Discover more from Liviam Capital - Finding Reinvestment Moats
An old thesis on Apple
I wrote the following “thesis” for myself in September 2017 when Apple stock was trading at ~$40/share. Sharing it now for the first time. It’s nice to look back on now given the stock has tripled in under 4 years since then. Keep in mind I’m not an analyst, so this might not meet the quality bar for some of you:
Apple is an aspirational brand and a cash flow machine that creates consumer technology that aims to advance humankind. The retention rate of Apple products are unmatched industry-wide, driven primarily by a closed ecosystem that interplays hardware, software, and services in such a way that is very difficult, if not nearly impossible, for other businesses to replicate. It’s moat is wide and deep:
Although it may seem like switching costs are low for Apple devices, I believe this theory is 100% incorrect and actually flies in the face of basic human behavior and psychology. The consistently high retention rates for Apple devices across all of their product lines is plenty proof; people simply do not leave the Apple ecosystem once they become part of it.
Operating system: Once you become an Apple user it is very difficult to switch to a different system or device for various reasons; most importantly that it requires re-learning a different operating system and software, something most people are unwilling to do because there is no real reason to, but also because Apple’s operating systems (iOS and OS X) are considered to be industry-leading anyway. OS X in particular is different enough from Windows so as to “lock in” into the Apple ecosystem once they start to use Apple devices.
Data, Apps, Music, Messages, Emails, Numbers, Photos, Videos, etc: Apple products, especially the iPhone, are deeply, deeply embedded in every part of the consumer’s life, perhaps more so than any product in the history of civilization. This means that the iPhone is both the creator and recipient of all of a consumer’s data including photos, videos, emails, messages, etc. It would be nothing short of nonsensical and irrational to want to start over on another system or device. It just doesn’t happen.
The average Apple user: Apple has another thing going for it — who the typical Apple user is. The vast majority are relatively affluent people who have a preference for aesthetics and ease-of-use over technology. This user base gives Apple a couple of advantages:
They are not moved by price: it is difficult to win over these users with cheaper iPhones or laptops because money is not their main concern.
They are not overly concerned with technology. Remember, Apple championed the “closed” system when others like Dell promoted configurable and made-to-order systems. As such, the typical Apple user is not moved by memory or hard drive space. They are grandparents who want to facetime their grandkids or teenagers who want to use Apps to communicate with their friends. Convincing them to switch platforms with a larger hard drive or a faster processor simply does not work. Furthermore, Apple’s whole business model revolves around getting very few things absolutely right, and thus virtually all their capital and abundant resources are deployed towards their primary cash cow: the iPhone. Therefore, it is highly unlikely that a competing service or product will be able to create or offer an important feature that iPhone doesn’t have and that Apple is incapable of cloning very quickly.
This combination makes it extremely difficult for other companies to take users from Apple; if they cannot do it with price or with features, can they do it at all? One way would be to focus on the aesthetics of the products — but here too, Apple has built an almost insurmountable lead. Apple relentlessly focuses on designing products that are thinner, lighter, more beautiful, and easier-to-use than other brands and has marketed this concept aggressively. It is now virtually ingrained in a consumer’s mind that Apple has more beautiful and easier-to-use products than competitors and that is a very difficult thing to change because those traits are now synonymous with Apple’s brand. The amount of capital required to produce more beautiful products and outmarket Apple is simply astronomical, given Apple’s current cash position and future cash-flow generation abilities.
Apple is essentially the only consumer technology business with pricing power. This is a big reason why Apple consistently earns 90%+ of all the profits in the mobile device industry. Competition has intensified over the years and lower priced phones have saturated the market, but price simply does not influence consumer behavior in this market. In fact, staying at a higher price point reinforces the idea that Apple is an aspirational brand and contributes to Apple’s dominance.
Apple stores: Apple operates stores throughout the world, many of them architectural marvels that reinforce the idea of Apple as an aspirational brand. These stores are in major cities and in prime locations and can be viewed in some ways as a natural extension to traditional marketing. Other technology companies have tried to compete by copying the Apple store format, most notably Microsoft and Google, but no one has succeeded yet. One reason is that Apple has been curating the format for more than a decade, but a more valid one is because other companies simply cannot match Apple’s portfolio of consumer products that people love to touch and use. Competitors are faced with the “chicken before the egg” problem when it comes to competing with Apple stores. Which one comes first: the stores or the products? The answer is the products and that is difficult to do because Apple stores themselves are a big reason why competing against Apple is difficult. This gives Apple a powerful network effect of stores and products that is very difficult to break.
The AppStore: Because of Apple’s deep integration of both hardware and software and its direct distribution to the end-user, Apple upgrades users to the latest hardware and operating systems at a much better rate than their competitors like Samsung and Android, resulting in a much less fragmented user base than their competitors. As a result of this and because of iPhone’s popularity, App developers always develop first and sometimes only for iOS. This results in a much larger set of Apps for iPhone users than for other platforms, resulting in a strong network effect of a large number of apps and a large number of users, which seems likely to continue unabated far into the future.
By any measure, Apple shares have traded at a discount relative to the market, and in my opinion there are a few reasons that drive this undervaluation:
iPhone saturation: Investors believe that the market for iPhones is saturated and there is little room for future growth
iPhone revenue too large: Because iPhone revenue is so large and because iPhone accounts for the lion’s share of Apple’s revenue, investors believe that new products and services will probably not move the needle on growth
Hardware business: Investors view Apple as a hardware business prone to disruption and intense competition (much like Nokia before it)
Examining iPhone’s true growth potential
Although smartphones will not experience the same type of growth going forward that it did in the previous decade, investors must remember that iPhone’s market share is still under 15%. That means that 85% of smartphones are not iPhones and that is an enormous group of phones that come due for an upgrade every 2-3 years or such.
Furthermore, investors do not credit Apple enough for its ability to command premium pricing. In fact, Apple was able to raise iPhone ASP’s (average selling price) by $101, or approximately 15%, from $695 to $795 in the Q4 2017 vs Q4 2016 after the release of the iPhone X. When you account for volume growth, Apple grew iPhone revenue by an incredible 20% YOY, on an already humongous base. It is obvious that Apple can create additional iPhone revenue through innovation and pricing if not through volume.
Primarily because of those two reasons, it it my opinion that Apple will be able to grow iPhone revenue moderately on an annual basis going forward.
Examining growth potential of other products
Apple’s services business includes things like the AppStore, Apple Music, Apple Pay, and so on.
What makes Apple so interesting to me is their fast-growing services business. Although it only accounts for 10% of Apple’s revenue, it is growing at 25% annually and it has virtually double the gross margin of Apple’s hardware business.
Apple is also not given enough credit for their ability to create new streams of revenue. It is my belief that Apple will continue to add new hardware categories that will extend the moat of their ecosystem, and Apple Watch is the first of many examples.
In my view, Apple’s biggest risk is Apple itself, not its competitors. Apple’s business relies on two general sets of buyers: upgraders and switchers. Upgraders are people who have Apple products who upgrade to the newest iteration and switchers/new buyers are those who switch from a competitor to Apple, often buying their first Apple device. The issue Apple has and will continue to have is that upgrade cycles continues to lengthen -- meaning the devices are becoming so good that people are satisfied with them for longer periods of time. This places the onus on Apple to continue innovating across all their product lines, and to continue coming up with features that customers want and need -- a very difficult task. Upgrade cycles also depend on the product itself, for example people usually upgrade iPhone every 1 to 3 years whereas iPad may be upgraded every 5 to 10 years. I believe this is a major determining factor of markets in which Apple enters and has dissuaded Apple from entering markets such as TVs. On the flipside, Apple does not typically have large shares of the markets they are in, even iPhone where they had a 13.7% market share as of May 2017, and that means switchers/first time buyers are a much bigger slice of the pie than upgraders are, and I believe that any downside risk from longer cycles will be alleviated and even surpassed by switchers and first time buyers.
For example, most Mac buyers are switchers and not upgraders, and I believe this will continue to be the case far into the future. There remains a very large opportunity for Apple to bring new buyers into their ecosystem.
iPhone upgrade cycles:
iPhone upgrade cycles have appeared to be lengthening in recent years but it’s difficult to tell because Apple has not been transparent about this. Nevertheless, even with a lengthening upgrade cycle, Apple should be able to grow iPhone sales going into the future. Realistically, Apple’s growth to the active installed base is coming from both upgraders and switchers, and as long as that installed base continues to grow at a better rate than the decline in upgraders, Apple will manage to grow.
I view Apple’s management as second to none. There are several key themes that you can clearly see from a long track record of success:
Resisting the institutional imperative: In several areas, Apple has refused to enter markets that don’t make sense for them, even while other companies have done so, including TV’s and Netbooks, to name a few.
Low level of M&A, especially larger deals: I view larger M&A specially for Apple to be mostly a waste of money and time, and Apple management has always been focused on organic growth, and not on adding revenue through M&A. However, they will often buy smaller businesses mostly for technology or talent.
Extreme focus: Apple’s focus is key to their success -- they focus on only a few key areas and do them really well. Even with ever-increasing amounts of cash, Apple does not overspend on R&D, choosing to focus only on areas where they can make the biggest impact and leaving all else aside. This is also because they can afford to wait while competitors figure out the market, and rely on their brand name to strike with a better product, albeit a bit late, when it’s ready. Underlying the outward facing consumer product, Apple invests in the foundational technology that drives the capability of consumer products forward — and this is probably most important.
Shareholder oriented: Apple’s management is extremely shareholder oriented, with large buybacks and an increasing dividend payout.