Apple: Worry About The Downside, The Upside Will Take Care Of Itself

| About: Apple Inc. (AAPL)
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Summary

I'm often criticized for being an Apple permabear. That doesn't portray reality.

I fully recognize Apple's strengths, but as is customary, I focus on risks.

For good measure, here's another thing where Apple will see its advantage widen during 2017.

One of the curious things about my Apple (NASDAQ:AAPL) articles is how I'm seen (and attacked) as a tremendous Apple bear. It isn't hard to understand why this is: Most of my Apple articles cover risks Apple is facing.

However, what's less well known is that more than 80% of my articles are tagged as "long ideas." How can this be? Along with other developments, this article will cover the reason.

To start, I'd like to quote a little-known hedge fund manager, Mark Sellers*:

Focus on the downside, and let the upside take care of itself.

The idea is, if you find something you believe has the potential for good economic returns, you should spend a lot of your work just trying to see what might go wrong. If, in the worst of scenarios, downside looks limited, you've found a good investment. Traditionally, this is what a low valuation provides, also known as a "margin of safety" in Graham/Warren Buffett talk. Additionally, this also is what a "moat" provides, again in Buffettspeak. A "moat" protects the "castle" of sustainably high margins.

It is in this context that many of my articles are written. Even at Idea Generator, I spend a whole lot more time updating and covering what's going wrong than what's going right. I do this even though a lot more goes right than goes wrong.

So, when it comes to Apple, what's actually my opinion, to make it clear? It goes as follows:

  • I believe Apple has a powerful brand. A brand is perhaps the best kind of moat, as it allows Apple to launch products at high profit margins. The recent Airpods are an example of this, as is the Apple Watch. Apple also takes care to deliver good products, which protects the brand. Given its brand, Apple isn't an expensive stock. This moat and reasonable valuation explain Warren Buffett's interest. ("It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.")
  • However, in spite of its quality and valuation, Apple remains wildly reliant on the iPhone, with an estimated 80% of profits coming from it. Given this reliance, Apple always is under pressure to deliver another giant iPhone success year after year. The iPhone is the most profitable product on Earth and won't easily be replicated by Apple or anyone else. The iPhone 8 looks good enough to be the next yearly success Apple needs. However, once the iPhone 8 is done, the focus will immediately shift toward what comes next, and there is no assurance that what comes next will keep the growth flame alive.
  • Any threat to iPhone growth, given Apple's reliance on it, is a threat to Apple's valuation. The problem here is this isn't limited to competitive threats. Smartphones becoming "good enough," just as what happened with PCs, also is a threat. The impending smartphone market maturity is thus a threat to Apple's valuation.
  • From a technical standpoint, we could argue smartphone flagships matured as far back as late 2013. That's when the iPhone 5s and LG G2 came out. Arguably, these phones possessed everything which would satisfy a modern consumer (minus fingerprint unlock for the G2 and a large display for the 5s). The result from this is that a large part of flagship smartphone owners can easily extend their use for years without feeling "left out." For lower-end buyers, the market is arguably on the cusp of attaining the same "good enough" benchmark at the $120-175 price point (in China, but this will migrate West). What's missing? Just an LG G2/iPhone 5s-level camera, which should be happening as we speak. This reinforces the idea that the smartphone market is near maturity. It will be hard for anyone, Apple or others, to grow substantially in the future.
  • Additionally, Android has long been stealing market share from the iPhone. That was followed by usage share. And now, it's being followed by wallet share. This has happened in large part because even low-end Android devices became fully usable (as per the last bullet). This is set to continue and creates a long-term risk for the iPhone, in the sense that iOS might see its developer mind share threatened. This will manifest earlier in audience-focused businesses such as Facebook (NASDAQ:FB), where the eyeball number matters relatively more than each one's buying power. But ultimately, it can spread to all market segments.

So, what do I take from these long-term, structural, observations? I take that I would not sell short Apple under any (other than very temporary) circumstance. I'd be neutral or long. However, personally, I'm not incredibly fond of mega capitalizations like Apple, so I lean toward neutral but fully understand Warren Buffett's position as a long.

Here's Something Positive

Now, so that all don't again accuse me of just seeing the bad in Apple, I'm going to explain something else which has already materialized.

This development actually means Apple will widen its advantage over Android flagships during 2017. I already started covering this in my article titled "Samsung And Qualcomm Lag: Game Apple," only that was on Qualcomm (NASDAQ:QCOM), so my Apple detractors seem to have ignored it. So, what happened?

In my view, in a bid for larger volume, Qualcomm designed its flagship Snapdragon 835 SoC so as to be as cheap to manufacture as possible. Qualcomm did this by using the 10nm process shrink to produce a smaller chip (and hence cheaper, as more chips are produced per wafer). Now, CPU designers usually have three ways to increase performance:

  • Increase clock frequency, thus making the chip run through more cycles per second - typically, at the cost of higher power consumption and thermal limitations.
  • Increase the number of cores. This allows the chip to process more instructions per cycle on unrelated and non-interfering tasks. However, any task which needs to be completed in full sequence will not benefit.
  • Or increase chip IPC (Instructions Per Cycle), through architectural changes, which allow the chip to do more work per cycle. This is usually done by having a wider and more complex chip, thus a chip which uses more transistors. As a result, this also leads to a larger chip, and a larger chip is more expensive.

Qualcomm took the first two of those three paths. At the same time, Apple has long taken the third way, providing fewer but much faster cores. Apple did go to a four-core design with the A10 but with just two performance cores.

As I described in my linked-to article, in going this route, Qualcomm ensured very little in the way of performance gains from 2016 to 2017. At the time, I quickly speculated that Apple wouldn't do such a thing. Now, we have more on the way of data, namely through A11 leaks. What these leaks show is that Apple again took a large jump in performance from its A10 (2016) to its A11 (2017) chip. Here are the first leaks:

Source: MacRumors.com

What this leak shows is that, as predicted, Apple increased its lead over Qualcomm's best offering. The A11's single-threaded performance jumped to ~4,500 from ~3,400. This is a 32% increase. The Snapdragon 835, as we recall, improved barely 13% on single-threaded performance over the Snapdragon 821 (on Geekbench), to around 2,050. Ultimately, what this says is that on a single-threaded workload, the A11 will be more than twice as fast as a Snapdragon 835. It also will be faster on multi-threaded workloads.

Now, the Snapdragon 835 will basically be in all main Android flagships but some Samsung (OTC:SSNLF) S8 models. It will set the standard for how good (from a CPU perspective) Android devices can be. Yet, what this translates to in reality is that something like a 2016 OnePlus 3T smartphone using a Snapdragon 821 will have nearly imperceptible performance differences to a Snapdragon 835-based device under most workloads. Said another way, for Android flagships, 2017 brings little CPU improvement. The iPhone, though, will again show a meaningful jump over the previous year.

Sure, it can be argued that users can't discern it anymore. That last year's iPhone was already a performance monster (and it was). But still, factually, what is happening here is that Apple will have increased its leadership when it comes to CPU performance. If Samsung wants to drop a phone into a dock and turn it into a desktop replacement, Apple can do it twice as easily and better.

Indeed, it can also be argued that Apple is pressing so much because those chips will end up in Macs sooner or later, to Intel's (NASDAQ:INTC) detriment. This seems even more likely. Such happening also would be favorable for Apple, since it would increase margins on all Macs using Apple CPUs.

But importantly, here, we have an argument for defending that for one more year, the iPhone will really have no direct competition at the flagship level. This will be particularly important because the iPhone 8 will remove yet another recent iPhone disadvantage: design, where the iPhone was lagging Samsung (and others) badly.

Conclusion

No, I am not some sort of Apple permabear. Yes, most of my articles have been on risks Apple faces. And, Apple still faces many of those risks because of its reliance on the iPhone.

However, I recognize Apple's advantages as much as anyone else. And, indeed, in this article, I just pointed out another one: the iPhone's 2017 widening of the CPU advantage. Though, of course, right now, Apple's main advantage isn't technical. It's simply that it has a massively valuable brand, allowing it to sell products at a large and sustainable premium (the very definition of Warren Buffett's moat).

Finally, as I said above, I'm not a fan of mega market capitalizations. I also think that the market as a whole is stretched and that Apple's reliance on the iPhone cannot be ignored even if the iPhone 8 looks like a sure winner for another year. Thus, while I understand all the reasons to be positive and overweight Apple, I myself remain neutral on it.

* As a side note: Ultimately Mark Sellers didn't heed his own advice. He eventually got clocked during the 2018 sell-off, just as Felix Salmon predicted. This highlights yet another important thing we should never take our eyes off: the need for discipline.

Disclosure: I/we 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.