First Rule Of Investment: The Media Rewards Dumb & Lazy
Investors demand content 24/7 and the financial media is more than willing to accommodate their need. The problem, however, with this arrangement is the tendency of media to be lazy, take a simplistic approach and fall into a simple, repetitive narrative.
It is just too easy (and often more lucrative) to write something along the lines of, "iPhone share is down, Apple is doomed" as opposed to digging into numbers and providing some new insight.
Whether driven by laziness, ignorance or deadlines, the financial media has a tendency to place too much weight on simple performance metrics and blanket statements when discussing the health of a company's business or its future prospects.
So, how does an investor learn to identify and ignore weak/simplistic insight? One step is to take the time to regularly evaluate a company's long-term opportunities across more robust multi-dimensional metrics.
In this article I hope to show, using fair share analysis of iPhone profits, why I think Apple (AAPL) investors should temper their concern over the recent iPhone market share declines.
However, before we get started, a quick quiz. Let's assume you are offered a choice of investing in two companies. All you know is Company "S" has a 33% share of the market, while Company "A" has an 18% market share. Based on this information, which company would you chose to own?
A) Company S, because it's all about selling more stuff!
B) Company A, only because I suspect this is a trick question.
C) I need more information to make a decision.
D) I think I'm lost, I'm just cruising the net looking for some Kardashian pics.
If you chose answer "C", congrats, you've made your business professors proud. If you chose answer "A", that's somewhat understandable - there will always be some folks that fell asleep in business classes, or recently experienced some of that pesky head trauma. A more likely scenario, however, for answering "A" is that you have become the victim of exposure to the financial media's simplistic narratives.
The Risk of Market Share Myopia
Let's now focus on a recent narrative that has been widely adopted by the financial media: To paraphrase, "The Apple iPhone is losing global market share, and thus, the company is doomed in the smartphone space."
Here, the primary problem with using market share as a measure of business health is it provides no insight into the profitability of the product being sold.
Let's use an extreme example to illustrate my point: Imagine "Company Q" which has a 90% market share for its product (high volume), yet earns only a 10% share of the market profits (low profits).
It's obvious in this case that company Q is "buying" market share at the cost of profits. Keeping things simple (ignore the razor/razor blade scenario), an investor is better off avoiding company Q and focusing their investments on the remaining companies that are selling fewer products, but earning the majority of the market's profits.
To avoid this kind of "market share myopia" it's important to incorporate a profitability and price metric into our analysis. For this we will use a fair share profit index.
Fair Share Profit Analysis
The basic tenet behind the fair share profit index is that a 1 point increase in market share should, at least, deliver a corresponding 1 point increase in profit share. (Again, we are avoiding the razor/razor blade scenario).
Achieving less than a 1-to-1 gain in market and profit share will demonstrate a company that is buying market share.
Correspondingly, if a company is seeing more than a 1-to-1 gain (e.g. a 1 point gain in market share equates to a 2 point increase in profit share), we know we have identified a company that is able to differentiate its products, provide more value than its competitors, and thus charge a premium for its products (The company has pricing power).
Fair Share Profit Index Calculation
A fair share profit index is calculated by dividing profit share by market share, then multiplying by 100.
Fair share profit index = (%profit share/%market share) * 100
Ex. From the previous example, the company Q's fair share profit index would be calculated as: (0.10/0.90)*100 = 11.1
The value of the fair share profit index is it measures a company's pricing power and profitability against the overall market.
How to interpret the results:
Fair Share Index <100: Company profit share is lower than its market share. Every percent increase in market share brings in less than a point share of market profit. The company is likely competing primarily on price. The company has not been able to differentiate its product in the market.
A Fair Share Index = 100: Company profit share and market share are equal - the company is earning its "fair share" of market profit. i.e. Every point increase in company market share equates to a point increase in market share of profits.
A Fair Share Index > 100: Company profit share exceeds its market share. The company's product is differentiated and has some level of pricing power in the market. Every point in market share brings in more than a point in market share of profits.
Android Fair Share Profit Analysis: The Race To The Bottom
Android (GOOG) accounts for approximately 70% of global smartphone shipments and 29% of global profits (IDC, Q4 2012).
Android fair share profit index = (0.29/0.70)*100 = 41.4
An index of 41 equates to the "average" Android OEM facing the unenviable task of earning just 41% of its fair share of market profits for every Android smartphone sold. Viewed another way - the average Android OEM needs to capture 2.4 points of market share just to earn an incremental point of market profit (100/41).
Such a low fair share profit index can indicate a number of things, including:
- Difficulties in differentiating products in the market because of the common Android operating platform. (Similar to the problems Dell (DELL) and HP (HPQ) face in PCs.)
- The willingness of some Android OEMs to sacrifice profits in the hopes of securing market share in a growing market. (The proverbial "race to the bottom.")
- Disadvantaged cost structure - the company can not, or has not, reached economies of scale in the manufacturing process.
Samsung: An Android Fair Share Winner
With the ongoing success of the Note and Galaxy lines of smartphones, Samsung (GM:SSNLF) has recently moved into a position where it is earning more than its fair share of smartphone profits.
Samsung: 2013 Q1 market share =33%, profit share = 43%
Samsung smartphone fair share profit index = (0.43/0.33)*100 = 130
Net, each increase in market share for Samsung corresponds with a 1.3 point increase in the company's profit share. Samsung is not "buying" market share and is currently successful in its ability to differentiate and add value to its products.
Samsung's high index also demonstrates skilled execution with the company's smartphone product mix. Remember, Samsung sells a broad line of smartphones across price points. The company's 130 fair share profit index is indicative of an effective product/price mix. (Samsung is not building share by "dumping" low margin product.)
(Profit data, source: Canaccord, Market share, source: IDC)
Apple iPhone: A Staggeringly Consistent Profit Machine
Apple iPhone: 2013 Q1 market share = 18%, profit share = 57%
Apple iPhone fair share profit index = (0.57/0.18)*100 = 317
Net, each point in iPhone market share equates to 3.17 points in market profit share.
Additionally, there has not been a significant decline in the iPhone fair share profit index in YOY comparisons. (Pricing power for the iPhone does not appear to be eroding.)
Apple iPhone: 2012 Q1 market share = 23%, profit share = 74%
Apple iPhone fair share profit index = (0.74/0.23)*100 = 322
(Profit data, source: Canaccord, Market share, source: IDC)
- The decline in iPhone global market share in Q1 2013 came without a significant decline in the iPhone fair share profit index versus YOY levels. Hence, we are not seeing material iPhone profit erosion - Apple has maintained its pricing power.
- Despite a decline in Q1 market share, iPhone sales actually increases based on YOY comparisons. (iPhone sales are not declining, they are growing slower than the overall market.)
- Lower priced smartphones (especially in emerging markets) are the next large growth opportunity in the smartphone market.
- With the iPhone 4 in the US, Apple has shown the ability to effectively differentiate and compete at multiple price points with smartphones in a market.
- Changes to build quality (incorporation of plastic) and performance (older chip sets) should allow Apple to deliver a moderately priced, differentiated smartphone to emerging markets while adequately protecting the company's historic margins.
- Apple is not in the business of chasing market share. The company's goal is to deliver a high-value, differentiated product that supports the company's pricing structure over the long term. (The company's Mac line of PCs demonstrates its ability to avoid comoditization over the long term).
- Apple not only has pricing power, by focusing on just a few smartphone models, it has become the low-cost manufacturer in smartphone. At a lower price point, it is very likely to capture more profits than the competition in the smartphone space.
Pricing to gain market share simply for the sake of market share is a chump's game. However, given the size of the smartphone market, it is a game many Android OEMs seem tempted to play. Further motivating a low cost war is the desire to achieve economies of scale in manufacturing. Without product differentiation, Android OEMs risk being sucked into a hellish price war.
Android smartphones' long-term profitability will be based on an OEM's ability to avoid the "beige box" mistakes made by Wintel PC manufacturers. Samsung is currently the only Android OEM showing the ability to execute profitably.
Steep shifts in quarterly smartphone market share are unavoidable given the boom-bust volume shifts that occur during ever-shortening product cycles. These shifts in market share need to be analyzed based on how share is being won. Fair share profit analysis is one way to measure the strength and sustainability of a company's product and pricing execution.
Based on fair share profit analysis, as well as Apple's history of maintaining high-value/differentiated product lines, it seems likely that Apple will be able take advantage of smartphone growth in emerging markets to further build its smartphone business.