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David Rolfe Comments on Apple

July 25, 2014 | About:
Vera Yuan

Vera Yuan

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Apple (AAPL), circa 2012-2014, is Exhibit A on how investing with the conviction of a successful business owner is a prerequisite for repeatable investment success. Before we explain, we would like to offer up pop quiz. Quick, off the top of your head, what is the 1-year, 2-year and 3-year return (roughly) of Apple stock (and the S&P 500 too) as of the end of the second quarter? Here is a graphic hint:



We have had the opportunity to do this quiz with more than a few clients of late and the most common response is surprise on how well Apple (the stock - +95%) has done versus the perception of how not-so-well Apple (the company) has been doing over the past couple of years - particularly against the backdrop of a gain of nearly 50% in the S&P 500 over the trailing three years. Over the past twelve months Apple has gained +60% versus a gain of +22% in the S&P 500. However, in a reversal of fortunes, Apple has only gained 10% over the past 24 months versus a gain of +45% in the S&P 500 Index.

With the benefit of hindsight, the roller coaster stock ride in Apple over the past few years could have been ripe (NPI) for a clairvoyant speculator to make a killing on the upside - and downside. Similarly, the long-term Apple investor has nearly doubled their money in the stock - if only they had the courage of their conviction to tune out the cacophonous consensus view that rang daily last summer purporting that Apple was without question a permanently broken growth company.

Now, to be fair, from the fall of 2012 through the spring of 2013, Apple game was certainly guilty of disappointing Wall Street. The Secretariat of Silicon Valley (see here) was becoming a distant memory as Apple began a course of failure – at least in the eyes of Wall Street. Act I was Apple’s failure of their once prodigious growth rate to crush Wall Street’s quarterly earnings estimates. Act II was Apple’s failure to crush their laughably conservative earnings guidance. Act III was Apple’s failure to even offer quarterly earnings guidance at all. Act IV was Apple’s failure to release new products with the same meter as once before.

Act IV was complete by last summer. Wall Street’s critics had had their say. In just eight short months Apple stock had plummeted -45%. In fact, the crash of the stock was worse than that. Even though Apple’s earnings growth rate had ground to a halt, the Company was still generating billions in cash each and every quarter. If balance sheet cash is excluded, the enterprise value had in fact crashed by more than -60%.

By then the critic’s reviews came pouring in: Apple was nothing without the irreplaceable Steve Jobs. CEO Tim Cook was the wrong person for the big chair. Innovation was no longer possible without Steve Jobs. $150 billion of cash on the balance sheet was irrelevant because the Company will no doubt squander it on foolish capex or acquisitions. The high-end smartphone market was saturated. Other smartphones have caught up to the iPhone’s best-in-class features. Samsung had indomitable smartphone market share. iMac innovation? Who cares? iPad innovation? Who cares? Apple will be nothing more than The iPhone Company. Apple’s only salvation (said the legions of bears) is for the Company to compete on price, which in turn, will crush margins and earnings even further. Game over said the bears…

Well. Here is a recent, yet perfect headline that reflects Wall Street’s and tech punditry’s 180 degree reversal on Apple (the company): “How Apple Got it’s Groove Back” (see here). In the past six quarterly Client Letter’s we have had a running commentary in five of those Letter’s on the soap opera that Apple has become. In those Letters we offered our thoughts - and hopefully plenty evidence - that Apple was not a broken growth company, nor lost it’s groove.

You’ve seen how our operating systems, devices, and services, all work together in harmony. Together they provide an integrated and continuous experience across all of our products, and you’ve seen how developers can extend their experience further than they’ve ever done before and how they can create powerful apps even faster and more easily than they’ve ever been able to.

Apple engineers platforms, devices, and services together. We do this so that we can create a seamless experience for our users that is unparalleled in the industry. This is something only Apple can do. You’ve seen a few people on stage this morning, but there are thousands of people that made today possible.

Tim Cook, CEO, Apple

2014 Apple WWDC

So, speaking of groove, Apple’s groove in the summer of 2014 may be the grooviest in years. In our opinion, far too many still focus solely on Apple’s hardware products without enough regard to the critical role software plays in both the Company’s user experience and ecosystem growth. To that end, the Company’s recent Worldwide Developers Conference was a must see tour de force (see here).

Without question Apple’s hardware and software vertical innovation is alive and kicking, but the speed on innovation was new charted territory for the Company. The Company unveiled to near rave reviews both a new computer operating system (OS X Yosemite) and a new mobile operating system (iOS 8). Among the numerous new features of each new operating system, the most ground breaking was a significant stride in the evolutionary integration of each operating system with one another. A key new revolutionary feature called Continuity will forever change how Apple devices automatically communicate with one another. Here are Continuity’s key features”

• Initiate a phone call while using your iMac or MacBook. Your iMac or MacBook just became a big speakerphone.

• A new feature called Handoff allows a yet to be completed email or text message on your iPhone start an email or SMS message to be completed on your Mac. The immediate syncing of your iPad or iPhone via Handoff allows for example for your currently composed email on an iPad, but you desire to attach a photo stored on your Mac hard drive. With Handoff, you simply pick up where you left off on the Mac, attaching the photo file.

• Airdrop – long a favorite application – is now synched between iOS and OS X.

• Instantly create a hotspot link with your iPhone’s 3G or 4G connection with your Mac. No configuration required. There’s no need to enter a password or fiddle with your iPhone or Mac settings. Your OS X and iOS devices now know each other and automatically configure with each other without the mess of changing each devices settings or remembering a whole new set of passwords.

Key to making such advancements in user experience possible is, of course, best-in- class hardware and software, but also providing the means to access and update latest software advancements to Apple customers as cheap and easy as possible. Apple no longer charges their customers for Mac OS X software upgrades. In addition, the frequency of iOS upgrades is at such a rapid pace, as compared to the Company’s main competitors, that Apple has by far the largest percentage of adoption by their customers of their latest software. The graphic below speaks volumes of Apple’s “closed” ecosystem versus Android’s “open” ecosystem.



More on software. In 2007 and early 2010 Apple received just plaudits and industry awards for both the iPhone and iPad. If we could go back in time to the launch of the Company’s App Store in 2008, we think the Company would have hit the Product of the Year trifecta in those three short years. Recall that the App Store – released with the iPhone OS 2.0 in summer of 2008 - officially introduced third-party app development and distribution to the iOS platform. Through the lens and landscape of 2014 the App Store has been nothing but revolutionary. This is what we wrote (and predicted) back in the fall of 2009 in iCash:

App Store: Time Magazine’s 2009 Product of the Year (a prediction)

“I would now like to talk about the App Store for a few minutes. One area we completely changed the value proposition from mobile devices is the App Store. Customers will download the 200 millionth application from the App Store tomorrow. Only 102 days since its launch on July 11th - the 200 millionth App! We've never seen anything like this in our careers. There are now over 5,500 applications offered on the App store in 62 countries around the world, and the rate of new applications being submitted is increasing every week. Competitors are scrambling to keep up with our App store, but it's not as easy as it looks, and we are far along in creating the virtuous cycle of cool applications begetting more iPhone sales, thereby creating an even larger market, which will attract even more iPhone software development. It is clear that customers are now attracted to iPhone if only for its amazing functionality and revolutionary multi-touch user interface, but also for its unique ability to let users easily purchase, download, and use thousands of different applications, ranging from free games to financial planning and health management. All of this in only 102 days!”

Steve Jobs, earnings conference call, October 2008

“The rate of App Store downloads continues to accelerate with users downloading a staggering two billion apps in just over a year - including more than half a billion apps this quarter alone. The App Store has reinvented what you can do with a mobile handheld device, and our users are clearly loving it.”

Steve Jobs, September 2009

As we mentioned earlier, we predict Apple will again grace the cover of Time magazine - for a sixth time. And the reason for the accolade will be the mighty App Store. The App Store now offers nearly 100,000 apps - written by over 125,000 developers in the iPhone Developer Program – to the installed base of over 50 million iPhone and iPod touch users. The global reach for this massive installed base is 77 countries. Can anyone say, “game over” for the competition?!

Wedgewood View. 3rd Quarter 2009 iCash

Steve Jobs’ succinct explanation of Apple’s ecosystem circa-2009 was without a doubt powerful then. Fast-forward just a half of a decade in the future from 2009 and Apple’s App Store size, scale and scope of the Company’s ecosystem would make John D. Rockefeller green with cash-envy. Consider the following metrics (Company and industry sources):

• 600 million paid iTunes customer accounts.

• 1.2 million apps – up from 5,500 in 2009.

• 75 billion apps downloaded – up from 200 million at the three-month post- launch mark in 2009 – and a 50% increase over the last twelve months.

• 300 million people visit the App Store every week.

• Cumulative iOS platform App revenue has reached $25 billion - +$10 billion more than cumulative Android.

• Cumulative payout to App Store developers by January 2014 - $15 billion and $7 billion over the past twelve months and $5 million in calendar 2013.

• iOS users spend 3 to 4 times Android users.

• According to App analytics firm App Annie, Apple mobile app developers earned around 2.6 times more revenue than Android developers in the first quarter of this year.

• According to App analytics firm Distimo, among the top 200 grossing apps in both Apple and Google App Store stores, Google Play applications brought in $1.1 million in daily revenue, compared with $5.1 million in the Apple App Store by April 2013.

The root of our long-term growth thesis on Apple continues to be buttressed by Apple’s competitively advantaged ecosystem size, scale and scope. The result of both repeat and new customer hardware purchases, growth in apps, app purchases and app developers, growth in iTunes accounts and growth in new services (iCloud) continues to foster and grow the current crop of iOS users, which has now exceeded 700 million. The focus of just three hardware platforms (iPhone, iPad and Mac), with relatively few iterations of each, is a growing competitive advantage as well. Apple is so large now that if they choose to offer, say, a cutting-edge 64-bit processor to drive a cutting edge user experience, so be it. Apple circa-2014 need not marshal the support of a complex global supply chain of component manufacturers and product assembly, who most likely in turn are conflicted with other customers which too have great demands on scare resources. No, circa-2014 finds Apple’s supply chain partners most willing to do business with Apple first. In the Company’s 2013 Annual Report, $18.6 billion was listed in future non-descript purchase obligations. In later reporting periods zero purchase obligations were listed. Apple has the fattest wallet on the planet – bar none. In the six months ending in March, the Company sold 95 million iPhones and 42 million iPads. Given such numbers of essentially just two products, the Company’s vendors cannot be fatted more by Apple’s competitors.

Over the course of the next six months Apple’s customers will be feted with significant hardware upgrades across all of their product categories. The advantage of larger phone sizes – woefully missing from Apple’s iPhone lineup – which the Company’s competitors have enjoyed is set to be significantly challenged with the expected release of larger iPhones. The Company’s recent hires over the past twelve months certainly point to a new product category. The eponymous iWatch – or other biometric sensor rich “smartwearables” - is the expected new health and fitness hardware product that developers have been kick started to write new apps for in conjunction with the Company’s just released HealthKit development app. The resultant ecosystem and I-device tie-ins are innumerable to ponder.



The current State of Apple post-Steve Jobs is in full flower under CEO Tim Cook. Cook’s earlier career path at Apple – starting as SVP of worldwide operations in 1998, to EVP of worldwide operations, to COO in 2007 – built the global logistics infrastructure that is the envy of the Company’s competitors. Under Cook’s CEO leadership, since he took the reins in August 2011, the combined competitive advantages of Apple have never been better on all key fronts: user experience, product design and focus, hardware and software integration, ecosystem growth, new product and service introductions, unmatched scale in global logistics and a fortress balance sheet. Even through the growth pause in fiscal 2013, the Company still generated +$53 billion in operating cash flow and a return on equity of 30%, as well as initiating a huge $130 billion capital return program. Apple circa-2014 is Tim Cook’s Apple.

Apple's reaccelerated growth and heightened competitive advantage has certainly not gone unnoticed by the market. After peaking in March 2012 at 47.4% - and relentlessly falling to 36.9% in June 2013 - gross margins have increased three quarters in a row and are currently back to 39.3%. Given stock's 25% gain over the past three months (and 60% over the past twelve months) we have trimmed back our position in the stock.

From David Rolfe (Trades, Portfolio)’s Wedgewood Partners Second Quarter 2014 Client Letter.


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