Narrow Moat Around iOS And iPhone: Should Apple's P/E Drop More?

Jun.20.13 | About: Apple Inc. (AAPL)

Background: A major factor that continues to depress Apple Inc.'s (NASDAQ:AAPL) share price may be that it never made its once-revolutionary iPhone operating system, iOS, a smartphone industry standard, or something close to that. As cool as the look of the iPhone was and is, software standards are more durable and "stickier;" network effects are far greater for software than hardware, where they are almost nonexistent. Investors are now realizing that it may simply be too late for Apple to avoid being relegated to second-tier status in the mobile telephony (and tablet) space. Apple's hardware is not so unique anymore either: the iPhone has solid competition now in both software and hardware. For AAPL shares to be attractive to new money, why should they not sell at a price that incorporates the risk that profits may have peaked for years to come?

Apple's brilliance, then blunder: Once the iPhone was proven to be a big success with immense potential, which was clear by 2008, Apple had the smartphone world at its feet - because iOS had no peer. Having nearly been bankrupted in desktop and mobile computing wars with IBM (NYSE:IBM)-compatible PCs and then against Microsoft (NASDAQ:MSFT) specifically, Apple knew the importance of dominating the new product category that would define the future. Yet it took too few steps to establish global control of the smartphone category before Google's (NASDAQ:GOOG) Android or other platforms could challenge Apple's lead. The iOS platform was so superior, Apple could and should have done with the smartphone whatever it took to pre-empt the competition. Yet it stuck with an unimaginative strategy of producing only one type of iPhone once a year. Take that, consumer: one phone type for you! Shades of Henry Ford offering the consumer any color car, just so long as it was black! (And then Apple even had trouble creating a second color of the identical phone.)

Thus consumers migrated to other, lesser phones that offered more choice in form factor and price as well as in operating system (OS) characteristics than the iPhone. The very statistic that the iPhone was earning most of the smartphone industry's profits indicated that Apple was earning the excess profits that always accrue to the innovator. However, without a Windows-type software-based monopoly, that profit share had nowhere to go but down.

It is difficult to see Apple replicating the come-from-nowhere success of the iPhone and its follow-on similar product, the iPad.

A growing number of investors may realize that as wonderful as its brand image and products are today, Apple has failed to secure a wide business moat for the iPhone and iPad. A fair, conservative valuation for the stock could be in the 9-10X range on trailing 12-month earnings. After all, Deere & Co. (NYSE:DE), which has been in business for 175 years and possesses a wide moat as the largest manufacturer of farm equipment in the world, sells at 10X trailing earnings - which may be at a cyclical high. Deere has certainly shown its staying power, though, having survived the 1873-79 depression, the Great Depression and lesser disasters. And, unlike the consumer electronics field, which is highly deflationary, farm equipment participates broadly in the current general trend toward global inflation.

A phenomenon like the iPhone, and a line of products like the iDevice line, only comes around very rarely. A company with veterans such as Apple's board members and executives should have realized this was the opportunity to control the future, not simply grab the (very large) cash profits that an innovator can obtain.

Here they had a great product. It was a single size. Initially that size actually appeared large to a public used to small cell phones. When mobile phones got popular in the late 1980s, they were bricks. My medical practice shared one due to the cost. This phone cost close to $1000 and that was in 1987 dollars. It did not come close to fitting in one's pocket. The goal was to get smaller. Motorola's (NYSE:MSI) StarTAC and other products were breakthroughs because they were so small.

Apple could have appealed to more people with a smaller iPhone as a second choice. And/or, as discussed below, it could have created a less expensive version of the iPhone that also utilized iOS (perhaps a less complete OS, perhaps the full OS), to attract more people, more quickly to purchase the product. This would have been especially helpful globally, where incomes were nowhere near as high as in the U.S. Instead, Apple made the iPhone a stationary target and relegated iOS to a proprietary system to support the company's hardware sales. This was what it did with the Mac's OS in the 1980s. Apple was approached back then to license out the Mac's OS to titans such as Digital Equipment Corp. and others, but refused. What followed, of course, was that Apple Computer nearly went bankrupt.

A similar focus on hardware was also an IBM error in the PC industry in the early '80s. IBM controlled Microsoft at the time but gave up control because for IBM, everything revolved around the hardware. An OS? Of what importance was that? IBM missed the coming PC software revolution.

One way or another, Apple may have reprised IBM's error and its own prior error of the 1980s by not focusing on aggressively seeding the world with iOS in addition to developing marvelous physical iPhones.

Unfortunately, Apple also did not compete aggressively in the hardware side of the business, either.

Apple has so far ceded the larger form factor space to Samsung (OTC:SSNLF) and other players. Why they have done this is inscrutable. What is Apple's fetish about one-hand use of the iPhone when making a call? Why does Apple, and not real people, know best? Why could Apple not have competed right away in the "small phablet" category, where Samsung and others have made large sales?

Also, Apple has actively ignored most of the world's population by not developing a first-class line of "affordable" phones using the full iOS or a stripped-down version of iOS. It could have named that line of lower-cost phones a different name to not harm the brand image of iPhone. This is how Intel (NASDAQ:INTC) helped beat back the AMD (NASDAQ:AMD) challenge: it developed the Celeron brand, while still promoting the higher quality "Intel inside" theme.

Some may wonder if Apple was a bit smug and refused to get its cool hands dirty. Perhaps it just was not willing to "stoop to conquer." It did not make a Celeron-level smartphone as part of a plan to dominant the globe. Plus, as an alternative strategy, it wasn't in its DNA (so say many people) to license out iOS to anyone, even if Apple retained a veto on hardware quality and even if the license were revocable after a fixed number of years. It was content to rest on its well-deserved laurels but it did not give stockholders warning of this strategy in advance. We had to scope it out painfully for many of us.

Apple's strategy allowed the stock to reach undreamt of heights, so my comments are hardly a harsh criticism. Instead, they address the future for the stock, given that those undreamt of heights are now in the rearview mirror.

Valuation comment: AAPL sells at more than twice sales per share. This is a high valuation for a company that is primarily a hardware developer and marketer. It is not difficult to see AAPL selling within the next couple of years at one times sales per share, perhaps somewhat higher in view of its net cash on hand - but perhaps eventually less than that. The further question is whether AAPL can even grow sales and profits at all on a consistent basis.

Since consensus EPS and sales numbers for AAPL are well known, I am going to keep this section brief.

Conclusion: Apple achieved an historic, brilliant and game-changing success with its iPhone and then iPad but it failed to nail down its victory, in part by focusing on hardware sales rather than on making its once-revolutionary iOS a global industry standard as Windows became. And then it pursued a non-diversified hardware strategy, compounding its problems.

Apple has provided investors no vision of how it is going to reverse the Android tide. [The anti-Apple onslaught also involves Windows phones, BlackBerry (NASDAQ:BBRY), perhaps a new OS from Samsung, etc.] All proposed solutions have problems.

More broadly than simply focusing on the iPhone and iOS issues, Apple management has provided investors approximately zero visibility into its strategy to grow profits. Months ago, Tim Cook advised investors not to bet against Apple. The stock was in the low $500s then. Why should we trust him now when he advises us that great new products are coming soon? He may, of course, be correct (I hope so) but how much money are investors willing to risk on that proposition? How great is the downside risk to AAPL shares if he's wrong again?

The media is now full of talk that AAPL is probably at the lower end of a long-term trading range, as Microsoft was after the tech wreck. This fosters the idea that AAPL is a strong hold and a decent buy, especially if one buys the stock and sells covered calls for income. It's a reasonable possibility. But ...

This may be too pat an analogy; it may be wishful thinking by the bulls. Neither sales growth nor operating margins are guaranteed to avoid shrinking and negative sales growth is possible. The "curse" of recent hypergrowth may end up biting AAPL shares, which could trend toward the upper $300s or 10X current fiscal year earnings estimates.

Market saturation and other factors may conspire to lay the stock low and then even lower if really bad things happen. Fears of a rerun of the first post-Steve Jobs era could become prominent.

Why might the P/E for AAPL collapse quickly to yet lower lows? Perhaps because there is no reliable business moat. Because iOS is now just another excellent mobile OS, not the clear leader amongst mobile OSs it was merely two years ago. Because the physical iPhone has largely stood still for six years. Thus there simply is no obvious floor to sales and profits as one could count on for Microsoft after the share price came down to earth after the Y2K-era bubble.

The considerations discussed here, and related ones, led me to exit a very large long position in AAPL near the peak last year.

Apple is not, however, in an existential crisis. Even if AAPL stock does drop further, it may regain its current glory for any of a number of reasons. It designs and markets superb products. Its ecosystem is superb and broad. It could come out with a breakthrough product at any time. I and many others are rooting for that to happen. AAPL is a stock and is so well-covered that I truly hesitate to say too much about its future behavior. The Efficient Market Hypothesis is likely at work more for this stock than almost any other (if it is valid at all).

Overall, though, I continue to think that shares of other companies offer both better fundamental valuations and similar or better growth prospects. Thus I do not view AAPL as a good new money buy for most investors: risks are high and the upside potential may be a bit limited.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Not investment advice; I am not an investment adviser.