How About a Piece of the Apple Pie?

So my brother tells me that a friend tells him to sell his investment in Apple (AAPL), "It is dead money... just like Steve Jobs is dead."

Well, yeah, maybe. Certainly, many investors worry about Steve Jobs' health, not solely for the man and his family, but for the company... and for the stock.

Time has proved Steve Jobs to be a singular force of nature; even while deathly ill he still musters the strength to challenge other CEOs, mano a mano, to a screaming match. All in his visionary quest to get the best deal for Apple, Inc. But we investors and bystanders have the opportunity to see, real time, the mettle of Apple's bench; can the other executives rise to the occasion?

Another worry that plagues many investors is whether Apple's heyday is behind it; that the company's phenomenal cycle of innovation now is a thing of the past. Perhaps. No one, me included, can really confirm that possibility. Apple's strategy might be best defined as evolutionary rather than revolutionary, with a focus on its three core markets. (iPhone, iPod, and the Mac.)

Apple chooses to play in only a handful of businesses that manifest huge addressable markets; the company offers a narrow suite of premium products to these huge markets. Apple is most bullish about its iPhone business, where it has massive opportunity to gain market share (and has done so already); one in which software would be its principal differentiator. (Its operating system and, more importantly, the App store.)

Investing is a discounting mechanism; investors buy today to sell at a higher price tomorrow. And vice-versa. But the process of investing discounts the knowns, the perceptions, and how other investors might react to changing perceptions and changing realities. Sometimes, though, there exist some facts that are little known, if at all.

Click to enlarge

Consider:
1) The Apple retail store. Apple has always bordered on a cult, if not a full-fledged religion, with the Apple fanatics proselytizing the company's products. Someone at Apple had the bright idea to hire the nicest, friendliest, most knowledgable among them, cloak them in the appropriate priestly robes (er, white t-shirts), and have them share with you, gently, the truth, beauty, and elegance of owning an Apple. Each priest -- er, salesperson -- is knowledgable, helpful, and discreet; nary a one pesters you to distraction. God love 'em all. The sales at Apple's stores qualify as a retailer's dream, an amazing $4700/sq ft; leaps and bounds ahead of its nearest competition.

And just last week, Microsoft (MSFT) announced its me-too strategy, that it will also open retail stores. Somehow, the cachet of selling goods, damaged while still in the box, does not compare to the Apple experience; i.e., Apple's successful retail sales strategy is a result of its well-designed and lovingly-engineered products and the religious devotion of its consumers. Microsoft offers nothing even remotely similar. Nor for that matter, does any company. Talk about elegance.

2) The iPhone. Everyone, me included, splashed water on the notion of Apple building and selling a cell phone. Cell phones were mostly differentiated by shape, color, service provider, and service plan -- until Apple joined the fray. With one fell and resounding swoop, Apple wrested control of the cell phone's destiny from the service provider and placed it firmly into the hands of the phone's builder. Apple dictated terms, and the service providers bullied one another for the opportunity to be the sole seller. In the U.S., the winner was AT&T (T), alas, but the iPhone is an instance where the beauty, functionality, and usefulness of the iPhone trump the ugliness of the service provider. Although barely.

But this all is well known. Less well known is Apple's ultra-conservative accounting for iPhone sales. Unlike other cell-phone manufacturers that book 100% of the revenue from each phone sold within the quarter the sale occurs, Apple amortizes the revenue over eight [8] quarters, 2 years! Apple's thesis is to match iPhone revenue with the standard 2 year service contract. This accounting is very conservative, as mentioned, but think about it: iPhone sales reported within any quarter actually represent only 1/8 (12.5%) of the total sales. This means there exists an increasing chunk of revenues yet to report. If accounted for under GAAP, Apple's revenues and earnings from the iPhone would be higher, much higher -- which makes the stock inexpensive, and downright cheap. Go figure.

3) The Applications Store, especially iPhone apps. The Apple apps store upends the entire software business model; previously, a buyer would think long and hard before spending $500 on software; licenses at $30/ year also caused buyers to pause before taking the plunge. But at 99¢ -- who needs to think? You buy, and if the program satisfies you, great! And if it fails to work or inspire you, no big deal.

And, suddenly, just like that, everyone has a method to strike it rich, instantly. Write a program, like Ocarina, take advantage of the network effect and sell it to hundreds of thousands of iPhone users, and bling bling, sit back as the cash registers ring. And ring. Yes, you too can be a millionaire.

But I neglect to mention the elegance of this setup for Apple, and Apple investors. Apple merely builds and minds the store; non-employees dream up these addictive programs, and sell them on Apple's apps store. The sharing arrangement is 70/30, which means that almost the full 30% of the revenues from the apps store drops to Apple's top and bottom line. The company's SGA for this part of the business is next to nil. Beautiful. The apps store looks only to improve. Who knew?

Oddly, two of the three items above are peripheral to the company's primary mission of making and selling electronic devices. But each also takes advantage of a unique set of circumstances that only a company such as Apple, with a visionary leader such as Steve Jobs, can offer.

I could quantify for you even more the value of Apple's story, but why bother? You hope to divine the market's every squiggle, a tempest in a teapot, which effort causes you not to see the big Kahuna, the wave that will carry you all the way to shore. Market cycles come, and market cycles go, but value always wins out. Sell Apple, if you prefer, because you fear its share price will decline (farther) due to a sloppy market. The best opportunity is on sale at a ridiculously cheap price, growth at a value price. So how about a piece of (apple) pie...?

Full Disclosure: Long Apple. And happy.

Comments

[top_tier:]

"there exists an increasing chunk of revenues yet to report. If accounted for under GAAP, Apple's revenues and earnings from the iPhone would be higher"

Typo; if accounted under "non" GAAP...earnings would be much higher.

I normally ignore typo's, but this one changes the fundamental premise and is important to correct.

But true, if one ignores the huge amount of deferred earnings by strictly looking at GAAP numbers, then they undervalue Apple tremendously.

Feb 16 08:22 AM

[Mac'em X:]

"... the company's phenomenal cycle of innovation now is a thing of the past. Perhaps."

Perhaps so. But is there actually any *reason* to think this?

"Apple has always bordered on a cult..."

No. That meme is and always has been nothing more than the lazy journalist's crutch. Let's give it up already.

What binds Apple customers to the company is *perceived value* of the products. It's true: there actually are companies that produce great, unique products, and customers who seek those out. Though for some reason, pundits find this so hard to believe in the tech industry that they resort to religion-themed fantasies instead.

Otherwise, Mr Gordon, some good points in there!

Feb 16 08:28 AM

[another.ana...:]

"The Apple retail store. Apple has always bordered on a cult, if not a full-fledged religion, with the Apple fanatics proselytizing the company's products. "

I resemble that remark.

Finally, an SA pundit who "gets" it. AAPL is NOT the 2nd coming but its close enough until the real thing.

Ayuh

Feb 16 08:36 AM

[mollytjm:]

the Apple store employees were originally in black t-shirts so the white apple and the white ipod really stood out. Disney survived Walt and Wal-mart survived Sam. The gift Steve Jobs gave his investors was to be the man who made it so good a company, it can survive almost anything, even losing him, eventually.
i think Apple has passed the cult phase, if you want to call us oldtimers that. I'd like to think of us as 'the informed':) When Apple is top rated by nearly everyone...including it's customers, it's no longer a tiny niche company...it's products are desired by half the people on the planet...even some of my pc friends went to the Apple store and bought iPods and now one bought a Mac and is talking about an iPhone. i have to admit that the Apple store is a sort of religious experience...it's so beautiful that it's hard not to be in awe. i can't wait to see what they do next!
long APPL, too.

Feb 16 09:01 AM

[Aristophanes:]

Smart companies have lots of cash. Apple has lots of cash. It also has the best inventory manager in the business in Tim Cook.

Apple has passed the cult phase. When they booked out of future Macworld's they said so explicitly.

However, their product pricing is a severe problem. The point of having cash is to be able to react. They will need to spend some of it to keep from backsliding in market share. pricing is important and Apple has been to focussed on the higher margins. That's good in a positive economy, but can be extremely problematic in downtimes. Market share is a valid measure and it needs to be moved up Apple's agenda a few notches now. The last thing Apple needs is to price themselves into elite, boutique oblivion.

Feb 16 11:33 AM

[User 357946:]

Think about what's next for apple. iChat on the iPhone (the Dick Tracy watch!!!). iTunes on your Flatscreen television, eliminating the need for stereo components. The patented touch screen on your computer screen, eliminating the need for a trackpad. I can't tell you what the stock is going to do, but I'll tell you what revenues are going to do....through the roof.

Feb 16 12:22 PM

[brewer:]

You are leaving out the computer business in this article. All Apple would have to do is release OS X for the generic PC and Microsoft's business would truly crumble.

Guess what they are working on?

Feb 16 12:46 PM

[Tradestar:]

Yeah, recommend it as a bargain now that it is almost $100. Sounds like a timely article and analysis from a typical incompetent writer. Why didn't you write this when it was $80 share a month ago?

Feb 16 01:06 PM

[FreeRange:]

Nonsense - this is short term thinking - there is no reason to reduce the prices / margins of this company's great products that are sought out by consumers. Once you reduce prices / margins, it is near impossible to move them back as you have changed consumer expectations. Apple needs to stay the course, and keep building great products, producing great software, and providing great service and they will come out of this just fine, and in a better position than their competitors. Reducing margins / prices just means you need to sell more to realize the same revenue, all while people are not buying as much. This is the thinking that gets poorly managed companies in trouble.


On Feb 16 11:33 AM Aristophanes wrote:

> Smart companies have lots of cash. Apple has lots of cash. It also
> has the best inventory manager in the business in Tim Cook.
>
> Apple has passed the cult phase. When they booked out of future Macworld's
> they said so explicitly.
>
> However, their product pricing is a severe problem. The point of
> having cash is to be able to react. They will need to spend some
> of it to keep from backsliding in market share. pricing is important
> and Apple has been to focussed on the higher margins. That's good
> in a positive economy, but can be extremely problematic in downtimes.
> Market share is a valid measure and it needs to be moved up Apple's
> agenda a few notches now. The last thing Apple needs is to price
> themselves into elite, boutique oblivion.

Feb 16 01:23 PM

[Stephen Ros...:]

"Another worry that plagues many investors is whether Apple's heyday is behind it; that the company's phenomenal cycle of innovation now is a thing of the past. Perhaps. No one, me included, can really confirm that possibility."

R&D has increased from $782 million to $1.1 billion year over year ending 9/08, a 41% increase. Last quarter's R&D rose from $246 million to $315 million (Q1 08 to Q1 09).
Apple has made fantastic use of its R&D. The higher budgets indicate that Apple is not done innovating.

Feb 16 01:32 PM

[brewer:]

You write this as if they don't have absolutely massive potential in the Mac business. Guess again.

>>>Apple is most bullish about its iPhone business, where it has massive opportunity to gain market share (and has done so already); one in which software would be its principal differentiator. (Its operating system and, more importantly, the App store.)

Feb 16 01:56 PM

[Madhumita S...:]

It is really nice to hear that at least something is going good. Apple is comparatively doing better in this recession period. Whatever might be the reason behind the good going, the products are worth admiring. Financially everything will get better with the rise in the stock market.

Feb 17 06:34 AM