Apple: America's First Trillion Dollar Company
Back in 2008, I wrote about my first Apple product purchase - an iPod Touch. This was a big milestone for me as I was a diehard Apple hater before this point. As a Rhapsody user and playlisting freak I was extremely bullish on subscription music. I still think it has a bright future, but I lost Real Money on Real Networks stock. The subscription music model just never grew as I had envisioned. I let my own personal product preferences cloud my investment decisions instead of looking at the reality of the numbers. Apple dominated, and I hated them for it. I would regurgitate all the typical Apple-hating talking points on a regular basis. But then I broke down and bought an iPod Touch. I purchased it because I wanted a portable solution for the gym, and because I liked the idea of being able to get email and access the web.
My experience with that product was eye opening. How could something so small do so much, so well, so fast? Its interface was simply perfect and it never crashed, I started to understand the appeal for Apple products because I shut my mouth and starting using one. My delightful experience with the iPod Touch piqued my interest in Apple as a company and after some research, as an investment. I bought in at $164/share and can't complain about the returns. AAPL reported another blowout quarter today, but is Apple still a good investment at these levels? I have done my own analysis and can say with conviction that Apple is still the opportunity of a lifetime. This is a company with the stability and balance sheet of a mega-cap, but with the growth rate and nimbleness of a successful small cap. Below is my analysis of AAPL, which has led me to not only stay invested, but to go "all in".
First, let's start with the current headwinds the company faces. These can all impact the company and the stock price negatively, so I must consider them when determining whether I should continue to hold.
Top 5 Apple Headwinds
1. Steve Jobs health
This is the biggest elephant in the room. Steve Jobs is a visionary and has become a business and technology icon of legendary proportions. In 2004, Steve was diagnosed with pancreatic cancer. The word cancer is bad enough, but put the work "pancreatic" before it and the knee-jerk reaction is an assumption of death. The good news is that the type of cancer diagnosed was the islet cell variety, which is far less aggressive -- people can live for many, many years with treatment. The bad news is it's been 7 years since his diagnosis. Since that time Steve has had a liver transplant, and last quarter took a medical leave of absence without announcing a return date. Some shareholders have complained that the company has not released details on the CEO's medical condition. My view is this: it's none of our business. As an investor you need to assume the company will not be led by Steve Jobs in the future. If AAPL is not attractive to you without Jobs, sell your stock. I would like nothing better than for Steve to return, but if he does not, I have faith in both the management team and the culture he has built. The company is more than capable of keeping the ship moving at least for the short and mid-term. With this decision, I understand that my shares will take a temporary hit if Steve leaves. Further, I have made a decision to watch the stock if this happens and add to my position on any emotion-driven overselling.
2. Market Cap
There is no denying that the "law of big numbers" is a headwind for Apple. With the second biggest market cap in the nation behind only Exxon Mobile, the conventional wisdom says that Apple cannot continue to grow at such a rapid pace. It's much easier for a company with a billion dollar market cap to double than one with a $300 billion market cap. The problem with this theory (which is usually a sound one) is that Apple has grown its revenue, on average, around 60% each year over the last 5 years, and their current sales and expansion show no signs of slowing down. Just today AAPL reported an astounding 95% year over year growth for fiscal Q2. In addition, Apple currently has around $50 billion in cash and is adding to the kitty every quarter. What happens when Apple's cash holdings equals its market cap? We will never know the answer to that, because at some point Wall Street will realize that a $300 billion market cap is not too big for a company that is on track to have that amount in the bank. So in my view, this headwind is creating a buying opportunity even if Apple only performs in line with estimates. If they continue to exceed estimates, watch out. My advice is this, when you see Apple missing targets, it's time to rethink your position. Until that time the market cap argument is a false one that will be removed by basic math.
There have been many articles about the continued rise of Android smart phones, and Android's entry into the tablet market with Honeycomb. And there is no doubt that Android will continue to be a player. However, a mistake many are making on this point is the assumption that there will only be one winner. The smart phone market as a whole grew at 67% last year when compared to the year before, and this growth is set to accelerate further. Estimates peg Apple as holding about 25% of this market. So even if the iPhone does not capture any more market share, it will grow in excess of 16.7% per year as the market itself expands. When you look at the mobile phone market as a whole, Apple holds just 3%. So the opportunity for growth here is staggering. While Google gives away its Android OS to manufactures for free in hopes of reaping ad revenue down the road, Apple sells every iPhone as a package that reaps multiple rewards. In addition to being a player in Google's space by collecting ad revenue with their iAds product, they make money on the hardware (with some of the best margins in the industry), and let's not forget recurring revenue from iTunes, iBooks and the App Store, which are bundled in every new phone sold. In fact, Apple's iPhone business alone brings in more revenue than Google does in total as a company. All of these data points are fun to analyze, but the most important thing you can do to size up the competition as a potential investor is to pick up the devices and try them. When you do, you'll discover that iOS is so far ahead in design and usability that it's no contest. Give a Playbook , or a Xoom to a 5-year old and see how long it holds their attention, then give the same 5-year old an iPad. Let me know what you discover. The ease of use and intuitive design found in Apple products is as close to perfect as it gets. 100% frustration free, and at the most basic level, this is what's driving Apple's success.
4. Supply Constraints
The Japan earthquake was a horrible disaster and there are Apple suppliers who were impacted. There have been stories of Apple paying higher prices to secure a reduced inventory of the parts they need to continue ramping their product. Could this have some pressure on margins? Maybe, in a worst case scenario, in the short term. But I see this as a big plus for Apple. Apple is first in line because they are THE largest customer and have the ability to pay cash up front to secure supply. This means any shortage in parts will be amplified for Apple's competition. And in general, it's always a good idea to buy a stock that is depressed based on a one time unforeseen natural disaster. Companies will figure out a way to fill any gaps in Apple's supply chain. There is just way too much money to be made to think a gap will remain for very long. Bottom line is this: If there are supply constraints, they are a speed bumps and the competition will suffer more than Apple does. Apple made it clear that they can produce a "very large number" of iPads in Q3 and that they see no fiscal, or production shortfalls due to the disaster unless some future, unforeseen disaster strikes.
5. Product Misses
Remember, I was an Apple hater before I turned into an Apple bull, so I am not so blind that I do not see the issues with Apple. I feel iTunes has indeed become slow and bloated. I think it makes no sense that users need to physically connect their devices to a computer, Ping is probably the worst excuse for a "social network" I have ever laid eyes on, Apple TV is still just a "hobby", and I still don't understand why Apple has not embraced the subscription music model. However, I think Apple knows their weaknesses and will improve upon them. But even if they do not, the company's strengths far outweigh my nitpicking. Of course, the risk always exists that Apple will release a product that does not work and sucks profit, but so far the track record speaks for itself and the management team is as good as you'll see anywhere.
Apple's Money Making Machines
Let's start with the basics in the form of a few rhetorical questions: Which smart phone produces lines of people who camp out overnight just to ensure they can be one of the first to have the newest iteration? Have you ever seen a news story about people camping for a new Android device, or Blackberry? When you think about which consumer products (across any industry) are currently the most in demand, what pops into your head?
Simply put, the iPhone is taking the world by storm. The device is creating mass buying hysteria in China, which is a huge new market for Apple. But if you don't believe the rumors and the long lines, maybe some hard numbers will convince you. The below chart shows the sales growth of the iPhone over the past ten quarters. iPhone sales increased by almost 52% in 2010 when compared to 2009, and 2011 is tracking to a growth rate of over 90% compared to 2010! And remember, iPhone is just starting to get a toe hold in Asia, and by some current estimates it only has about 3% of the global mobile phone market. This friends, this is what opportunity looks like.
iPod growth has reached a plateau as more consumers depend on the mobile phone to also be their portable music device. But Apple has not sat on its laurels. They have the widest selection of portable music devices of any company, and they span a range of price points. Apple will retain the majority of market share (currently 70%), although the market itself is shrinking. However, some recent news plays well for Apple. As the market shrinks competitors are dropping out completely. Microsoft has ended its Zune player, and others will surely follow leaving Apple with a bigger piece of the pie. The iPod has expanded its functionality to steal dollars from companies outside of the music market. Cisco recently announced that it has ended its Flip video camera. Going forward, consumers looking for a compact, no contract video device like the Flip will now turn to the iPod. Also something to consider are the amazing number of games available at low price points in the App Store -- this is helping transform the iPod Touch into a direct competitor to the Nintendo DS and Sony PSP.
With the iPod and iPhone, Apple has proven that it can enter new markets and succeed, even dominate. What separates the iPad is that Apple did not enter the tablet market, it created it. The iPad was dismissed when it was first announced, the name resulted in tampon jokes flooding the Internet, it was "just a big iPod Touch that had no practical application", the naysayers screamed. But the problem was not with the iPad, the problem was that the bashers did not actually pick one up and use it. The iPad is not about computing power, or technical specifications. It's about having an instant-on device that is indeed," magical" to use. The iPad has been the most successful new consumer electronic device in history. The naysayers are still out there, but they are significantly fewer in number. We are witnessing a sea change in how people access everyday computing tasks and we are already starting to see the erosion of the PC market due to iPad and Mac penetration. No one knows how big the market will turn out to be, but I think it will be bigger than anyone expects. You must spend some time with an iPad to understand. And make sure you also spend some time with a Motorola Xoom. The difference is staggering. Where the iPad is intuitive and a joy to use, the Xoom is frustrating and complicated. Xoom is no competition for the iPad as the sales numbers prove out.
Much has been written about the Apple "Halo Effect". This is a theory that says as more people become familiar, and fall in love with an Apple product they will buy more Apple products. The ecosystem created by Apple ensures their devices work seamlessly together, this helps contribute to the halo effect. No Apple product has more to gain from the halo effect than Macintosh. The Mac has always been a niche PC that attracted creative professionals for its power and design aesthetic, but it has been consistently gaining market share as more regular people opt out of a Windows-based PC and choose a Mac. These people are also gladly paying a premium. The Macintosh market share grew from 7.3% in 2010 to 9.3% in 2011. The PC market is enormous and the Mac is a very profitable business for Apple. It is the ace in the hole that should continue to drive significant growth. I have not yet bought a Mac. I have always owned a PC, but the next computer I purchase will be a Mac. I have learned to live with software crashes, viruses, and incompatibility issues on my Windows PCs, but my iPad and iPhone always work flawlessly and quickly. Why would I not join the Mac club? I suspect there are millions more like me who plan to make the switch, even if they don't call it the halo effect.
Accessories have been such a small part of the earnings picture, why even bring them up? Well, because as Apple product sales grow accessory sales will grow, and with the iPad 2 launch Apple showed us they are taking accessories more seriously. Steve actually spent a good deal of time on their new "Smart Cover" with uses magnets to perfectly align itself to the iPad 2 and protect the screen when not in use. It also turns the device off when closed and on when opened. Obviously, no one is in a better position to create well-designed Apple accessories than Apple is. The Smart Cover has already brought in more revenue for Apple than the Xoom has brought in for Motorola. That speaks volumes and I think Apple will capitalize more on device accessories in the future.
When Apple first started opening retail locations I thought it was the wrong move. Why take on all that expense? Well, I was wrong, and the success of Apple's retail store strategy taught me that I need to understand the big picture before I solidify a position. Apple stores are a massive success story. For one, they are destinations. People will drive hundreds of miles to visit one, not solely for the products, but also because they're architectural marvels and contain employees who can actually answer questions. Apple's attention to the customer and ability to get the products into our hands has been a boon. Face to face will always be the best way to sell, especially with complex, or expensive products. Apple store employees show customers HOW to accomplish tasks, answer questions, offer free classes, make them feel like they are part of something special, and that results in not just higher sales numbers, but customer loyalty. Apple stores generated a 90% year over year increase in revenue in Q2 2011 and Apple plans to open 40 more stores in the remainder of the year.
Does Apple make software? Yep. And they make money on it in two ways. Obviously, the register rings when they make the sale, but more importantly, Apple software runs on Apple products. Get someone to fall in love with an application that only works on your hardware and you've just snagged a whole lot of future revenue. And let's not forget the growing future recurring revenue from newspaper/magazine subscriptions and growing iBook, app store, music and movie/TV show sales. The more hardware Apple sells the higher this revenue climbs.
Apple has always lagged behind in enterprise adoption. Windows and Blackberry own the market, but it's a huge opportunity for Apple and they've been working to close the gap. Today Apple reported that over 88% of Fortune 500 companies are deploying, or piloting the iPad, or iPhone. As Apple continues to improve corporate deployments they will gain revenue from this important market at the expense of Microsoft and Rim. More importantly, the consumers who are falling in love with Apple products at home have jobs, and in many cases these fans make purchasing, or IT decisions for their employers.
One of the Option Action guys on CNBC actually said he was not bullish on Apple this week because they had no new products in the pipeline. I am not sure how a CNBC talking head is not aware of the iPad, but even if we consider the iPad a mature product line there are other irons in the fire. We know, for example, that Apple is getting ready to open the largest data center that exists on the face of planet earth in North Carolina. Rumors of cloud services and maybe a streaming video service to compete with Netflix abound. Can Apple make cable companies a thing of the past, or at least steal a large chunk of their revenues? Will we be able to stream our music from any of our Apple devices no matter where we are without having to load the device? Is Apple readying a branded flat screen HDTV to take a chunk of the $100 billion/year HDTV market? Is a lower-end iPhone coming that will enable Apple to conquer the enormous non-smart phone mobile market? These are all good questions, but even if none of these specific rumors happen, I'll bet my retirement savings that Apple is not stopping with the iPad. There's no reason to believe this company will stop entering new markets, even if the market does not price it in.
Bottom Line (my view)
Everyone needs to do their own homework and come to their own conclusions about Apple, especially when considering it as an investment. But in my view Apple is the biggest opportunity since railroads during the industrial revolution, or the world wide web during the Internet revolution. We are in the middle of a sea change -- people are fed up with crashes and viruses, people are no longer interested in tech specs - the masses want a great experience to help them do what they wish to do quickly and easily, all packaged in a hip design. Mobile computing is not a fad, it is the future, and Apple is best positioned to continue to benefit from this historic transition. Prediction: Apple will be the world's first trillion dollar market cap company and it will happen within 5 years.
I am long AAPL with both stock and call options
This blog is NOT advice for you to buy, not buy, sell, or hold any equity. Please do your own research and make your own decisions. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. This analysis is my own and in no way condoned by Yahoo Music, or Yahoo! Inc.
I have not forgotten that this is a music playlist blog, and considering that it was music that set Apple on its path to being the most successful company in the world, I give you my playlist:
Ode To Apple: A Playlist
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