When I
sold down a significant portion of my RIMM (or BBRY now) last week at its recent peak before it took a 25% dive (it was
luck, not skills), I thought I had to park the cash aside for some time. Yet, Mr Market handed me Apple straight away. How ironic it is. This was the time when Mr Market was very excited about RIMM but very grim on Apple. "Be Fearful When Others Are Greedy and Greedy When Others Are
Fearful", said Warren Buffett famously. Usually you can only experience
one half of this maxim. How rare it is that I experienced the whole
thing back to back.
This is going to be a long post. Be warned.
The economics of mobile computing platforms
We all use the PC industry as a proxy to understand mobile platforms. The present war between iOS vs Android is so eerily similar to the war
between Mac and Windows decades ago. Under this view, Apple is facing a serious dilemma. On one hand, Apple insists on making premium products without compromises and charging premium prices. On the other hand, the economics of platforms leads to "winner takes all". For a platform to survive, it requires market share. And only at a low price point and being open can a platform achieve mass adaptation. This was arguably the main factor that undid Mac 20 years ago.
However, this view is incomplete. There are subtle yet important differences between PC platforms and mobile platforms.
I
argued before mobile platforms are less sticky than PC platforms. The stickiness of PC comes from the applications developed on the top of the platform's API. The API is the lock-in. But the nature of mobile apps is different and the switch cost of mobile devices is lower than PCs:
- Price of the apps are orders of magnitude lower.
- Most of the essential apps are cloud-based and the clients are free on all mobile platforms. Given the business models of these service providers (e.g. Amazon, Google Search, Facebook) who want ubiquitous access to their services, this won't change in foreseeable future.
- In order to protect their investments, many businesses will utilise portable HTML5 instead of native APIs to implement their business apps when the applications are not consumer facing and "snappiness" isn't the priority. (This has already happened on desktop applications for years. If you visit a bank, very likely you will see their desktop applications run on browsers which communicate to their back-office servers.)
Besides, there is a different form of lock-in in the broader ecosystem: the (cloud-based) services available exclusively on one platform. Examples of Apple's iCloud, Face Time and iMessage and RIM's Blackberry Messaging (this is going to change with BB10). Here, Apple has the advantage. It's not in Google's business interest to limit their services only to Android. Apple can employ exclusivity. Google won't.
Lastly, mobile devices are so much an extension of our public persona. They are displayed prominently in public. They are like watches and diamond rings. Brand recognition and brand loyalty are important drivers of repeated purchases. The trust and emotion associated with the brand are so fluid you can't called them lock-in. Yet they do attract long-term followers. (I shall talk more about this brand issue below.)
In a nutshell, the risk that iOS will be marginalised by Android because of the asymmetric market share is lower than what it appears.
Valuation
Let's turn to the numbers.
Apple's trailing-twelve-month (ttm) earning is $41.75B. Current share price is $450 and total market cap $422B. Apple has $137B cash (inclusive of marketable securities). The way Apple structures it capital on the balance sheet tells us $97B of that is not needed for its operations. Let's assume all of this cash is trapped overseas and will incur a 20% tax in order to repatriate it back onshore. This leaves us $78B distributable cash. Removing this amount from its market cap gives us $344B enterprise value. This gives us a ttm P/E of 8.2x, or an earning yield of 12%. At this P/E, the market assumes Apple's earning will be going downhill from here.
Will Apple's earning go downhill?
Let's look at the bear case scenario that Apple won't introduce any new product categories. i.e. Apple will just rehash and incrementally improve its current product lineup. We further assume the profit centre is iOS products. We focus solely on iOS devices. i.e. iPhone and iPad.
We need to look at both sale volume and profit margin. Let's look at sale volume first.
Buyers of iOS devices fall in three groups: (1) non-consumers (i.e. people who never own a smart phone or tablet before), (2) existing iOS users who are upgrading and (3) buyers switching from different platforms (i.e. churning). At the moment a large portion of Apple's sales comes from non-consumers. But this will change some time in the future. When the market is saturated, the consumer mix will shift to mainly upgrades from existing customers. How about churning? Churning has been minimal. Apple users are immensely loyal. Satisfactory rate of iOS products is 90%. We assume the lost of existing customers and gain of new customers cancel out each other.
So we can rephrase the question: can Apple sustain the current sale volume if majority of the business is upgrades from repeated customers?
Apple sold about 200m iOS devices in the last 12 months. The lifespan of mobile devices is about 2 years. So we need a 400m install base to sustain a refresh rate of 200m units per year once an equilibrium is established. I've estimated the current install base of iOS devices is about 350m units. What this means is it isn't far off for Apple's sale volume to become self-sustainable. No doubt the lifespan of mobile devices will eventually get longer. And the assumptions and approximations I use here can be off. But the important thing is the scale of the magnitude. It is within Apple's reach to become self-sustainable in sale volume.
What about profit margin?
If we reduce Apple's gross margin from the current 38% to 28%, Apple's revenue will drop 15% and its profit will be cut in half. Suddenly Apple's 8.2x P/E becomes 16.4x which doesn't look cheap anymore.
Profit margin is the real deal here. It's not that far-fetched Apple's gross margin can shrink to 28% level if competition pressure intensifies or production costs increase.
What are not properly priced in?
After all, maybe Apple's 8.2x multiple is justified. Given the risk of margin compression, maybe Apple is fair value at $450.
But there are a few things coming with Apple that we don't see on the shelves, on the balance sheets nor on the cash flow statements. These are the intangibles that are impossible to quantify. There are the values not properly accounted for in Apple's current price:
- Apple's brand
- its DNA and organisational processes
- growth potential in China
- new products
Let's address them one by one.
How valuable is Apple's brand?
How valuable is Apple's brand? I frankly don't know how to put a price on it. However, I want to point out three observations.
When Steve Jobs brought Apple back from the brink of bankruptcy, Apple introduced a stop-gap product to buy itself enough time to develop more innovative products. It was the
iMac G3. What's striking about iMac G3 is it possessed no major technological breakthrough. Its technical spec was not that different from its predecessor G3 All-in-one.
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| iMac G3 |
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| Mac G3 All-in-one |
What iMac G3 had was a new look. Apple has mobilised its fans by just altering the look of a product. I'm not diminishing the importance of such industrial design. The creativity required is no less than the creative mind that conceived mass as energy. What I'm trying to point out, however, is that only a strong brand can utilise this to bring commercial success. (iPhone and iPad currently are available only in black and white. How
much time can Apple buy if it merely offers different colours with only
mild technological upgrades?)
The second thing I want to point out is triggered by
an article
I read on Financial Times about kids receiving iPods and iPads as their
Christmas presents. This immediately reminded me one of Buffett's
favourite businesses: See's Candy. Why See's Candy? Chocolate has no
lock-in power. What See's Candy has is brand value. Let me quote
Buffett: "[People] had taken a box [of See's Candy] on Valentine’s Day
to some girl and she had kissed him… See’s Candies means getting
kissed." It is not about the chocolate. It's about the emotion value and
trust the brand brings. When you buy your nephew an iPad, it's not
about the feature set, it's about the recognition of the Apple brand.
This brings me to my third observation.
Apple's products are more like fashion items than computers or consumer electronics. Take a look at this survey done in China recently:
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| Best brands for gifting by men (source: Hurun Chinese Luxury Consumer Survey 2013) |
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| Best brands for gifting by women (source: Hurun Chinese Luxury Consumer Survey 2013) |
Do you see what Apple's peers are in consumers' eyes? These are prestige brands deliver repeated sales on seasonal basis by altering "just the look". Apple is the only consumer electronic company on these lists. It is the monopoly in this market segment. And where is Android or Samsung? In terms of brand image iOS and Android are very different.
While we shouldn't read too much into the lists because they are not good representations of the whole market, they give us a different perspective of Apple's basis of competition. A $10 T-shirt I buy at Target is functionally the same as a $1000 T-shirt available at Louis Vuitton. But they are not directly competitors. That the $10 Tee has a 99% market share and the $1000 LV Tee has only 1% market share won't be a concern to an LV's investor. Similarly, to some extent, iOS and Android are not direct competitors.
In the hi-tech world, we are so afraid of disruptive innovations which result in better products. Yet no one is worried about such product disruptions faced by Louis Vuitton or Burberry. These companies have a product disruption cycles in months, not years, in the form of fashion cycles. Instead, what companies like Louis Vuitton will be worried about is disruption in the processes as what
Zara has shown them, not disruption in the products. When we look back at Apple, don't we focus on the wrong thing if we are worried about the products? Shouldn't we pay more attention to the processes?
Organisational processes and Apple's DNA
Apple as an organisation excels in two things: operation efficiency and product development.
Apple is
the king in efficiency. If you use cash conversion cycle as a metric, Apple is 50% more efficient than both Amazon and Dell. Stop for a moment and compare the logistic complexity that Apple faces with that of Amazon. Books don't involve co-ordinating multiple supplies. Books don't require assembling hundreds of components.
And I don't have to elaborate on its product innovation side.
Achieving where Apple is at now at such a scale isn't what a single person can do. A lot of the values come from Apple's organisational processes. Or you can call it DNA or culture.
Growth potential in China
When we say Apple is fair valued at $450, we assume there isn't much head room for iPhone/iPad's market to grow. Look at mobile phones alone. Currently smart phones penetration in US is about 50-60%. Some projections suggest it will become saturated in around 2 years.
However, that's just US. Worldwide, smart phone penetration is 20-30%. Apple has been actively pursuing the China market. China will surpass US has Apple's largest geographical segment in a couple of years. Yet, the current share price implies it doesn't exist.
Product Pipeline
Tim Cook said in the recent conference call that Apple's product pipeline was "chock full". Ok, no one takes what management says at face value. Let's discount the "chock full pipeline" to "have something in the pipeline".
No matter how you cut it, it's a certainty that Apple has some new products in its development pipeline. No one will dare to bet otherwise. Given Apple's track record, there is also a fair chance these new products will have meaningful impact on Apple's bottom line. The only thing we don't know is what they are and when they will be available. This is the key uncertainty here. This is the kind of uncertainty Mr Market hates.
I read about a comment by a fund manager that he sold his Apple stake because of the uncertainty in Apple's product pipeline. Over and over again, Mr Market mistakes uncertainty as risk. If you agree that Apple, with its current product lineup, is fair valued, then what this pipeline uncertainty gives you is not risk but a valuable optionality, coming for free.
How important is (the absence of) Steve Jobs?
The Brooklyn Investor blog has two insight articles on Steve Jobs and Apple. (see
here and
here.)
I agree with them on many fronts. However, I take a more "anything has a price" view. i.e. Jobs is important to Apple at $700; he is less important at $450. To put it differently, true, a Jobs-less Apple isn't as valuable as an Apple with Jobs around. But we as investors can still do well as long as we pay a low price.
Pre-mortem: What has gone wrong?
It is now 2015. My investment in Apple has turned sour in 3 parallel universes in one form or another and my capital is permanently impaired.
What has gone wrong?
Universe 1: Without Jobs around, internal bureaucracy mushrooms and destroys Apple's ability to execute anything effective. Apple becomes Sony or Microsoft.
Universe 2: The upgrade cycle of mobile phones and tablets slows down too soon and too much.
Universe 3: I've completely misjudged Apple's brand power. Mobile devices are tools. A cheap and good tool trumps an expensive and flashy one. Apple's profit margin evaporates.
This investment isn't without risk. To me, it has enough margin of safety and enough upside potential. This is a high quality business worth paying a fair price. You need to make the judgment yourself.
Closing
While researching Apple, a lot of things Buffett said about quality businesses popped up all over my head. Let me quote a couple of things Roger Lowenstein says about Buffett in "
Buffett: The Making of An American Capitalist".
After Buffett scooped up the ailing Berkshire Hathaway in 1962, he bet big in American Express in 1964. This is what Lowenstein said:
His sleuthing led to two conclusions, both at odds with the prevailing wisdom: (1) American Express was not going down the tubes. (2) Its name was one of the great franchises in the world. Amex did not have a margin of safety in the Ben Graham sense of the world.... But Buffett was a type of asset the eluded Graham: the franchise value of Amex's name.... The loyalty of its customers could not be deduced from Graham's "simple statistical data"; it did not appear on the company's balance sheet...
When I accompanied my wife to a shopping mall one day, I paid a visit to the Apple Store there. This visit remained me what Lowenstein wrote about Buffett's viewing of Disney's Mary Poppins in 1965:
He saw that [the audience was] riveted to the picture, and he asked himself, in effect, what it would be worth to own a tiny bit of each of those people's ticket revenues -- for today and tomorrow and as many tomorrows as they kept coming back to Disney.
Over many days, I asked myself over and over again: wasn't Buffet describing Apple?
(Disclosure: Long AAPL, RIMM/BBRY)
