Apple (AAPL, Financial) was a top contributor to performance during the fourth quarter. Revenues grew by almost +30%, with earnings further boosted by margin gains from the insourcing of processor design and production for the Company’s Mac lineup. Despite these sourcing changes, Apple still ran into some shortages of mass market inputs and would have otherwise reported even higher growth. The Company also continues to take smartphone share in China roughly a year after Huawei was forced to abandon the industry. Apple’s iPhone franchise should be a beneficiary of Huawei's colossal failure for some time. We continue to hold Apple shares as a core position.
Apple
Apple (AAPL, Financial) continues to develop new products and services that capture dominant profit share in some of the largest and most competitive industries around the globe3. Having owned Apple continuously for the past 16 years, we find it surprisingly difficult to know what new products the Company will unveil over a multi-decade timeframe. For example, in 2006, we did not know Apple would sell MacBooks with Apple-developed CPUs starting in the year 2020. In 2006, Apple had just made a huge pivot by launching its first Intel-based computers, moving away from IBM PowerPC4. But we did know that Apple’s vertically integrated (software and hardware) product development strategy was unique and extremely capable of creating products and experiences that customers thought worthwhile enough to spend growing amounts of time and money on. Today, that development strategy culture is still intact and as entrenched as ever thanks to Apple’s methodical long-term investments in key areas such as semiconductors and integrated circuits (IC), which have been complemented by continuous software innovation.
In just a few years after Apple’s switch to Intel for its PCs, Apple made a couple of strategic acquisitions that launched its internal semiconductor development platform. These acquisitions, including PA Semi and Intrinsity, saw the Company add several hundred silicon engineers in the process, initially with the stated goal of expanding Apple’s parallel processing capabilities for its line of Mac computers.5 However, Apple’s first internally-designed system on a chip (SoC), the A-4 (launched in 2010), was not a multicore chip, nor was it designed for a PC. Yet by 2011 it was rumored that Apple had “1,000 engineers working on chips.”6
With the introduction of the iPhone and the creation of the Open Handset Alliance in 2007, off-the-shelf solutions for the touchscreen smartphone industry exploded, setting up supplier-customer dynamics reminiscent of the “Wintel” era of the 1990’s. Samsung, Qualcomm, Broadcom, and NVIDIA (to name a few) often provided off-the-shelf inputs for original equipment manufacturers (OEM) like Nokia, Samsung, ZTE, Sony, and Apple. By definition, these inputs were not custom made; therefore, those parts alone would not provide any sort of differentiation. So, the real benefit of recruiting semiconductor design talent was that Apple could create custom inputs to make products that would significantly stand out from the competition.
Apple has developed well over a dozen custom processors and other integrated circuits since it launched its first “A-series” processors. The A-series processor family seems to be an annual iteration of Apple’s mobile CPUs, often enabling new iOS-specific functions that sometimes takes competitors years to mimic. For example, in 2017 Apple’s A11 Bionic processor featured a “neural processing unit” that provided the iPhone X with enough processing power specifically dedicated to operating the device’s FaceID 3D mathematical algorithms so users could securely unlock their phones and also make digital payment authorizations. It took years for competitors to copy this feature using similar biometric scanning, but even those have been sparingly embraced by users, meanwhile Apple’s FaceID helps authorize over 600 million payments per year.7 Payments alone are probably not a huge reason to go out and buy an iPhone or iPad, but after more than a dozen years of chip iterations we would argue that regular device feature innovations along with quality improvements have yielded a consistent and differentiated value proposition that regularly convinces consumers to stay and grow in the Company’s lucrative ecosystem.
To capture the vast majority of the profit share in mobile, Apple has had to do more than generate revenue by focusing on user experience. The Company has also had to maintain a disciplined value chain to keep expenses under control. One obvious but immensely important aspect of their strategy has been a focused product set. This concentrated purchasing power likely affords raw chip procurement economics that are not far from off-the-shelf solutions.8 In addition, Apple has been able to secure leading-edge fabrication technology at its fabrication partners at huge scale. This rare capacity alone provides a multiyear head start on many processing competitors. So, Apple can reap the benefits of custom chips without paying exorbitant prices, which creates value for most everyone involved.
We expect Apple’s strategy of differentiation through silicon will continue for years to come. According to Apple’s website, Apple currently has as many job openings for silicon-related development as they do for software applications and frameworks. More recently, Apple has started to displace Intel CPUs from its PC lineup and replaced it with Apple’s M-Series silicon. Apple also plans to replace Qualcomm modem silicon by including an internally developed modem on upcoming A-Series processors.9 Of course, Apple does not participate in the server CPU market or cater to hyperscale customers, despite iCloud, the App Store, and all of its other cloud-based services. However, we would not be surprised if one day Apple tried to bend the curve in the cloud. None of these moves are mean feats given Intel and Qualcomm have been competing in processor design and production for generations.
Apple has effectively created a semiconductor business that rivals and even surpasses some of the most established semiconductor-focused businesses in the industry. Apple continues to differentiate through vertical integration, which has been a hallmark of Apple’s long-term strategy to grow and capture superior profitability. It is difficult to predict what new products will be unveiled; however, we think this strategy should continue to serve shareholders quite well.
From David Rolfe (Trades, Portfolio)'s Wedgewood Partners fourth-quarter 2021 letter.
