests over long periods of time. It does so without our conscious effort but rather, through a subconscious ease by which we use the various products that make up the system. The entire system is taken for granted much like we take for granted the air we breathe and the water we drink. Only when a component of the system doesn't work, causing us discomfort, or creating a chain of events that deteriorate our way of life, do we then realize the importance of an entire ecosystem.

For an ecosystem to work and more importantly, for a technology ecosystem to provide a firm with a competitive advantage, it must have the following five components:

1. It must be holistic - an ecosystem must satisfy all of our needs, particularly the ones we don't even know we have. The risk of leaving just a small gap in offerings can be the beginning of the end.

2. It must be seamless - all of the parts of the ecosystem must work together with little to no effort.

3. All of the parts/components must be interdependent - the success of one aspect of the ecosystem must be intertwined with all other aspects of the system.

4. It must be easy to use - for a non-techie like me, plug and play is the only way to go.

5. It must have content - it must contain tons of content. Without it, you have a system with no reason for existing.

Our analysis of Apple suggests that it probably has the most well recognized and potentially addictive ecosystem of all of the technology companies. Apple would rate high on all five of the components mentioned above for a strong ecosystem.

The Apple system, as we can see from the diagram below, includes just about every electronic device we use on a daily basis. At this point in time the only device missing from the Apple suite of products is a gaming console that can compete with XBOX.

Source: www.calvin.edu

It is also completely seamless and interdependent. For example, I can connect my phone to my desktop (PC) and iTunes will automatically synchronize my music. For a non-techie like me, this is invaluable. As Adner points out in the HBR blog:

When Apple expanded from music players to phones, it carried over to the iPhone not just the technology and software that powered the IPod but also the users' entire music collections and its music stores entire supplier base. This was not about creating switching costs (iPod users could continue to listen to their iPod while using Nokia phones). Rather, it was about leveraging existing relationships to create enhanced offers(by porting over your iTunes collection, Apple made the iPhone more valuable to you). By carrying over elements from the iPod ecosystem, Apple gave the iPhone a running start.

While not absolutely necessary, the more interdependent each component of the ecosystem is with other components, the greater the potential strength of that ecosystem. Apple, for example, uses a proprietary format that is compatible across all of its devices and cannot be used on non-Apple devices. The iTunes mentioned previously is a great example.

What seamlessness and interdependence creates is switching reluctance. The more a user has invested, financially or otherwise, into a system, the less likely they are to switch.

GFK analyst Ryan Garner conducted a study to determine the likelihood of users switching platforms when they own multiple devices from the same company. According to Garner:

Those who are satisfied with their current set-up will be difficult to tempt to a new platform and the more services they use, the greater a consumers loyalty to a brand

As we can see from the chart below, the higher the number of devices owned within the Apple suite of products, the higher the probability that the next purchased device will be an Apple.


(Click to enlarge)

Easy to Use - lets face it. There are more and more tech geeks in the world today than there were a few decades ago. But the average person is not technologically savvy and so the higher the level of technology or capabilities within a component, the easier it must be to use. I picked up my Apple phone and started using it immediately. No need to read the instructions. It was easy.

As for content, Apple dominates its competitors with the number of apps available and the ability to access these apps from multiple devices. According to Topeka's Brian White:

Apple's ecosystem still remains the best in the mobile device world with over 650,000 apps in total and 225,000 apps that are native to the iPad. This compares to 600,000 apps in total for Google and an insignificant amount that are native for tablets. Apple already has 400 million accounts on the App Store with more than 30 billion App downloads, while 125 million users have registered for iCloud.

Where it might still need work are in the areas of social networking, office suite, TV, and cloud based software. In every other area of the ecosystem, Apple is strong.


(Click to enlarge)

Challenge of Maintaining Ecosystem

It is hard to argue that Apple's ecosystem is not the best in the world. But like any King and his Kingdom, the wider and more encompassing the system becomes, the more resources are required to maintain that system in place. Challenges arise from many angles and Apple must focus on these challenges to maintain its hold on the consumer and further deepen the switching reluctance we previously mentioned.

In regards to products, many Apple doubters are apt to mention that in order for Apple to continue to succeed, they must continue to innovate and make each product much better than the previous one. Not slightly better, but substantially better, with richer features, slicker designs, and the capability for us to perform an activity on it which we previously didn't know we needed to do. While Apple diehards will upgrade with every opportunity, more practical consumers will weigh the additional benefits versus the added costs before spending money on a new phone every two years.

And the success of each new product, whether an upgrade to an existing one (i.e. iPhone) or a completely new product launch (i.e. gaming console), may be overly dependent on the ecosystem of which it is a part of. For example, will loyal xboxers purchase an Apple offering that when isolated from its ecosystem, does not offer the same level of graphics, controls, games, etc., that is offered by Microsoft?

After all, an ecosystem, like a chain, is only as strong as its weakest link. At what price point do consumers forego buying an iPhone in favor of a cheaper alternative with similar, albeit, slightly inferior features? Even if they have to sacrifice the seamless, interdependent, easy to use Apple system.

Morningstar analyst Brian Colello believes that:

Apple will have to continually develop superior products on all fronts (hardware, software, services and third-party apps) while fending off many strong rivals in end markets highlighted by short product life cycles and intense competition. We expect Apple to remain a premium supplier of devices, even though rivals will clearly compete on price; Amazon AMZN is essentially selling its hardware at cost in order to profit from higher online media sales, and Google gives the Android OS to handset makers for free in order to drive search traffic. Apple may do a better job than any other phone or tablet maker in raising the switching costs associated with its devices, but as rivals like Samsung develop products with similar functionality and others offer serviceable products at much lower prices, a few missteps from Apple could drive customers to leave iOS altogether, especially as consumers replace phones every couple of years.

A great example is the recent launch of the iPad mini at a price point considerably higher than the Kindle Fire or the Google Nexus 7. Some call the Google Nexus the most beloved 7 inch tablet. Cnet.com was running a poll at the time this article was being written and out of 4,950 respondents, 73% preferred the Google Nexus 7 over the Apple iPad Mini. At a price of $329 for the iPad Mini and $199 for the Nexus, can Apple really compete in this space? Of course they can, but the playing field has changed and continues to evolve.

The ecosystem can be attacked from a variety of angles. The Samsung Galaxy S3 looks like a pretty slick phone with some cool features that can compete with the iPhone. The Xbox is a leader in the gaming console category that Microsoft is leveraging to strengthen its own ecosystem. We already mentioned the Google Nexus. At some point, these products may be so much better than Apple's offering that a consumer may be willing to sacrifice the value of the ecosystem in exchange for the best product in a specific category.

Or worse, as we see from the chart below. A competitor need only match Apple configurations at cheaper prices before they switch. While some consumers will require much larger discounts than others to have any incentive to switch, in a world of ever decreasing technology and labor costs, someone is bound to come along at a lower price.


(Click to enlarge)

So is Apple's ecosystem truly a strength that will continue to allow Apple to dominate every market that it participates in? Or will the ecosystem and the challenges it presents eventually become a liability? Will new product launches require Apple to compete on price, eroding profit margins on the software sale so it can focus on the applications? These questions are being asked much more often now than they were just a few months ago.

Valuation

But have no fear my Apple diehards!! I don't think that time will arrive anytime soon. Apple's ecosystem is still further ahead in its ability to capture and maintain users than any of its other competitors.

Furthermore, I believe Apple is currently trading at well below intrinsic value. Morningstar analyst Colello states:

We are raising our fair value estimate to $770 per share from $670, based on improved long-term growth assumptions. This fair value estimate implies fiscal 2013 (ending September 2013) price/earnings of 15 times, enterprise value/EBITDA of 11 times, and a 6.5% free cash flow yield. Given the success of the iPhone 4S, iPad 2 and "new iPad" to date, we project 45% revenue growth in fiscal 2012. We expect Apple's momentum to continue in the near to intermediate term and project 21% sales growth in fiscal 2013 and 17% in 2014.

We agree with Colello that revenue growth should continue to be robust and point out that despite its lower than expected earnings this past quarter, Apple is trading at just 12.4 times earnings and 9.2 times next years earnings!!! The S&P 500 is trading at a 14 times forward PE. Is that a joke? If you were like me and missed the opportunity to buy Apple before, take a long hard look this time. As the saying goes, "fool me once, shame on you, fool me twice, shame on me."

Source: Apple's Ecosystem: Strength Or Liability?

Additional disclosure: I am also long GOOG