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Apples Sustainable Competitive Advantage (Or Lack Thereof)

|About: Apple Inc. (AAPL), Includes: GOOG

Summary

Apples sustainable competitive advantage has to stem from software.

They need to use their market share as a shield.

Without more innovation, Apple is flirting with disaster.

Apple (NASDAQ:AAPL) has just about everyone, from other tech giants to small startups, gunning for them. Despite this they have succeeded in sustaining maintaining their leadership position in the high end smartphone market. They have huge margins, a loyal base, and generate huge amounts of hype with each smartphone release. Both investors and consumers pay lots of attention to these releases. My thesis hinges on the idea that hardware matters little to Apples long term success, and that their software is the key to maintaining leadership. For a long time, Apple has created an insular, differentiated ecosystem and a strong brand of quality. These things have led to a competitive advantage, but they are beginning to be eroded away. Maintaining this competitive advantage will be key to keeping their position as the market leader in the high-end smartphone market. I will be applying the VRIO framework to Apple to examine if they have a sustainable competitive advantage. VRIO stands for Valuable, Rare, Imitable, and Organized to Capture Value. This chart, copied from Wikipedia, explains the implications of each question

Valuable?

Rare?

to imitate?

the organization?

Competitive implication

No

     

Worthless product

Yes

No

   

No advantage (commodity)

Yes

Yes

No

 

competitive advantage

Yes

Yes

Yes

No

competitive advantage

Yes

Yes

Yes

Yes

competitive advantage

Apple's value is obvious, their rarity is found in their software design, their high cost to imitate comes from their network effect, software design and brand, and the proof that they are organized to capture value can be found in their income statement.

Apples Value

The question being asked here is, what opportunity is Apple exploiting/what threat is Apple mitigating. Apple is obviously selling things of value because they are selling massive amounts of product. To continue to be valuable, Apple must continue to come out with good products. It does not have to be particularly innovative to be valuable but it would certainly help. Apple's product's value is not under any question in this article.

Apples Rarity

The question here is, are the resources used to make Apple products scarce. If they are, and Apple harnesses them, they will have a temporary competitive advantage. While the physical components are certainly not scarce, the software used to run it is unique to Apple and incredibly hard to copy. This is why we see a proliferation of phones with comparable specs, but less demand. Apples software has long been the source of its competitive advantage. Steve jobs said at the release of the first iPhone that Apples advantage was that their products were " software wrapped in a beautiful package." This is a rare skill, but one that is not insurmountable. While most Android phones struggle with bloatware and awkward UI's, the Pixel phone has an advantage of being a purely Google (NASDAQ:GOOG) phone. Its UI is cleaner and there is less bloatware. I think we can expect this trend to continue and the Pixel phone to get closer and closer to "software wrapped in a beautiful package". I recently got to see one in person and it is a wonderfully fast and well-designed phone. Its owner had nothing but nice things to say about it, and he had switched from an iPhone. While this is anecdotal, it illustrates the point I am making well. Apples beautiful OS is no longer a rarity. Apple has succeeded because Android has historically not been as intuitive or clean, but this is less and less the case. This is a serious threat to Apple. However, it will take some time for Android phones to shake their reputation, but once they do this the advantage will be gone.

If you don't believe me look at the PC industry. Beautiful software is expected, and innovative hardware and an attractive price tag are the keys to selling laptops. Thinness, lightness, speed, versatility, and usability are what matter now. If you read reviews of a laptop, software is almost never critiqued. However, reviews of phones often include blurbs about bloatware and UI design. Beautiful, useable software is expected in the PC industry, and thus much more emphasis is place on hardware. In the PC industry Apple competes decently on the hardware front. People keep buying Macs because they have learned the OS and because there is no compelling reason to switch because their hardware has kept up with the competition. I don't see that changing any time soon. I also don't see Windows users having a compelling reason to switch to Mac anytime soon. If Mac hardware fell behind, people would begin to jump ship. It is a different story in the smartphone industry. iPhone hardware tends to lag Samsung's, but their software has allowed them to carry on being the market leader. Samsung beat Apple to OLED screens, wireless charging, waterproofing, and curved screens. Despite this, Apple has continue to beat them in the high end market. Apple's continued success depends on effective software updates. The IOS 10 update could have been a beautiful move that differentiated the Apple platform further and pulled users deeper into it. It attempted to make the size of their user base into a rare resource by creating more social features in the Apple OS Ecosystem. These kinds of social features would be hard for Android to imitate because of the fragmented nature of Android OS. Let me elaborate further. When Apple releases a new update, all users get it at virtually the same time. The last update included features in iMessage that attempted to create a strong network effect through special effects and an iMessage Appstore. If successful, this would turn each Apple OS user into a tiny anchor that keeps other users tied to Apple. When Google releases an update, It slowly and unevenly rolls out across the Android software landscape. The update is tweaked for each phone. Because of this lack of continuity, Android will have difficulties creating the same network effect, despite having an overall larger market share. This is could be Apples rare resource that gives them an advantage. However, the iMessage update does not seem to be getting a lot of use and the growth rate of new apps posted to it is declining. This is very bad sign. Currently iMessage and Facetime create a limited network effect, but not one that is insurmountable.

Cost to Imitate

Imitating Apple's network effect is hard to do, but just decreasing the effect would have powerfully negative effects on Apple. Apples network effect would decrease if the iPhone's social features such as messaging and video calling became more compatible cross platform. Apple knows this and keeps compatibility to a minimum. Another way it could decrease is by making alternative, cross platform social apps more compelling than Apple's. As messaging apps and video calling apps become more and more advanced and mobile data becomes cheaper and cheaper, there is much less reason to only use Apples messaging service. These factors have yet to coalesce into a serious threat to Apple, but as these services grow Apples network effect will decrease. Apple is trying to combat this by making iMessage into a more fun and interactive experience. If the iMessage features take off and are continually updated, then they will strengthen the network effect. This outcome is by no means a forgone conclusion. A lack of new apps, as mentioned above, is a sign that not many people are really using the new features. If this is the case, Apples network effect advantage looks very shaky.

One large competitive advantage that is extremely hard to imitate is brand. A brand as strong as Apple's takes years of hard work, impeccable design, and numerous other factors. Apple generates more hype, more leaks, and more interest per phone release than any other company. One can hear rumors about a new iPhone months before its release. While the same can be said of Galaxy's, the volume and intensity of the hype surrounding iPhones is much larger. This is a loyalty that will take years of hard work and flawless execution to reach.

Competitive advantage should have thought of like a stool. The more legs a stool has the harder it is to knock it down by removing just one. The more advantages Apple has in its tool belt, the harder it is to take away it's overall sustainable competitive advantage. iMessage could be one of Apples biggest advantages right now, but currently its not that big. Apples biggest advantage is its brand image and loyalty, but something like this is hard to control. People are fickle and unpredictable. Apple's stool has 3 legs. They are, social features combined with lots of users, a great brand, and its beautiful software. However, these legs are shaky, and steps should be taken to add more legs and shore up the ones that exist. The existence of these advantages will only continue if they are fed by the update to IOS 11.

Apple Music, Apple's music streaming service, could be a competitive advantage that kept people on the iPhone, but it is currently available to both Android and Apple users. I believe this was a bad move. It's value that it could add to both the top and bottom line is questionable both now and in the future. However, the value it could add as an Apple exclusive feature to keep people on the platform is much higher. In addition, Apple is working on Augment Reality. Apples move into AR will likely start as an application, and then move into something hardware. This could potentially be another leg in the stool.

Ability to Capture Value

Apples ability to capture value at this moment is unquestioned. They capture 91% of the smartphone market profits. They had 214 billion dollars in sales in 2016. However, investors should be concerned about the future of this ability. Debt to equity ratio has been increasing and the ROE has been decreasing. Revenue decreased by 17 billion and profit margin eroded by 1%. This could be a hiccup, or it could be a sign of Apples eroding competitive advantage. I believe it is the latter.

Currently, Apple certainly has a competitive advantage but the sustainability of this advantage is in serious question. Apple doesn't have much time to re-group and protect its position. All eyes should be on its next software update.

The future

Apple's sustainable competitive advantage that they have enjoyed since they launched the iPhone is quickly eroding. However, R&D expenses have increase by 4 billion over the past 2 years, so I feel good that they are working on something. What this something is, when it will be released, and what value it will add, is all unknown. As of February 28 th, Apples PEG ratio sat at 1.68 per Zacks. If Apple does not do something significant with the release of IOS 11, then they are opening themselves up to Samsung and Google to take market share. A TTM PEG ratio of 1.68 does not accurately reflect this risk. It suggests that people think Apple will grow significantly more in 2017 than it did in 2016. This belief is absent any obvious growth factors in 2017. The future value of Apple does not look like it has room to move upwards. Because of the fierce competition and the uncertainty of Apple's innovation, as well as the high valuation, this investment looks incredibly risky. 2017 needs to be the year that Apple proves it can innovate without Steve Jobs at the helm. Avoid Apple until this happens.

Disclosure: I am/we are long GOOG.

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.