A long Idea Sold Short
I've been following Apple's (NASDAQ:AAPL) evolution as a company through its products since mid-2007, first through the iPod, then the iPhone, and ultimately to the iPad (big and small). While a user of two of these three products (with some inclination to switching to their desktops and MacBook's), I remain ambivalent to the attractiveness of the product. I don't love Apple products, but I don't dislike them either. I think the company has a narrow economic moat, and anyone who buys the stock for the hardware has the rationale for purchasing fundamentally wrong. The user experience can easily be duplicated in other brands such as Samsung (OTC:SSNLF) and Sony (NYSE:SNE), so any product fanaticism is misplaced. Ignore the short-term incremental upgrades and rewards, and buy the tree, not the fruit. Since I first started following the company from an investment perspective, it has been a case of the rise and rise of Apple - ignoring short-term noise for longer term gains.
A moat is useful until it is breached
The idea of an economic moat refers to a Morningstar concept as to how likely a company is to keep competitors at bay for an extended period. One of the keys to identifying superior long-term investments is buying companies that will be able to stay one step ahead of their competitors. The strength and sustainability of a firm's competitive advantage can be used to apply an economic moat rating to the quality of a company as an investment.
The key to assessing the potential investment and return on capital of a company is to look at the company's historical financial performance. Companies that have generated returns on capital higher than their cost of capital for many years running usually have a moat, especially if their returns on capital have been rising or are fairly stable. But a moat (much like their original protective design and purpose) is only useful until they can be breached. As previous performance is no indicator of future success, it is important to consider what impact changes in technology may have on a company's excess economic profits and whether their economic moat is wide, narrow or non-existent.
For example, a competitive advantage created by a hot new technology usually isn't very sustainable because it won't be too long until someone comes along and invents a better version of the same product. It could be suggested that AAPL's earlier success gave it a marginal to non-existent moat as while it was life changing technology (iPod and iPhone) it wasn't long before companies such as Sony and Samsung introduced similar technology and products to the market.
Some of the attributes that Morningstar assesses which can give companies economic moats include the following:
- Network Effect. The network effect occurs when the value of a company's service increases for both new and existing users as more people use the service.
- Intangible Assets. Patents, brands, regulatory licenses and other intangible assets can prevent competitors from duplicating a company's products or allow the company to charge a significant price premium.
- Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins or they can charge market-level prices while earning relatively high margins.
- Switching Costs. When it would be too expensive or troublesome to stop using a company's products, the company often has pricing power. For example: Architects, engineers and designers spend entire careers mastering design software packages, creating very high switching costs.
What's more important - the lure or the hook?
Apple makes great smartphones and tablets, and follow through with incremental product upgrades which maintains consumer satisfaction, product turnover and revenue (in that order). But guess what, so do their competitors.
But the illusion or lure of the product upgrade is merely the consumer bait what truly hooks them (and attributes a narrow economic moat rating) is the intangible qualities and the switching costs.
- Intangibles: Fanatical consumers, product design preference (look/feel/touch), it's the Apple way or the highway, "I'll have one (or two) of each (iPhone, iPad, Apple TV, MacBook)."
- Switching Costs: Ingrained practice/familiarity with operating systems, product interface, dollar value cost to switch, and... the zero-cost obstacle to switching (which I will revisit later).
Fanatical consumers and advocates of Apple is not what underpins the revenue stream, it is the incremental upgrades which maintains short-term buyer interest. But the underlying "Apple ecosystem" is what underpins and maintains the Apple revenue stream. Yet at the same time stops incremental growth from non-Apple consumers.
Why? Ask yourself this question. Your partner (the Apple fanatic) drops their iPhone and smashes the glass - badly. You (the ambivalent Samsung consumer), take your partner shopping for a new phone, putting up all manner of alternatives from Samsung and Sony that offer similar functionality and interface, often at a discounted entry price to Apple. Your partner is at a point of vulnerability and offers to compromise on one condition… you facilitate the changeover for them. Which prompts this series of questions:
- Can you get my iTunes play lists migrated over to the new non-Apple phone?
- How do we access the iCloud photo albums and document storage with the new phone?
- How does the new non-apple phone sync with the iCloud and my other Apple devices?
- Will the one device cable work for my Apple and non-Apple products?
Buy the tree, ignore the fruit.
"Do you know what - let's just get another iPhone...
And that there is the true hook that keeps the Apple consumer engaged and why the recurring revenues make it such an attractive stock to consider holding in a portfolio. The barriers to switching are so simple to understand, yet the majority cannot be bothered to invest the time required to overcome (not to mention switching ingrained behavior). The incremental upgrades simply serve to reward the consumer in the short term, whereas the interlocking and synchronization of the Apple network is what the investor should focus on in the longer term. Maintaining the Apple ecosystem maintains the moat.
In short - buy the tree, ignore the fruit.
Disclosure: I am/we are long AAPL.
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.
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