Earlier this week I wrote about
the psychological challenges that Apple shareholders face.
I also discussed the evolution of Apples i
gadgets the iPod, iPhone and iPad and how they
have created an ecosystem unlike those of other technology
Apples ecosystem is an important and durable
competitive advantage; it creates a tangible switching cost
(or, an inconvenience) after Apple has locked you into the
i-ecosystem. It takes time to build an ecosystem that consists
of speakers and accessories that will connect only via Apple
systems: Apple TV, which easily recreates an iPhone or iPad
screen on a TV set; the music collection on iTunes (competition
from Spotify and Google Play lessens this advantage); a
multitude of great apps (in all honesty, gaming apps have a
half-life of only a few weeks, but productivity apps and my $60
TomTom GPS have a much longer half-life); and, last, the
underrated Photo Stream, a feature in iOS 6 that allows you to
share photos with your close friends and relatives with
incredible ease. My family and friends share pictures from our
daily lives (kids growing up, ski trips, get-togethers), but
that, of course, only works when were all on Apple
products. (This is why Facebook bought Instagram for $1
billion. Photo Stream is a real competitive threat to Facebook,
especially if you want to share pictures with a limited group
of close friends.)
The i-ecosystem makes switching from the iPhone to a
competitors device an unpleasant undertaking, something
you wont do unless you are really significantly
dissatisfied with your i-device (or you are simply very bored).
How much extra are you willing to pay for your Apple goodies?
Brand is more than just prestige; it is the amalgamation of
intangible things like perceptions and tangible things like
getting incredible phone and e-mail customer service (Ive
been blown away by how great it is!) or having your problems
resolved by a genius at the Apple store.
Of course, as the phone and tablet categories mature,
Apples hardware premium will deflate and its margins will
decline. The only question is, by how much? Let me try to
From 2003 to 2012, Apples net margins rose from 1.1
percent to 25 percent. In 2003 they were too low; today they
are too high. Lets look at why the margins went up. Gross
margins increased from 27.5 percent to 44 percent: Apple is
making 16.5 cents more for every dollar of product sold today
than it did in 2001. Looking back at Nokia Corp. in its heyday,
in 2003 the Finnish cell phone maker was able to command a 41.5
percent margin, which has gradually drifted down to 28 percent.
Today, Nokia is Microsofts bitch, completely dependent on
the success of the Windows operating system, which is far from
certain. Nokia is a sorry shell of what used to be a great
company, while Apple, despite its universal hatred by growth
managers, is still, well, Apple. Its gross margins will
decline, but they wont approach those of 2003 or
Nokias current level.
For Apple to conquer emerging markets and keep what it has
already won there, it will need to lower prices. The company is
not doing horribly in China its sales are running at $25
billion a year and were up 67 percent in the past quarter.
However, a significant number of the iPhones sold in China
(Apple doesnt disclose the figure) are not $650 iPhone
5s but the cheaper 4 and 4s models. (Also, on a recent
conference call, Verizon Communications mentioned that half of
the iPhones it has sold were the 4 and 4s models.) Apples
price premium over its Android brethren is not as high as
What is truly astonishing is that Apples spending on
R&D and selling, general and administrative (SG&A)
expenses has fallen from 7.6 percent and 19.5 percent,
respectively, in 2003 to a meager 2.2 percent and 6.4 percent
today. R&D and SG&A expenses actually increased almost
eightfold, but they didnt grow nearly as fast as sales.
Apple spends $3.4 billion on R&D today, compared with $471
million in 2001. This is operational leverage at its best. As
long as Apple can grow sales, and R&D and SG&A increase
at the same rate as sales or slower, Apple should keep its 18.5
percentage points gain in net margins through operational
Growth of sales is an assumption in itself. Apples
annual sales are approaching $180 billion, and it is only a
question of when they will run into the wall of large numbers.
At this point, 20 percent-a-year growth means Apple has to sell
as many i-thingies as it sold last year plus an additional $36
billion worth. Of course, this argument could have been made
$100 billion ago, and the company did report 18 percent revenue
growth for the past quarter, but Apple is in the last few
innings of this high-growth game; otherwise its sales will
exceed the GDP of some large European countries.
If you treat Apple as a pure hardware company, youll
miss a very important element of its business model: recurrence
of revenues through planned obsolescence. Apple releases a new
device and a new operating system version every year. Its
operating system only supports the past three or four
generations of devices and limits functionality on some older
devices. If you own an iPhone 3G, iOS 6 will not run on it, and
thus a lot of apps will not work on it, so you will most likely
be buying a new iPhone soon. In addition and not unlike
in the PC world newer software usually requires more
powerful hardware; the new software just doesnt run fast
enough on old phones. My son got a hand-me-down iPhone 3G but
gave it to his cousin a few days later it could barely
run the new software.
As I wrote in my previous column, Apples success over
the past decade is a black swan, an improbable but significant
event, thanks in large part to the genius of Steve Jobs. Today
investors are worried because Jobs is not there to create
another revolutionary product, and they are right to be
concerned. Jobs was more important to Apples success than
Warren Buffett is to Berkshire Hathaways today.
(Berkshire doesnt need to innovate; it is a collection of
dozens of autonomous companies run by competent managers.)
Apple will be dead without continued innovation.
Jobs was the ultimate benevolent dictator, and he was the
definition of a micro-manager. In his book Steve Jobs, Walter
Isaacson describes how Jobs picked shades of white for Apple
Store bathroom tiles and worked on the design of the iPhone
box. He had to sign off on every product Apple made, down to
and including the iPhone charger. His employees feared, loved
and worshiped him, and they followed him into the fire. Jobs
could change the direction of the company on a dime that
was what it took to deliver black i-swans. Jobs is gone, so the
probability of another product achieving the success of the
iPhone or iPad has declined exponentially.
What is really amazing about Apple is how underwhelming its
valuation is today it doesnt require new black
swans. In an analysis we tried very hard to kill the company.
We tanked its gross margins to a Nokia-like 28 percent and
still got $30 of earnings per share (the Streets estimate
for 2013 is $45), which puts its valuation, excluding $145 a
share in cash, at 10 times earnings. We killed its sales growth
to 2 percent a year for ten years, discounted its cash flows
and still got a $500 stock.
There is a lot of value in Apples enormous ability to
generate cash. The company is sitting on an ever-growing pile
of it $137 billion, about one third of its market cap.
Over the past 12 months, despite spending $10 billion on
capital expenditures, Apple still generated $46 billion of free
cash flows. If it continues to generate free cash flows at a
similar rate (I am assuming no growth), by the end of 2015 it
will have stockpiled $300 of cash per share. At todays
price it will be commanding a price-earnings ratio (if you
exclude cash) of 4.
Of course, the market is not giving Apple credit for its
cash, but I think the market is wrong. Unlike Microsoft, which
does something dumber than dumb with its cash every other year,
Apple has a pristine capital allocation track record. It has
not made any foolish acquisitions or, indeed, any
acquisitions of size. Other than buying an Eastern European
country and renaming it i-Country, Apple will not be able to
acquire a technologically related company of size, nor will it
want or need to. The cash it accumulates will end up in
shareholders hands, either through dividends or share
What is Apple worth? After the financial acrobatics
Ive done trying to murder the valuation of Apple, it is
easier to say that it is worth more than $450 than to pinpoint
a price target. When I use a significantly decelerating sales
growth rate and normalize margins (reducing them, but not as
low as Nokias current margins), I get a price of about
$600 to $800 a share.
Growth managers dont want Apple to pay a large
dividend, as though that would somehow transform this growing
teenager into a mature adult. But I have news for them: Apple
already is a mature adult. Second, when your return on capital
is pushing infinity (as Apples is), you dont need
to retain much cash to grow. Two thirds of Apples cash is
offshore, but that doesnt make it worthless; it just
makes it worth less only $65 billion, maybe, not $97
billion, once the company pays its tax bill to Uncle Sam.
In the short term none of the things I am writing about here
will matter. Remember, Everyone knows Apple is going to
$300, as a client recently e-mailed me, as everyone knew
it was going to a $1,000 a few months ago when Apples
stock was trading at $700. The companys stock will trade
on emotion, fundamentals will not matter, and growth managers
will likely rotate out of Apple, because once the stock
declined from $700 to $450, the label on it changed from
growth to value. But ultimately,
fundamentals will prevail. Like the laws of physics, they can
only be suspended for so long.
Vitaliy Katsenelson (firstname.lastname@example.org) is CIO at Investment
Management Associates in Denver and author of The
Little Book of Sideways Markets.