Can Anyone Breach Apple's Moat?

| About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) qualifies as one of the greatest turnaround stories in business history. Steve Jobs is gone but the company is very much alive and recently released another blockbuster offering, the IPhone 5. The chart below is worth a thousand words, so here is what has happened to Apple's stock price since the release:

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The dramatic price decline has investors in a flurry of activity, seeking advice on whether now is the time to buy, sell, or hold Apple shares. However, Apple's share price history tells us panic in the face of the recent decline may be unfounded. On April 25, 2012, Apple's stock price reached a new high of $618 and fell to a low of $522 by May 18, 2012; a drop of $96. On Sept. 19, 2012, the share price then rose to reach a new high of $702 and has fallen $85 to the Oct. 19, 2012, close of $617. So let's all take a deep breath and take a look at how Apple got to be Apple and speculate a bit on the company's growth prospects going forward. In this article, we will address those questions using the concept of economic moats popularized by legendary investor Warren Buffett.

What Is an Economic Moat?

An economic moat is a protective barrier shielding a company's profits and prospects from competitors. Some moats are considered narrow and thus easier to breach, while wide moats afford the most protection. One of the principal ingredients of a moat is brand name, which can translate into additional moat components including pricing power and market share.

The Apple brand name is perhaps the company's best asset as evidenced by the ferocious loyalty of its customers, willing to endure long waits to get their hands on whatever product Apple is rolling out. This allows Apple to charge premium prices and gives it staggering gross margins for a company that is basically a "gadget" maker. To illustrate, if you factor iPad sales into PC sales figures, Apple holds 19.4% share of the global market with Hewlett-Packard (NYSE:HPQ) at No. 2 with 12.5%, according to a survey conducted by market intelligence firm Canalys for Q2 2012.

Apple's gross margin stands at 44%, while Hewlett Packard's is almost less than half that figure, at 23%. The conventional view of economic moats is that they pose "barriers to entry," making it difficult for competitors to even enter the market. However, an extension of that viewpoint is that the moat may allow competitors on your land, but not into your "castle" of profitability and growth. So how did Apple resurrect itself and create its impressive moat?

Building Apple's Moat

If you are someone who has had the time and temperament to follow tech blogs and forums over the years talking about Apple's products, you would surely have seen these two words pop up time and time again: usability and reliability.

At the core of Apple's success is the simple fact that it makes exciting products that are both user-friendly and very reliable. The origins of this business model go back to the early days of the Apple I and Apple II computers in the late 1970s. Unlike the PC, Apple owned and operated everything that went into its products. With the first graphical user interface and a product that didn't crash they were off to a great start. It is hard for younger generations to comprehend what it was like on early PCs as users faced a blinking cursor and had to learn Microsoft's Disk Operating System commands to get started.

At that time, price and more importantly the lack of an ecosystem of any kind trumped reliability. Again, it is hard to imagine that back then software was not compatible across architectures. As Microsoft software began to dominate, more and more users were forced to go along with the crowd.

Today one of Apple's greatest strengths is its company-owned and operated ecosystem. Their proprietary formats and products keep users within the Apple family with everything they sell from the devices to the music to the applications to the videos.

Along the way to its current dominance, each game-changing new "gadget" spawned competitive "killer" products. When the revolutionary iPod drove the ubiquitous Sony Walkman into obscurity, Microsoft (NASDAQ:MSFT) rolled out the Zune, a supposed "iPod Killer" that failed. The iPhone has spawned numerous competitive smartphones up to the Android line, none of which have as yet dampened enthusiasm for iPhones. The latest game changer, the iPad, has withstood the test of the Kindle Fire and a host of Windows based tablet computers.

In short, Apple maintains its moat because it has been able to keep putting out "gadgets" deemed by the consumer to be more user-friendly and more reliable.

Microsoft and Google at the Moat

Google's (NASDAQ:GOOG) introduction of the Android operating system is nibbling away at the iPhone's market share, but not its gross margins. Although some recent estimates claim Android smartphones now have about 52% of the market compared to the iPhone at 33%, Android phones are spread across manufacturers, with many being low-priced offerings with inferior features.

Google's Android based tablet computers are also eating into Apple's iPad dominance. A recent study by the "Pew Research Center's Project for Excellence in Journalism" on mobile device ownership showed that the 2011 iPad market share of 81% has dropped to 52%, with Android tablets rising to around 48%. The survey was conducted before the introduction of the Nexus tablet. Apple is responding with its iPad Mini to be released on Oct. 23, 2012. This, however, is something that should worry Apple stock owners long term as it puts Apple where it has traditionally not wanted to be -- competing on price.

The Android success makes many investors feel Google is the best candidate to breach the substantial moat Apple has built around itself. However, Android lacks a true ecosystem, if you believe the desktop/laptop computer still has a place in the modern digital world.

The real threat to Apple comes not from Google, but from Microsoft. While Steve Jobs famously predicted a "Post-PC World" dominated by tablets and interconnected mobile devices, Microsoft sees a "PC-Plus World" where a fully integrated operating system -- like the soon to be launched Windows 8 -- ties everything together, with a hybrid tablet at the core.

If you have seen any of the features of the upcoming Microsoft tablet computer the Source, you know they could spell trouble for Apple. After years of peaceful slumber, Microsoft is getting into the hardware business in a big way. They believe the "PC-Plus World" calls for a hybrid tablet suitable for work and play. The Source comes with a flip stand and a magnetically attached cover that doubles as a keyboard, transforming this device into a cross between a tablet and a notebook or laptop. As revolutionary as the iPad was, you can't create a graphics presentation or a lengthy document very easily on an iPad.

Microsoft's new operating system, Windows 8, has gotten rave reviews in pre-releases. And the company is partnering with Nokia to introduce Windows 8-based smartphones that could further threaten the iPhone.

The key question here is: Will Microsoft be able to produce reliable products? It has had some recent successes with a flawless release of Windows 7 and the Xbox Kinect has actually knocked the acclaimed Nintendo Wii from the top spot. The company is planning to pay developers to extend their apps and recently announced free music available for the Kinect. They are subsidizing Nokia and have the cash on hand to take substantial losses to breach that Apple moat. According to Yahoo finance, total cash on hand as of the most recent quarter at Microsoft stood at $62 billion, compared to Apple's $27.7 billion.

Widening Apple's Moat

Critics point out Apple of late is releasing enhanced versions of existing products with the iPad being the last true game changer. All that could change with the "gadget" that could propel Apple stock to the magic $1,000 price -- the iTV, or iHub, as some are calling it. As usual, Apple is being secretive about the iTV, so speculation abounds on what it could do. Some see the potential of the iTV replacing traditional TVs via a subscription service for traditional as well as premium channels, along with integrated streaming and Internet surfing capability.

In summary, the recent flurry of negative news about the iPhone map apps snafu and the troubles with iPhone suppliers in China may have caused some jittery investors to flee, but this should not come as a surprise with a growth stock that has run up so far so fast.

Going forward, Apple investors or potential investors should be monitoring iPhone 5 sales, still projected to set records, as well as reception of the iPad Mini. In addition, watch the sales of the Microsoft Surface tablet and the Windows 8-based Nokia Lumia 920 and 820.

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.