Hi,
This is a Value Investing research summary on Apple Inc.
Key findings
1) Strong Brand Loyalty
2) Effective Research and Development
3) Competent management
(A) Business description
Apple Inc. is a globalised company which designs, manufactures and markets mobile communication and media devices and personal computers, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. Some of the company’s most renowned products and services are iPhone®, iPad®, Mac®, Apple Watch®, Apple TV®, a portfolio of consumer and professional software applications, iOS, macOS® , watchOS® and tvOS™ operating systems, iCloud® and Apple Pay®. Additionally, Apple Inc. sells and delivers digital content and applications through the iTunes Store®, App Store®, Mac App Store, TV App Store, iBooks Store® and Apple Music®. Apple Inc. distributes its products and services through a wide array of methods. For instance, the retail stores, online stores, direct sales force, third-party cellular network carriers and wholesalers. Furthermore, Apple Inc. made use of these distribution channels to also sell third-party Apple compatible products too.
(B) Industry overview and competitive positioning
1) Fall in Competitive Pricing Power
In the past, Apple Inc. generated more growth than the global electronics and appliance specialist retailers market due to its strong demand for its innovative products. However, as the competitors start to offer similar products, Apple’s products loses its differentiating factor which resulted in the fall in volume demand and the Year-on-Year competitive performance by value growth of Apple to slowly converge towards the market (Figure 1).
2) Threat of Substitution
Android and Microsoft users would be faced with a higher threat of substitution because of the low switching cost. Since most of the products operate with the similar software, migration of data and information is easy and efficient. However, Apple users would face a lower threat of substitution because of the high switching cost. Apple products operate within its own operating system that is non-compatible with the Android or Microsoft operating system. Thus, it is more costly for users to switch away from Apple products.
3) Threat of New Entrant
The barrier of entry is high in the smartphone market as a large sum of capital is required to sustain its business operations. Furthermore, additional capital is needed to produce innovative products that differentiates itself. Using the price factor as its business strategy would be not successful because there are many low-cost smartphones that are already being offered.
4) High Degree of Smartphone, Tablet and PC Concentration
The smartphone market is dominated by 3 players (Figure 2) which collectively holds approximately 50% market share in terms of units shipped. Samsung is the market leader (20.9% as of 2017), followed by Apple (14.0%) and Huawei (9.8%). Furthermore, Huawei is chipping away the market share from Samsung and Apple is mainly due to the low-cost phones that they offer.
Whereas in the tablet market, it is dominated by 4 players (Figure 3) which collectively holds approximately 60% of the market share in terms of units shipped. Apple is the market leader (26.6% as of 2017) followed by Amazon (15.6%), Samsung (14.1%) and Huawei (7.1%). Additionally, Huawei is gaining market share rapidly whereas Apple faced declining market share since its first inception.
In the PC market, it is dominated by 3 players (Figure 4) which collectively holds 60% market share in terms of units shipped. HP is the market leader (22.7% as of 2017) followed by Lenovo (21.1%) and Dell (16.1%). Together with Apple, they experience improved shipments from the past year while the other players suffered from loss of market share. In particular, Apple grew 5.9% Year-on-Year which is second best in the PC market.
5) Bargaining Power of Suppliers
Since the supply of semiconductor is high, Apple is able to select its suppliers from a large pool and this would result in the fall of switching cost. Furthermore, as Apple orders a selected few components from of a handful of suppliers, these suppliers would have a low bargaining power against Apple as their revenue would suffer significantly if Apple pull the plug on them.
(C) Investment summary
1) Strong Brand Loyalty
One way to gauge how strong the brand loyalty is by looking at the effect of price increase. Simple Economics would tell us that when the price increase, the demand would fall in a competitive market. Thus, we would expect that this principle to hold in the smartphone industry, where there many phone of somewhat similar capabilities that is sold for a price range. However, the sale of iPhone, Apple’s main revenue driver, has always experience a higher demand despite an increased in its price (Figure 5). This peculiar observation could attributed to the combination of innovation and loyal customers. Since the normal smartphone life cycle is approximately 2 years (Figure 6), if there is no Apple’s loyal customers, we would expect that the sale in 2015 to dip because of its high price in a competitive market. Furthermore, in 2017, when consumers are probably halfway through the smartphone life cycle, the demand for iPhone increased despite its high price indicate to us that the strong support from their loyal fan base because if they are not a fan of Apple, their wouldn’t even bother to switch to the newer phone so quickly. Thus, the brand loyalty is a consistent driver of Apple’s growth and this could aid in the future growth of Apple.
2) Effective Research and Development
On the other hand, the innovation has also contributed to the high demand of iPhone. Apart from the smartphone segment, Apple has constantly produce innovative products throughout the years. Moreover, Apple is ranked above its peers as the most innovative company in 2017 and 2018 by Fast Company and Boston Consulting Group respectively. For instance, the Face ID technology in the latest Apple flagship phone provides a unique and secure phone protection for its users and this technology is not yet achieved by its competitors. Additionally, Apple’s self-designed processor dominates its competitors (Figure 7).
One of the reasons that allowed such achievements is that the R&D is focused only on the Apple ecosystem. Thus, with control over its software and hardware, Apple’s R&D team is able to come up with innovative ideas more quickly and efficiently.
3) Competent Management
Having a strong R&D capabilities has helped fuel the production of innovative products that suits the needs of consumers and their satisfaction of the products builds brand loyalty.
Apple has never failed to keep up with the technological progress and has consistently produce innovative products that suits the needs of the consumers. For instance, the MacBook, iMac, iPod, iPhone, iPad and HomePod. Not only do they provide in a timely fashion, they are always ranked in the top in terms of quality and performance. Thus, this once again shows how hard the R&D team works so as to deliver these products. Thus, with such high consistency in keeping up with the technology progress, we could safely assume that Apple would continue to innovate cautiously and smartly in the future.
Therefore, we could see that with the combination of competent management planning and effective R&D capabilities, Apple is able to produce innovative products that continues to bring value to its existing and new users that would eventually lead to a higher customer satisfaction and improved brand loyalty.
(D) Financial analysis
1) Steady Gross Margin
Over the years, Apple has kept a steady net margin (Figure 8) which proves Apple’s resilience against the poorer economic outlook in the past. Furthermore, the rapid technological advancement throughout the years has not disrupted Apple’s stable margin significantly. Thus, such stability is important as it provides a better dependency for its future outlook.
2) Loans
Since 2013, Apple has been accumulating debt as part of its business operation (Figure 9). By looking at the credit ratios, the leverage ratio (Debt/Equity) and the interest coverage ratio (EBITDA/Interest Expense), we could observe worrying signs for Apple. From 2013 to 2017, both ratios have been trending in the unhealthy direction as Apple’s borrowings is close to its equity level already and at the same time, their ability to pay the interest payment is decreasing too. However, the Interest Coverage Ratio may not paint the current situation in Apple because in fact, Apple’s interest and dividend income can readily pay off its interest expense. Thus, although Apple seems to be accumulating high level of debts, it is not a cause of worry as their effective investment strategy and strong balance sheet can prevent any major debt related problems in the future.
(E) Potential catalyst
1) Innovative Products
Beyond the handheld devices comes the Augmented Reality (AR) Glasses which could be the new break-through for Apple. AR technology is definitely an area that Apple is looking into after the launch of the ARkit in iPhone 8. Together with the purchase of several AR firms (Tel Aviv’s PrimeSense and RealFace), the number of key AR talent hires, AR and VR patents granted and several investment into chips and glasses, the possibility of a new release in the coming years is high and this could potentially bring in new revenue stream for Apple.
2) Services Revenue Growth
Digital content and Services, AppleCare, Apple Pay are some of the components of it services segment of Apple which has been growing at a fast pace in recent years and more growth could come when Apple Pay and its Digital content and Services is fully rolled out. For instance, Apple Pay has not reached its full potential yet as they have not penetrated into many places yet. Furthermore, if VISA and MasterCard supports contactless payment in the future, Apple Pay’s adoption rate would definitely soar as they provide a swift and safe transaction as compared to the chip-card transaction.
(F) Risks
1) Unsuccessful Product Launch
Like all retail businesses, its revenue growth depends heavily on its product sales and as Apple iPhone and iPad slows, an alternative product would be needed to rejuvenate Apple’s growth. Thus, if the subsequent Apple products are not attractive, not only would they make a loss on investment, their revenue growth would be negatively impacted due to the slowing growth of its current products.
2) Third-party Digital Content Not Available to Apple
Most of the content on iTunes Store are not locally produced. Thus, in order to keep the iTunes Store attractive, they must continue to supply good digital content for its users. However, if Apple fails to secure these deals in the future, their services would not be attractive anymore and this could impact their financial significantly.
(G) Corporate Governance
The board of consists of all outsiders except for the Chief Executive Officer (CEO) which indicates that it is mostly an independent board and they are elected annually. Also, none of the board members have any relationship with the key executive of Apple Inc. and all of the board members has attendance of at least 75%. Additionally, the compensation committee assists the board with its annual review of succession planning. Furthermore, Southwest Airline’s executives are paid based on performance. However, the directors met 4 times annually and they are paid above average compared to its peers.
Conclusion
In conclusion, Apple’s strong R&D and innovation could may continue to be the Apple of your eye.
Jia Yang
Research Analyst, Mind Kinesis Value Investing Academy
Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.
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