Apple (AAPL)'s stock continued its streak of absolute and relative underperformance during the second quarter. However, in our view, the Company's long term competitive positioning is strong and intact , particularly due to their aggressive, multi billion dollar re investment in its supply chain, which should bear fruit over a multi year period. While much has been said about Samsung since it recently surpassed Apple in terms of units sold, we think "units sold" is a poor proxy for competition, at the very least, until we figure the profits generated by those units. As of the first calendar quarter 2013, we estimate Apple generated $215 in operating profit per iPhone, compared to Samsung, which generated about $90 per smartphone. Clearly, Apple's collective smartphone value proposition is superior to Samsung and considerably more than the rest of their rival peer group which collectively continue to generate losses. However, Apple's profitability per iPhone during all of 2012 averaged about $265 , while Samsung averaged about $80. So at the margin, Apple ceded roughly $50 of profitability per iPhone relative to its 2012 average. This per unit profit decline could suggest that Apple's competitive edge has eroded. However, Samsung only picked up about $10 per unit, and the rest of the competitive field narrowed their losses by about $5 to $10 per unit, which begs, where did the other $30 35 of profit per iPhone go?
Given that Apple's average iPhone prices have not changed in proportion, it is certainly not accruing to Apple's customers. Perhaps some of that value accrued to customers of Apple's competitors? But if that were true, Apple's competitive cohort probably would have exercised some pricing power by now, but they have not done so, considering prices by smartphone segment have been relatively flat.
Now, as we have noted in the past, Apple's capital expenditure budget has risen rapidly over the years, meaning Apple is aggressively reinvesting into its business. Apple's "cost of sales" as a percent of revenues has risen nearly ten percentage points compared to the first calendar quarter of 2012. As a result of this dramatic rise in costs over a relatively short period of time, we suspect that much of the profitability per unit has gone to Apple suppliers. While it is unsettling to see per unit iPhone profitability decline, we believe that Apple will eventually realize returns on these expenditures, particularly by increasingly exercising more scale over its asset and supplier base.
So we realize that Apple's rival peer group is making competitive inroads, but we do not think they are as dramatic, nor as sustainable, as the market seems to be implying and that the majority of Apple's lower profitability represents current investments in future returns. Indeed, considering that the stock ended the quarter at close to just a 4 X Enterprise Value to EBITDA multiple, and although the past few quarters have been difficult for Apple shareholders, we believe patience and a focus on Apple's long term growth of their best in class ecosystem will be rewarded in due course.
From Wedgewood Partners' second quarter 2013 letter.