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How Much Would You Pay for the Apple Ecosystem?

February 07, 2013 | About:
Earlier this week I wrote about the psychological challenges that Apple shareholders face. I also discussed the evolution of Apple’s “i” gadgets — the iPod, iPhone and iPad — and how they have created an ecosystem unlike those of other technology companies. Apple’s 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 we’re 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 competitor’s device an unpleasant undertaking, something you won’t 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 (I’ve 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, Apple’s hardware premium will deflate and its margins will decline. The only question is, by how much? Let me try to answer that.

From 2003 to 2012, Apple’s net margins rose from 1.1 percent to 25 percent. In 2003 they were too low; today they are too high. Let’s 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 Microsoft’s 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 won’t approach those of 2003 or Nokia’s 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 doesn’t disclose the figure) are not $650 iPhone 5’s 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.) Apple’s price premium over its Android brethren is not as high as everyone thinks.

What is truly astonishing is that Apple’s 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 didn’t 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 leverage.

Katsenelson_Apple_Chart.jpg

Growth of sales is an assumption in itself. Apple’s 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, you’ll 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 doesn’t 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, Apple’s 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 Apple’s success than Warren Buffett is to Berkshire Hathaway’s today. (Berkshire doesn’t 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 doesn’t 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 Street’s 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 Apple’s 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 today’s 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 buybacks.

What is Apple worth? After the financial acrobatics I’ve 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 Nokia’s current margins), I get a price of about $600 to $800 a share.

Growth managers don’t 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 Apple’s is), you don’t need to retain much cash to grow. Two thirds of Apple’s cash is offshore, but that doesn’t 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 Apple’s stock was trading at $700. The company’s 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.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).


Visit Vitaliy Katsenelson's Website


Rating: 4.2/5 (13 votes)

Comments

nvakeel
Nvakeel - 1 year ago
Thanks for the nice article.
vgm
Vgm - 1 year ago
Two perceptive and thought-provoking pieces! Superbly written too.

Thanks for so generously sharing your thoughts and insights.
SeaBud
SeaBud premium member - 1 year ago
I have no idea what Apple will be worth in 5 years, but I can address a few points. It is silly to label Nokia "Microsoft's bitch" or a shell and assume that Apple will be king in 10 years. 12 years ago, Apple was bankrupt and anyone who thinks the "apple cart" can't, and won't, be upset again, is a fool. Since predicting the future is "fruitless", let's look at current value:

- Cash - tons. But not giving it to shareholders. Clearly valuable but no sign significant release.

- Hardware - Per your previous article, Apple may be in trouble here. They are no longer the best hardware in phones and are losing ground in tablets. The forces arrayed against Apple are huge.

- Ecosystem/software - Here is the key. Risks: non-US customers will not value or pay for the Apple ecosystem at the rate of Americans, the cloud devalues ecosystem reliance or Google/Windows achieve parity in function.

I have been in the consumer electronics business for decades and this quote always comes to mind "Enjoy it while it lasts kid, because it never does." I almost shorted apple over $700 but did not, and would not short now. However, I also don't see them being dominant in 10 years given the technical and competitive challenges they face absent them having "the next big thing".

You state Apple has not wasted capital. That is in the past - with Jobs. Now may be different. They are not giving the cash to shareholders so what will they do???

Short term (3-5 years to me), I think Apple at $400 is probably safe (I wouldn't start a position absent seeing the next big thing), but long term I believe the risks inherent to Apple are high.
crafool
Crafool - 1 year ago
Apple is a great company and true innovator, however it is not an Extraordinary company. What is the difference? Well I think about what Warren Buffett refers to the 3 i's of a business or industry, and how it relates to Apple.

The first I stands for "Innovator". This is the person or company that sees a need or opportunity and fills it. Because this need was previously not being met the "profit" from it is tremendous. So Apple creates the i-phone. This phone does more than any other phone can do at the time it comes out and consumers and business people grab it as fast as they can get it. The second I stands for "Imatator". Yes, those news stories showing people waiting outside of Apple stores trying to get the latest version of the i-phone was not lost on competitors like Microsoft, Nokia, Dell, Google, Samsung, Sony, HP and every other consumer electronic manufacturer. Those profits are pretty alluring and it brings competition for Apple. Competition will bring down profit margins as competitors will relentlessly work to gain some market share from Apple. Apple did not invent the phone and the tablet is basically a larger version of the phone. They do not have a "Patent" or other huge barrier that prevents others from competing with them. THe last I is for "Idiots". This is the last companies that are still piling into a market that is becoming more and more competive. The competition is and will drive the prices down, down and down. How much does a 60" plasma TV cost today versus five years ago? Apple can not stop the other companies and its dominance is related to "first mover advantage" rather than a more durable moat like a "patent". A great company has a great run of success, but an extraordinary company has a durable competivie moat that keeps it on top for decades of time.

What is the appropriate valuation for Apple? Well, I would use Ben Graham's process of determining normailized earnings as a foundation for determining it. I would look back 10-YEARS at Apple's earnings and take the average of those earnings and consider that as "normailized earnings" for Apple. It is up to you to put the appropriate multiple for you on those earnings, but those earnings are a lot less than the earnings Apple is currently showing investors. Am I too pessimistic that Apple's normailized earnings could be less than half its current earnings? Well, the cash hoard that Apple keeps and won't distribute says that I am not the only one!

That brings up another question, what should Apple do with its cash? Well, I have a crazy idea. Invest it in an "extraodrinary" company that is in its same industry, increases its return on the cash, high credit quality, at a price that offers a margin of safety and potnetial for above average total returns going forward and has liquidity. What could that be? Well, wait for it- Microsoft!!! What? Yes, Microsoft. If there was ever a competitor to Apple it would be Microsoft. I know there are people for personal belief don't like Microsoft for they have been the dominant company in technology for decades. Microsoft is the dominant and ingrained and embedded technology company. As I have said time and time again, there is an old saying regarding coporate Chief Technology Officers "You dn't get fired for hiring IBM!". IBM is not recommending that people go to Apple and make Apple a platform company like Microsoft has been and is today.

Microsoft has a cash hoard that they are buying back stock and increasing dividends. Their share buy back is based upon a stock that has a depressed P/E multile and normailzed earnings. THe company sells at nearly a 30% discount to the S&P 500 and pays around 3.4% or nearly 1.7 times the 10-year Treasury bond. Apple can't buy Microsoft stock! Why? The cash they hold earns shareholders less than 1% in nominal returns and in real return terms is losing investors money in terms of purchasing power. Microsoft is going to benefit from all the other companies competing with Apple and it will still have its core business. Microsoft is anextraordinary company and Apple could get some of that by buying a nice piece of Microsoft!

Happy investing to all!!

jonmonsea
Jonmonsea premium member - 1 year ago
What percentage of a stock portfolio consisting of 15-30 stocks would you accord Apple based on your analysis, mr. katsenelson?

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