Understanding Why I Was So Wrong About Apple

| About: Apple Inc. (AAPL)

While others have been making a fortune on Apple's (NASDAQ:AAPL) continued rise due to a strong product lineup and razor sharp execution, I've been sitting on the sidelines, expecting that the hype would die down and that Apple's products would eventually take their places as much lower margin, commodity products against fierce competition.

Boy, was I wrong. Dead wrong. And it's because I made a number of fundamental assumptions that completely missed the point.

The Mac Premium: The Secret's in the Software

As a PC enthusiast and tech geek, I could never understand what all the fuss was about these Apple products. On the computer (laptops, all-in-ones) side of the equation, it seemed that Apple was significantly overcharging for hardware that you could find for much cheaper on the PC side. To illustrate my point, I took a trip to the Apple online store and picked out a 13" MacBook Air with the following specifications:

  • 2.0GHz Dual-Core Intel Core i7
  • 4GB 1600MHz DDR3L SDRAM
  • 256GB Flash Storage

This came out to a total of $1,599.

Hopping on over to the Hewlett-Packard (NYSE:HPQ) website, I sought to configure an identical system. After doing so, the price came out to $1,449, which means that Apple charges a 10% premium for the same hardware. It seemed ridiculous to me that people would be willing to pay a 10% "brand tax" until I realized that the secret's in the software.

Unlike Microsoft's (NASDAQ:MSFT) Windows, which OEMs are able to purchase and deploy on their systems, Apple's operating system is only available on computers that come from Apple. It's not actually the operating system itself that I suspect sways most Apple customers, but the software ecosystem that Apple provides and controls.

With every Mac you get iLife, which includes iPhoto, iMovie, iDVD, GarageBand, and iWeb, which many users (including every Mac user I know) cite as being the main reason they prefer Macs to Windows PCs. An important, but niche, example of software luring people into the Apple ecosystem is the video editing program Final Cut Pro. With the popularity of YouTube, owned by Google (NASDAQ:GOOG), it seems almost obvious that there would be a strong demand for easy-to-use, powerful video editing software. While alternatives such as Avid Media Composer are available for the Windows OS, Final Cut Pro actually targets hobbyist and independent film makers, which is a much larger market than the professional market.

The bottom line: Apple is gaining market share against Windows PCs, and the competitive advantages that the company has against the less unified, less consumer-centric PC ecosystem should not be underestimated going forward. Windows 8 will take some steps toward bringing a "user friendly" and "consumer-centric" PC to the general public, but it remains to be seen how well it all plays out.

iOS Tablets: Understanding Apple's Long-Term Bet

Apple's Mac products are not the market share leaders and I do not expect Apple to be particularly interested in vying for the low margin bits of the PC business ... directly. That is, while I expect Mac OS products to remain relatively high margin, low volume products (that are still very profitable), iOS products will step in to fill the gap while trying to keep margins acceptable.

In the $1,000-plus price-band, we have the Mac OS products (MacBook Pro, MacBook Air, iMac, and Mac Pro), and below that we have the iPad filling the $399-$829 price range.

The future of the personal computer will very likely be ultra-thin laptops. The question is whether they will be devices such as the ASUS Transformer (a tablet with an attachable keyboard), or if things will look more like the MacBook Air/Ultrabook (an ultra-thin and light laptop, perhaps touch enabled). While I don't have the answer to that question, the hard fact is that Apple sold more iPads than any single PC vendor sold PCs in the last quarter of 2011, which confirms that the future will involve ultra-thin, touch-enabled, long battery life solutions.

The Android phone market has grown larger than the iPhone market and will continue to take share as smartphones become available at lower price points (especially in emerging countries), but Apple has managed to capture 71% of handset profits with 6.4% of the shipments. In addition, early market share numbers for Android tablets are not encouraging, at 28.8% market share in 2011. I have no doubt Android's market share will increase, but I doubt that Apple will be giving up much of its share of the profits.

An unknown here will be the success of Windows 8/Windows RT based tablets. The appeal here is obvious: On an x86 Windows 8 tablet, users get everything that they would've gotten from their traditional Windows notebooks, but you also get a tablet with all of the touch and portability goodness that draws people to the form factor. At this point, it'll all come down to how good Windows 8 is and whether it can offer a meaningful competitive advantage over iOS and Android. At this point it's anyone's guess, but Apple has seen unqualified success through excellent marketing, execution, and products.

The iPhone: Stronger Competition Than Other Segments

The common theme found in the success of the Mac OS and iPad products is that their competition simply trips all over itself. PC and tablet vendors cut corners to try to increase margin, but in the process damage the PC ecosystem's reputation and just convince customers to shell out extra for quality. Furthermore, Apple's software ecosystem advantage gives additional compelling advantages to join Apple's ecosystem.

The iPhone holds many of the same advantages over the Android ecosystem: compelling software/apps, high build quality, and strong brand image. The iPhone 5 is probably the single most talked about piece of future technology, despite the plethora of fast, high-quality phones from other vendors.

I, however, believe that the smartphone market will commoditize fairly quickly. While I don't doubt that Apple will remain incredibly profitable by selling high-end smartphones, I would be concerned about Apple's growth rate in the segment. The competition in the Android space is strong, especially as the Android OS sees improvement after improvement. While Windows Phone is not seeing a lot of traction just yet, its share is slowly and surely growing.


Apple has been, and will continue to be, a great investment for a good long while. Its products are of incredibly high quality, customers love the brand, and it has significant competitive advantages in all of its core businesses because of its sheer scale and strong software development abilities.

At 15 times past earnings and with over $100 billion in cash, I see Apple's shares as still being quite cheap, even at these all-time highs. The dividend is likely to continue to grow as the company matures. I further expect that even if Apple loses market share in the tablet and smartphone sectors, these areas will see enough secular growth to make Apple's position as the high-margin, high-end vendor a very profitable one. The company's health, competitive position, and ability to turn significant profits aren't in question; only its ability to grow market share significantly in the long term is. But, really, when your margins are sky-high and your customer base loves you, you don't need to please everybody to be the most valuable company in the world.

Disclosure: I am long INTC. 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.