Apple: Why Do The Bears Get It Wrong?

Apr.25.14 | About: Apple Inc. (AAPL)


Apple continues to deliver much to the chagrin of bears who expect smartphone ASPs to collapse.

We believe the bears consistently under estimate is the power of a market leader.

We believe bears do not understand the human psychology that drives AAPL results.

For several quarters now, Apple (NASDAQ:AAPL) bears have been forecasting the imminent decline of iPhone fortunes and a drop in AAPL stock price. The most recent quarter results have probably been a huge disappointment to a lot of them. Empirical evidence suggests that a lot of the shorts are well informed, do some of the best research, and are very thorough. So, what gives? And why is the AAPL short not working out for the bears?

We see couple of reasons for this. The first is that even savvy investors tend to consistently underestimate is the power of a market leader. Market dominant companies (Ex: IBM Corp (NYSE:IBM) in the mainframe era, Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT) and Cisco (NASDAQ:CSCO) in the PC/networking era, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) in the mobile era) tend to have a high level of persistence in customers' minds. What this means is that these companies can fail on product execution for a generation or two but the halo remains and customers come back to them. There are numerous examples of how these companies, and other market leaders, have floundered in the past with their product cycles but have recovered well to reestablish their leadership. When these market leading companies get into trouble, they have a considerable amount of leeway with their customers and their balance sheets to make up for the lost ground. For these reasons, it is never a great idea to bet against a market leader.

The other intangible factor that investors often fail to value is the power of brand. AAPL has one of the strongest, if not the strongest, corporate brands in the world. And, when this brand strength gets to a certain point it starts approximating the power of a cult or a religion. And industry observers know that AAPL has had a cult status since its Macintosh days, a status that has only become stronger with the iPod, iPhone and iPad. These products have made countless customers express themselves in a way they have never been able to. Given the simplicity of AAPL products, the impact on technically unsophisticated consumers has been particularly strong. And these customers remember what AAPL products did to them and they do not want to abandon AAPL.

In this context, it pays to understand a bit about human psychology. When a brand becomes cult or a religion, facts do not matter. People love what they love and they do not believe anyone else has a right to tell them they are wrong or that there are better options out there. For these people, change is likely a big worry. They would rather not change anything that works and with AAPL they have found products that work for them and these products have meaningfully changed their lives.

When this type of cult power sets in, people who are not the members of the cult (let's call them skeptics) tend to look down on the cult members. The skeptics' first thinking is that cult members are not well informed and they try to provide members with information they deem relevant. And when that invariably fails the skeptics' next reaction is that the cult members are brainwashed or are idiots. At this point, snarkiness and intolerance sets in for the skeptics. But soon after that phase, the skeptics realize that some of the cult members are well informed and smart people. And, now we have an onset of cognitive dissonance with the skeptics. And this is probably the state of some of the AAPL bears today.

The bears know they are right. They can compare AAPL products to Google Android or other products and see that AAPL products are lacking in several ways. And they see AAPL products as overpriced and they expect customers to leave AAPL In droves. And they believe that AAPL stock is set to fall. But AAPL keeps delivering and the stock keeps going higher.

What these bears need to come to grips with is that when it comes to companies like Apple with a strong cult following, logic does not always win. If logic dictated people's behavior, the world would be a very different place. Instead of trying to ignore the existence of emotion in people's behavior, it is better to understand it and see where it leads the discussion.

So, with this slightly modified lens, we can clearly see that Apple is a well-managed company. Cook is no Jobs but smart enough to know how to milk a global brand. And he is doing a good job of milking it. AAPL is able to use its cult following to command a significant premium for its products and will probably continue to do so for the foreseeable future (regardless of how a particular generation of its products compete with other products in the market).

But the AAPL brand does not live in a vacuum. Here is where we get to the core of the bear case. There is no arguing that smartphone innovation has reduced dramatically over time and smartphone ASPs are on a decline (for example, AAPL iPhone ASPs fell $41 in the most recent quarter).

Technological cycles and industry forces ensure that this ASP trend will continue. Competitively, a player like Google has much to gain by commoditizing smartphones as it serves the purpose of driving the market growth while simultaneously reducing cash flow at a hardware dependent competitor like AAPL. Technologically, the cost of semiconductors and other components of a smartphone continue to fall.

It may not be a surprise to people who have done research on smartphone prices that companies are selling Android phones for under $50 in developing countries. These cheap, underpowered, flimsy phones are not something a typical US customer would buy. But in a couple of semiconductor/product cycles, phones at this price point are going to be of good quality and will have a feature set acceptable to a vast majority of the world. So, there can be little doubt that smartphone ASPs will continue to come down rapidly. It is a matter of 2 or at most 3 product cycles before $50 phones are commonplace even in the US. AAPL will continue to command premiums even then but the absolute ASPs will be dramatically lower than where they are today.

Where would AAPL be as a company at that point in time? As the price drops, smartphone penetration will increase worldwide and AAPL's brand name will ensure that it will get a meaningful share of this growth. So, AAPL unit sales may be up 3 or 4 times from current levels and ASPs would have been down below $100 (but still at a premium to other smartphones). Thanks to semiconductor technology, even at this price level, AAPL would continue to have pretty good gross margins and net profits.

While the discussion so far has been mostly about smartphones, one should not forget that AAPL has increasingly diverse income streams. In all likelihood, AAPL will grow significantly in these other categories. Even assuming there is no killer new product category from AAPL, the app store, music, TV, content, Mac and other category sales would probably grow 2x to 3x by that point in time.

AAPL's market share in several of these areas may reduce but that does not matter. Unlike the old Macintosh days, where AAPL's destiny was tied to hardware sales, lower market share is not a death spiral these days. AAPL today has a self-sustaining ecosystem in several areas and will continue to do well as a company regardless of what happens to the competing smartphone ASPs.

In summary, with a strong cult like global brand, the downside of AAPL is rather limited. Given its decent dividend, it is likely to be an excellent long-term holding for any investor. While one can question the near-term growth prospects of AAPL due to smartphone ASP compression, even with a pessimistic set of assumptions, AAPL is likely to be a high income stock. These dynamics would suggest that bears are better off looking elsewhere for their food.

Disclosure: I am long AAPL, INTC, MSFT, GOOG. 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.