Understanding Apple As An Investment

| About: Apple Inc. (AAPL)

Apple misunderstood

Even though Apple (NASDAQ:AAPL) is one of the most closely watched stocks, I am still surprised at how misunderstood it remains. Why did iPhone 4S at its launch last year disappoint the smart money and analysts so much, but eventually exceed all expectations in actual sell-through?

More recently, a recurring view is that Apple needs the "next blockbuster" to maintain or grow its market cap. In my view, the last thing Apple needs is the next blockbuster. All it needs to do is continue its gradual squeeze on the competition with its annual incremental product updates on 3 fronts - Smartphones, Tablets and Ultra-mobiles (MacBook Air). Together, these products make up the vast majority (72+%) of Apple's revenues and they are the fastest growing mobile computing markets at the moment. In fact, Apple still has room to grow unit sales for the foreseeable future, even if its market share flattens (thought I am not suggesting this will happen).

How should we think about Apple?

Apple is best understood as a "curator of technologies". Some it invents. Some it buys. Some it licenses. It has shown itself a master of deciding what to put in. What to leave out. What the bill of materials looks like, and what to price the product at for the high volume consumer. And last, but not least, picking the right time to launch it. iPad was in development for years but was then pushed back for iPhone which was seen as a priority. iPad was subsequently launched when all the tech came together and the aggressive target price point could be met ($499 was half the price that most market commentators and competitors expected).

In addition, Apple focuses very keenly on the product value drivers for customers, and then makes trade-offs to ensure the price point is compelling for that phase of the market. And it keeps its manufacturing simple (one or few models) for which there are tremendous economies of scale at all levels. For the 4S, the incremental value drivers were mainly the superb camera, the iMessage integration, and Siri. and that was enough to ignite demand. The demand was huge even after critics, analysts, and investors gave it a big yawn at launch.

Another important thing to understand about Apple is that it is really a software company disguised as a hardware company. Having said that, it also happens to be one of the best consumer hardware companies around. The shiny beautiful hardware is the Trojan horse to get people to pay for the software (which essentially creates most of the real value). This is great because people don't normally like to pay for software. Apple has over the years been bringing down the price of its software because it gets it back via premium margins on hardware sales. Mountain Lion was recently launched for $19.99! An indirect competitive benefit of this approach to pricing its software is that it is slowly but surely putting the squeeze on the Microsoft (NASDAQ:MSFT) profit pool.

Apple's primary competitive advantage has not been mentioned in most analyst reports I have seen in the last 5 years. That advantage is its software development cycle and underlying Unix based, object oriented / x-code development system which had its roots in NeXTstep/NeXT operating system that Apple bought from Steve Jobs. This was eventually integrated into the Mac OS to create OSX. Combined with the vast library of well polished APIs over the years. Steve Jobs called it the bringing the "industrial revolution" to software development when he was at NeXT.

Apple's software development cycle is significantly faster than Microsoft. This is one of the fundamental reasons why Apple has been able to CLAW - with bleeding fingernails - its way to relevance again after a decade. It essentially took Apple about 12 years to become an "overnight" success.

This software advantage has been given an added boost with the "App" ecosystem. Third party developers now have access to highly developed programming API's and an excellent development platform. They are all creating extra value for Apple's ecosystem, and Apple doesn't have to pay them a dime for adding that value. On the contrary, it collects 30% of their sales.

It was Jobs himself who is said "i think we will be successful in the phone biz because fundamentally we are a software company." So even Apple itself knows that deep down, they are in fact a software company.

Is another blockbuster needed?

Let me state something controversial: Apple needs to be successful in only 2 key products going forward to drive shareholder value. iPhone and iPad. Together, they account for more than 70% of revenue now.

iPad 1, 2 & 3 demonstrated nicely the idea of technology curation that I mentioned earlier. What to leave out, what to put in, price point, standardization. But upgrade every year. Every year put a bit more "squeeze" on the competition. iPad 3's incremental value is the Retina screen, and the hi speed graphics for gaming (soaking up the profit pool from the traditional handheld gaming device companies like Nintendo and Sony).

Most companies have to make the trade off between market share or margin. Want more market share, then drop margins. Apple is currently the highest value provider (which people are willing to pay a premium for) but at the same time they are also one of the lowest cost producers when you include the entire supply chain from component sourcing, manufacturing to distribution.

Apple's market share has been growing strongly, yet its margins have generally been increasing and are one of the highest in the industry even with the recent seasonal decline in margins. They have a lot of pricing power to defend their turf when they need to - they just don't need to. Their preferred approach to apply competitive pressure appears to be to launch new products, and push older models down the price curve.

Market Share and Market Value

Everyone is fixated on Apple's market cap and many believe a company can't get much bigger. However, it is important to understand that market share and market value of companies is not necessarily proportionately related.

The broader handset market usually generates $0 to $10 of gross margin for every $100 of sales. Apple does much better. For every $100 of sales, apple generates in excess of $35 of gross margin. This is a crucial point because it means that market share moves away from Nokia and BlackBerry to Apple, the market cap share between handset makers will change more dramatically because Apple can extract more margin from the same amount of sales that it takes away from its competitors. Market cap (valuation) is more closely linked to P/E than to Price to Sales.

So the fact that apple has nearly a $600bn market cap is neither here not there and should not be compared to other companies merely by this size. At this market cap it has a forward P/E of only 10 net cash, and it has achieved this with only 12% global market share for phones, and 20+% share in smartphones. Yet even at this low share, iPhone is Apple's biggest revenue driver.

Sustainability of Margins

While most people ascribe Apple's higher margins to their higher selling price, there are many deeper reasons why the margins are more structurally embedded in Apple's business model on the cost side of the equation.

I list the main ones here but won't go into too much detail:

  • product standardization (admin, inventory, quality, warranty costs e.g.)
  • component sourcing
  • manufacturing equipment financing for their contract manufacturers
  • bulk purchase commitments
  • Apple stores and online sales that help retain the usual 20-40% retail margin leakage
  • ability for their phone models to last longer than other phones due to rapid and simple OS upgrades off WiFi or iTunes. (Android upgrades don't always work on old phones). This creates perceived value for iPhone and iPad customers.
  • iTunes, app store and iCloud value and stickiness

More significantly, Apple is retaining an increasing share of the CPU margins that Intel used to enjoy under the PC ecosystem. iPhones and iPad's don't use Intel (NASDAQ:INTC) processors. There is a possibility they may move their MacBook Air line away from Intel CPUs. It is clearly technically and practicably feasible for Apple to do so. The threat of this gives them a lot of bargaining power with Intel so here again, they might be getting a better deal from Intel now than the rest of the PC ecosystem - whether in terms of pricing, or availability of chips.

So by giving away software for almost free, and by using more and more non-Intel processors, Apple isn't just sucking up margins from other handset manufacturers or tablet makers, it is gradually eroding the PC ecosystem margins which is largely the Microsoft and Intel profit pool. This trend is likely to continue.

The future

Looking forward I am guided very simply by the following:

1 - Almost all phones will eventually be smartphones (whether its 5 years from now or 10)

2 - Apple has only a 12% share in phones, but a 25% share in smartphones. (in the US, their share is higher giving a preview of the global potential) This means that even with their smartphone share staying stagnant or falling slightly, they could still see strong unit growth.

3 - Nokia's (NYSE:NOK) peak market share was about 40% and they kept there for quite a while despite (in hindsight) mediocre software. So there is upside to the 25% level if they can counter Android over time.

4 - Samsung is a threat, but it does not control its operating system and has to rely on Google (NASDAQ:GOOG) who is both provider and competitor because of Motorola. Should we believe Google when they say level playing field?

5 - I believe Android is more about filling the vacuum of the need for a second smartphone standard, than competing with iPhone directly. Although here it is worth watching closely as the SIII is providing increasing competition. Android's value to Apple is that it is helping accelerate the global handset market to smartphones. I believe Android captures many first time buyers (and yes, the more technically savvy users who demand greater ability to customize). As these churn over time, Apple's higher customer retention rate should see gradual increase in market share.

6 - iPads have become the de-facto standard - others makers are still about 12 months behind and I think have little chance of catching up given the value, price point and ecosystem of iPads. They will have to find low price point niches to compete. So for iPad's, I think sustainable iPod type market shares of about 60-70% are very feasible. More so with an iPad mini if it gets launched. And at the high volumes Apple has now, it is difficult for competitors to break in and get good prices from suppliers. So competitors will have higher costs, and will need to price cheaper to compete with Apple. Their margin's are squeezed on both revenue and cost ends of the equation. Amazon (NASDAQ:AMZN) subsidizes Kindle's, but even so sales stalled after people realized the price to value proposition was still not better than more expensive iPads. Even as they compete, both Google and Amazon realize that it is crucial for them to support iOS since iOS users are spenders. Recent Google and Amazon announcements about iOS app commitments demonstrate this.

So in short, I think Apple revenues can double easily from where we are within 3-5 years (even though so big already) just on the back of 25% smartphone market share and 60-70% iPad share. No other blockbuster required. No need to increase market share, since the Smartphone, Tablet and Ultra-mobile markets are the fastest growing segment in the consumer electronics space.

Risks

There are risks. Apple makes very few products. If they get one upgrade wrong, especially an iPhone upgrade, expect a very big stumble.

The good news on this front is that they are "incrementalist technology curators" as I mentioned. Annual product updates with incremental improvements and value, and sometimes slightly lower prices. This annual squeeze on the competition has been a standard operating system for a decade. With this approach, the risk of a big stumble should be lower since the 3 primary products for future growth are already in place and only need to follow the standard Apple approach of annual incremental updates. Each year a gradual refinement of the previous. No superfluous technology. For example, they left LTE out of the last iPhone because of power drain and cost, but added huge perceived value by putting in excellent camera optics, Siri, and iMessage. 4S was clearly a blockbuster despite being an incremental update, and really No change in form factor!

The leaked iPhone 5 images look underwhelming. They look boring. Slightly longer. Slightly thinner. Perhaps LTE. Perhaps NFC.

As an investor, I love it. It means less execution risk in manufacturing super high volumes. Great cost control. Probably more margins than if they tried to re-invent the form factor drastically. Add iOS 6 to the mix, and the combination adds just enough value for creating another blockbuster launch.

The biggest risk amongst competitors remains Samsung. Their Galaxy S3 definitely had an impact in iPhone 4S sales this quarter and will exacerbate the September quarter slowdown due to iPhone5 anticipation. This could provide an excellent entry point prior to the iPhone 5, iPad mini, and Christmas run up, although it does appear we are starting to see the pre-Christmas accumulation on the stock which recovered quickly after the last results "disappointment."

If I had one strategic suggestion for Apple, that would be to start moving to a 6 monthly phone cycle to deny competitors a window for their own new products. I would also suggest that they create a second larger form factor to meet the demand of some users, and deny space to competitors.

Apple TV not required & Conclusion

Apple TV is not needed for my investment thesis. It is a distraction. Analysts who think this is very important are wrong. >$1000 price points are not high volume consumer. The future valuation of Apple depends on just 2 products. iPhone and iPad (with MacBook Air as a nice kicker).

All we need are these products to continue their march forward with increasing unit sales. Annual incremental upgrades. Not the next "blockbuster." All three I believe will continue to see double digit year on year growth.

iPad is in the bag this year - China sales have just commenced. MacBook Air continues to be on fire. 4S got good legs despite recent weakness.

The key risks for this year are iPhone 5, and ongoing litigation (although this seems to be receding).

If they get iPhone 5 right, and then push the 4S down the price point curve (which they just did), I believe this will result in another step up in market share I think. Imagine the 4S + iOS6 competing will all those other phones out there at lower price points.

There are some upsides. There are hints that iPhone 5 and iOS6 have been designed with China penetration in mind (did you catch all the China centric iOS6 upgrades coming). Will a China Mobile agreement be announced at the iPhone 5 launch?

At 10x price to book net cash, Apple is a "call option" on the future demand of the 3 legs of the fastest growing mobile computing markets - Smartphones, Tablets, and Ultra-mobile laptops. Even if Apple's market shares remain flat, unit sales will grow.

In a "low" scenario, Apple's market share declines gradually, unit sales remain flat, and the stock transitions to a 10-12x PE dividend stock at $600 per share.

Disclosure: I am long AAPL.