The smartphone sector has been especially heated over the last few years, as investors and consumers have seen a number of paradigm shifts, coupled with a lot of innovation, on the shoulders of the giants responsible for these shifts. Not surprisingly, the hottest stock on the market is Apple Inc. (AAPL), well known for paving the stylistic way for a great number of the computing devices available these days.
A number of folks take a look at Apple's stock chart, see an exponential upward trend, and are stricken with an eerie reminder of the dot-com bubble in the early 2000s. This brings me to my first point: Apple is NOT the next Research In Motion Limited (RIMM), and I am not convinced that the stock is about to "topple in" on itself in the event of a mistake or two.
To show this, a simple valuation argument is in order:
Click to enlarge
At its peak, RIM was trading at a very high earnings multiple, and even during its slide in 2010 and 2011, the company wasn't quite priced for death.
Now, let's take a look at Apple:
Apple, in stark contrast, has seen price-to-earnings contraction for most of its run up, and only recently has the firm actually started to see earnings multiple expansion to what would be reasonable levels for a rock solid, still-growing company.
To further bolster the notion that Apple still seems inexpensive, the company has a cash position of nearly $120B, which represents roughly 20% of the firm's market capitalization.
There's no denying it: Apple is still incredibly cheap, and I don't expect the firm or its stock to "crash" anytime soon. However, the competitive risks are too great for the Apple investor to ignore, and understanding these risks is critical for potential investors looking to get in at this time to understand.
The Risks: Not Insignificant
As part of my due diligence, I study the filings with the SEC for companies that I examine. In these reports, the companies outline the risks to the firm's business. In particular, the following risk factor stood out in Apple's 10-K, despite being fairly intuitive:
"Global markets for the Company's products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets"
The following points are made in the filing that further highlight the risks to Apple's (and indeed, any competitor in the smartphone, tablet, and PC spaces) business:
- Aggressive price cutting that exerts a downward pressure on gross margins
- Rapid adoption of technological and product advancements by the industry players
- Price sensitivity on the part of the consumer
Examples Of These Risks
I know, and I fully understand that a good deal of Apple's appeal comes from purely non-technical reasons. These include:
- Preference to/familiarity with the iOS/MacOS X ecosystems over the Google (GOOG) Android or Microsoft (MSFT) Windows/Windows Phone ecosystems
- The appearances of the devices
- Fashion/perception of superiority that comes with owning an Apple product over what are perceived to be "knock-off" devices
However, as Apple is still billing itself as a technology company, it is prudent to understand Apple's competitive position as a technology provider.
Phones Are A Cut-throat Space
A glaring example of where Apple significantly lags the majority of the phone industry is in the lack of 4G support in its current iPhone 4S product. Now, it is very likely that the upcoming iPhone 5 will be 4G enabled, but this feature omission is curious, especially given that a number of competitors have had phones sporting this higher data rate capability (and at a lower price) for much longer.
And therein lie some of the major risks in the iPhone space:
- Apple's one-phone-per year allows competitors to more quickly adopt new and potentially useful technologies; 4G is a prime example of this, but on more "technical" levels, competing phones often have faster processors, more storage, more memory, and even sell for less.
- Apple's primary advantage that allows for the firm to focus less on hardware specifications lies in the iOS and accompanying software ecosystem. This is a strong advantage, but as Android and Windows Phone improve and adapt to consumer needs going forward, the firm may not be able to maintain a competitive advantage at high gross margins (which may explain the feverish litigation over software patents)
See, the problem here is that the topic at hand is cell phones. While smartphones are neat, interesting, and can command higher margins now, the market will eventually commoditize, just as the desktop and the laptop spaces have. I have no doubts that eventually, the "good enough" syndrome that have been sweeping the PC/Mac ecosystem will wreak havoc on the smartphone space, and $100 phones (unsubsidized) will become "good enough" for most users. Whether Apple will lower its gross margin profile to defend its market share in this space or not remains to be seen over the next few years, but recent trends suggest otherwise.
However, there will always be a market for high end phones, and I do not doubt that Apple will still run a very profitable business here. Further, as most people aren't hungry to update their phones every year, Apple can get away with once-per-year releases and be okay. In short, Apple is currently riding the secular smartphone wave and doesn't need market share growth to grow sales in the near to medium term.
Tablets Will Become Commodity Items
Tablets are quickly being billed as the "PC killer". While it seems unlikely that the form factor, battery life concerns, and performance characteristics will allow tablets to "kill" the traditional mid to high end notebook, the desktop PC, and high end workstations, I do certainly see a case for the tablet absolutely wiping away the "netbook" category for casual users.
For watching movies, listening to music, and surfing the web, tablet PCs are great. Further, given that the hardware in these is limited, companies can milk much more rapid upgrade cycles over the next few years before the speed and capabilities of the standard tablet run into the dreaded "good enough" wall that will slow upgrade cycles considerably.
Apple is actually very competitive here. The latest iPad has a much higher resolution screen than any other competing tablet, has a very strong graphics processor, and has a strong software ecosystem. The problem, again, is that lower margin, "good enough" tablets will come in and eat the majority of market share, just as was seen in the smartphone space. Whether the other industry players can take share in the higher end, higher margin space is a totally different question.
While it doesn't seem likely that tablets based on Android will take significant share in this space (sales have been abysmal), Microsoft's Windows 8 and tablet offerings utilizing this operating system seem much more threatening. Let me explain:
As I noted above, tablets will very likely make netbooks ancient history. When Microsoft releases Windows 8 for tablets, running standard Intel (INTC) hardware and compatible with existing Windows software, tablets will officially be a viable "netbook" (or even "notebook") replacement. If the user wants a tablet, then Windows 8's "Metro" interface gives a fairly pleasant, feature-filled tablet-oriented interface. When the user wants a standard PC, (s)he will attach a keyboard and mouse and use the tablet as a standard PC. Microsoft's platform unification advantage should not be discounted here.
While I have no doubt, again, that Apple will still sell products in this segment quite profitably, it remains unclear if the firm will be able to hold onto its significant market share and/or pricing advantage in the space.
The Mac: A Profitable Niche That Can Take Share
There's no doubt that Apple's had an incredible influence on the PC space. Apple's pushed for higher quality displays, a strong software ecosystem, and high end hardware. In this space, Apple has succeeded brilliantly. As high end laptops, it is very difficult to find Windows-based PCs that offer similar build quality (Apple's still the only vendor offering a 2880x1800 resolution screen).
However, the concern, once again, is that the PC vendors will finally "get it", use high quality hardware in higher end models, and price the devices more competitively. In fact, an example of a vendor finally "getting it" is ASUSTek's latest "UX31A" Ultrabook. Anandtech praises the machine, calling it the "world's best ultrabook". It features a 1080P screen (compared to the MacBook Air's 1400x900 resolution), a 256GB solid state drive, and excellent build quality for $1,400. A comparable MacBook air is $1,500, but it ships with a lower resolution display and a 100MHz slower processor.
It is unclear how higher quality, higher cost PCs will fare in taking sales and mind-share from the well established MacBook Air machines, but it is noteworthy that the PC vendors are finally "getting it", and this could pose a risk going forward.
In short, while I am bullish on Apple as a company, as it is very well managed and in absolutely superb financial health, I believe that it is important to understand that there is no such thing as a "sure bet" and that yes, even the mighty Apple is a risk asset. Apple's products, while fashionable and high quality, may not always command the gigantic gross margins that they currently do as competition becomes smarter and stronger. Further, Apple's relatively inflexible "yearly model" approach is a double-edged sword: it makes product choice easier for consumers, but it forces those who desire flexibility on feature set, performance, and price to consider alternatives.
Let me reiterate: I do NOT believe Apple is "going under", and I further believe that the company will continue to generate plenty of cash and as the firm matures, it will reward shareholders by returning plenty of cash via buybacks and dividends. However, it is also imperative to understand that the company's high earnings is due primarily to extremely favorable gross margins across the firm's products. If these margins are threatened, and in the long term either margins will drop or market share will decrease, then this could adversely affect earnings and earnings growth. The question is, how much secular growth is there in the segments that Apple operates in to offset the eventual shrinkage of Apple's piece of the pie?