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The market sent a strong and clear signal after Apple's (NASDAQ:AAPL) earnings release on Wednesday, January 23rd: not good enough. How to react as an investor? Is this a falling knife, or is this a great company that's on sale due to market hysteria?

Here at SA we have had enough people crunching numbers, pointing to revenue, EPS, P/E, margins etc. - which are of course still very compelling, but it tends to obfuscate why the stock has cratered. Apple is down in the doldrums because of its future-looking story, or more precisely its lack of any story. Apple seems to be lacking ideas. These future-oriented ideas are, like it or not, what drives investor hype (Research in Motion (RIMM), Amazon (NASDAQ:AMZN)) or investor hysteria in the tech sector - see this insightful article by Vince Martin.

But hype and hysteria sometimes are not always wrong -- an investor must consider the possibility AAPL is a falling knife. And everybody will begin to doubt his or her analysis while looking at deep red losses post-earnings.

The bear case on Apple has mainly been focusing on its perceived lack of innovation. Maybe they are still innovating, I don't know -- only Apple's management knows what they'll bring out next -- and instead in this article I would like to focus on one factor that I believe will play an absolutely crucial role in Apple's future: the evolution of its brand-image. I will argue this is a serious moat around Apple's earning capacity.

Nonetheless, one must consider how this moat could shrink with time. I can see two potential catalysts that could reverse customer perception of its brand:

  1. competitors offering products of superior hardware, and
  2. product diversification.

I treat these points sequentially, and as a third point I will present the idea that innovation, which is now seen as Apple's biggest problem, only will need to be incremental instead of revolutionary in order to return value to shareholders.

1. Apple's brand versus Apple hardware

Some may tout Apple's products as the best in the world, and while I don't want to argue about that, I want to point something that is infinitely more valuable: Apple's brand. Like Nike (NYSE:NKE) or Coca-Cola (NYSE:KO), Apple seems to have succeeded in building up a very precious good: an instantly recognizable and almost universally appreciated brand.

This means that Apple products are not just about 'specs' any more: they are fashion statements. Incidentally, I believe this is why many will continue to detest Apple, simply because they are put off by Apple's brand-image. Yet, over the years Apple has acquired a very distinct and loyalty-inspiring brand - something never quite equaled by Nokia (NYSE:NOK) or Blackberry in the day.

Wait -- perhaps Blackberry came close. Yes, Blackberry also had a strong loyalty-inspiring brand, and a number today are still proud owners of BB devices. Yet Research in Motion has suffered a horrible fate, despite its brand. Could this happen to Apple?

Remember what brought about Research in Motion's demise: they were wiped out of the market by a vastly superior product, the iPhone. So if the analogy were to hold, and Apple to suffer the same fate, there would need to be a vastly superior product out there today. Is there? In all honesty, it does not seem like it. Today there is no revolutionary device out there - only devices with incremental changes, such as those with larger screens made by Samsung (OTC:SSNLF), better cameras in Nokia's Lumia series, or perhaps better software features in BB10. There does not seem to be anything out there that will redefine the smartphone market in a couple of quarters.

Nonetheless, if Apple's market share won't come crashing down all of a sudden, it is possible it may be whittled down slowly but surely. I see two potential factors:

  1. inferiority in hardware specs to other devices
  2. superior supply chain management by competitors (Samsung).

Let's consider these two factors now.

Unlike previous generations of iPhone, the iPhone 5, I am reluctant to admit, does not have the best hardware out there among its competitors. But because of brand appeal, the smooth intuitive appeal of the iOS, and the ecosystem, customers keep coming back -- last quarter's result show this is not much of a problem.

However, if Apple management rest on its laurels and bring out devices which are no longer equal (let alone superior) to its competitors, it will slowly but surely lose customers. Why? The Apple logo won't stand for pricey superior devices, but will stand for a rip-off. Apple prices its products as high-end, so it really needs to make its products superior to most of its competitors, including hardware. Apple can expect only so much premium for its brand.

However, it's not that difficult to have superior hardware: you just need to shell out a bit more for good components. I have confidence that Apple management realizes this -- and in fact, they are constantly toeing a fine line between maximizing profit margins and improving their products' hardware.

Concerning supply chain management, Apple has been doing very well here, as it is such a large customer and consequently has great bargaining power. However, the success of Samsung is largely due to the fact that they can produce a lot of the parts internally, and thus can organize a leaner, more flexible supply chain than Apple can. Witness the fact that Samsung excels at everything from smartphones to washing machines to ships. An excellent analysis of Samsung's strength here can be found in Jaded Customer's article series on mobile manufacturing.

Their expertise in supply chain management has translated into either higher gross margins, or an increased ability to price its products competitively. Nonetheless, when it becomes more economical for Apple to produce a component in-house, Apple has a history of doing so. For this reason, if we are to weigh the relative importance of this factor, it is likely to play a lesser role than the evolution of Apple's brand name.

2. Apple's brand versus product diversification

Perhaps the major catalyst for further growth would be product diversification. Saturated markets (such as the U.S. market) could show further growth if Apple offered alternative iPhones as it already does in the iPad and Mac line. (And nota bene: it would be good for Apple's European and Asian market share to bring down prices slightly over there, where Apple products are up to 30% more expensive than in the U.S.)

The idea of a cheaper iPhone is being widely circulated in the media; Apple has stated it 'doesn't chase market share' as it would dilute the company's brand. But would it really? As the smartphone market matures, the rationale for diversification between high-end and low-end products becomes greater, because many phone users will remain unwilling to fork out 700$ for what they perceive as 'just a phone' (think of your mother here). If Apple can find a way to offer basic functionality PLUS a distinct Apple experience, it should be able to ask a premium for these devices (as it already does with the iPad Mini by the way).

This possibility has been widely discussed elsewhere; and on the whole, yes I believe it is safe to say this would be a very good idea.

This is diversification with regard to cost. As an imaginative leap, why they don't diversify for different types of users?

Imagine two new product lines, say,

  1. 'iPhone Business', that would cater for businessmen, offering, say, the work/personal mode. This would also remove Blackberry's reason of existence in one fell swoop.
  2. 'iPhone Me' for teenagers, something that would similarly offer serious difficulties for Nokia.

Surely these products could easily be developed, considering Apple's enormous resources. Also, the marketing geniuses in Apple would surely be able to come up with a way to integrate these products within its total brand.

Nonetheless, my best guess is that Apple won't follow through on any such idea in the foreseeable future, because of the fear -- perhaps unfounded, perhaps justified -- it will dilute its brand-image. Probably this will require an external catalyst -- such as Research in Motion and Nokia grabbing some serious market share.

3. Is Lack of innovation a factor?

After the iPhone and iPad, what next? Apple TV is touted by some as Apple's next great innovation, but I fail to find this very convincing. Margins are notoriously bad in this industry, and competitors are already well-entrenched (Samsung, Sony (NYSE:SNE), etc.), so this would be at best an incremental addition to the business, not a revolution. The iPhone was the first to combine phone, mp3 player and touch screen; the iPad was a completely new concept. We already have TVs, so it seems safe to say Apple TV will not be revolutionary to the same degree.

Product diversification, managing the supply chain and entering new geographical markets are likely to be much more important for the bottom line.

In an interesting contribution, Ashraf Essea has interestingly pointed to the innovation in the new tablet/laptop hybrid market, innovation that Apple is completely ignoring. Yet, this observation does not factor in the role of brand-image. In a well-established company, brand-image must be supported by above-par products (i.e. if Apple starts making crap, its brand will be damaged), but does not depend on radical innovation.

That being said, even though the tablet/laptop hybrids might be too geeky for Apple, if Apple marketing thinks it will be successful, one could easily imagine Apple reacting to these trends. For example, a touch-screen laptop. Again, such things are incremental changes rather than revolutions. Thus in short, Apple's brand will fend off competitors, and Apple can easily latch on to incrementally innovative changes. (As it is doing with screen size by the way.)

Summary

I haven't done any quantitative analysis here, as the article is long enough and I wanted to focus solely on the ideas involved. I agree with many commentators that Apple is no longer the growth company it once was, but my point was to argue that this is not important with the stock price at these levels.

There is a genuine shock in the investing community as it abruptly revises its estimates downwards -- as Alan Brochstein notes here. But this has been coupled to a selling hysteria, as if people believe the lack of innovation will send Apple into bankruptcy. One only needs to look at the media headlines, 'The beginning of the end', etc.

This has happened to too many tech firms in the past; however, there is an asymmetry involved in the Apple situation, because today its customers care mainly about its brand-image, not innovation. Apple will need to keep putting out above-par quality products and keep up with incrementally innovative trends, but as long as it does that, it should be able to keep on demanding a premium for its products. There is a distinct probability Apple will be the first of the tech stocks to reach the status of a blue-chip as Nike, Coca-Cola or Procter and Gamble (NYSE:PG) -- companies where 'innovation' is a mere buzz-word, and shareholder return the real concern.

At $450, we have a company at 10 times trailing earnings, with decent growth prospects, and a company that has a sufficiently wide moat that should allow a smooth transition into a reliable, blue-chip company. Margins might compress a bit, but will continue to be higher than those of competitors because of the premium of the Apple brand. If Apple can prove its reliability, it will be rewarded with a higher P/E.

From this perspective, the end of radical innovation does not mean a crash, but the start of a stable company. If we assume that management will be able to shape up and address issues in supply-chain management, and product diversification, then Apple is almost definitely undervalued in the medium to long-term. I don't want to make a guess at a price target, but I am pretty sure it will be substantially higher than present levels (and definitely when the investing community realizes Apple's brand is its most valuable asset).

Source: Apple's Brand-Image Matters More Than Innovation