Description

Summary

Apple is a legacy fast follower technology company with a rapidly declining moat and lack of attractive reinvestment opportunities. Under current lackluster management, the company has transitioned into a high priced retailer whose sky high share of the mobile device global profit pool has nowhere to go but down. Insiders confirm this view with their consistent selling of Apple stock and continuous exit to growing, competing companies. The company’s emotional fan base has translated into an emotional and unsteady investor base. Apple’s optically cheap valuation masks opportunity for a successful short investment as business value deteriorates. Operations are not earning their cost of capital and the company is in slow liquidation. The company’s equity is worth $60 per share, 50% lower than today’s market price.

Link with accompaying charts: https://drive.google.com/file/d/0B5AhopgMAgquZjIzdUJqTUdqaXc/view

Company Overview

Gauged by its current market capitalization, Apple is the most successful company of all time. Founded in 1976 by two college dropouts and a businessman who provided seed capital, the company successfully developed one of the first and most popular personal computers. The company’s computers married internally designed hardware with internally designed software and sold in steadily increasing volumes throughout the 1980s. In the 1990s, Microsoft (operating system) and Intel (CPU) developed a personal computer platform that disintermediated other existing platforms. The Wintel platform divorced software from hardware, commoditizing the majority of hardware manufacturers. This simultaneous industry wide standardization of operating systems created the largest ecosystem for software developers to build new applications into and provided the surest way to monetize their efforts. Apple had a better product from the user’s point of view, but the network effects of the competing larger ecosystem decimated first Commodore’s then Apple’s market share.

Luckily for Apple, one of its founders was a product design genius, whose vision successfully remade the company into the mobile computing industry leader starting with the introduction of its mobile music player (iPod) in 2001 and culminating with the iPhone in 2007. The iPhone offered a combination of voice, data and internet services that were unavailable from competing products, and the product was wildly successful throughout Western markets. Sticking to its roots, the company’s growing suite of mobile computing products bundled internally designed hardware with internally designed software. Because of the company’s small relative size versus existing global manufacturing capacity, Apple was able to outsource all hardware manufacturing and operate a capital light model producing very high returns on capital. While switching costs have historically been very low for consumer tech products, the company designed its products to be interoperable only with one another, preventing the existing or future products (eg tablets, cameras, music players) of competitors from integrating into the Apple ecosystem. Finally, the large ecosystem of apps developed specifically for Apple’s products combined with interlocking devices created large network effects, protecting and growing Apple’s profit pool through 2015.

History Does Not Repeat, But It Rhymes: Research in Motion Analog

Founded in 1984 by two engineering student dropouts in Waterloo, Canada, and later led by an “aggressive, arrogant and sharp tongued” businessman who mortgaged his house to provide the company with capital, RIM was a software company initially focused on wireless data technology, later broadening into mobile communications including email. After licensing its technologies for 12 years to a variety of corporate and government customers, the company married its internally developed software with internally developed hardware, first creating a paging device in 1996, then a mobile phone (the BlackBerry) supporting voice and data service in 1999. Riding the success of its mobile device launch, RIM went public in 1999. The company pursued grass roots, guerilla style marketing tactics, taking products to industry trade shows and winning over potential users by demonstrating the BlackBerry’s dramatically higher feature set versus existing products. The young company was hungrier and scrappier than existing software makers Microsoft and Symbian, and hardware makers Nokia, Motorola and Palm.

For the next decade, the company drove a successful product upgrade cycle every 12 to 24 months, iterating new features that kept the company’s products at the forefront of available technology, and marketed to consumers under ever changing naming (eg BlackBerry Electron, BlackBerry Pearl, BlackBerry Storm, BlackBerry Curve, BlackBerry Torch, BlackBerry 7, BlackBerry 10). Due to controlling its own operating system and restricting what external devices could interact with BlackBerries, the company benefitted from a customer switching costs moat. Later, as many corporations mandated their employees use BlackBerry products alone due to perceived security features, and even subsidized them, RIM benefitted from a mild network effect moat. Revenues grew from $300 million in 2003 to $3 billion in 2007 to $20 billion by 2011.

In 2007, RIM became the most valuable publicly traded company in its home market. The company’s success turned Waterloo into the Silicon Valley of Canada, and created a culture of cultish loyalty to the company. The product became a status symbol and received free marketing from an expanding collection of public celebrities. In 2008, a campaigning President Obama stated “I cannot live without my Blackberry” and that his team concerned about data security would “have to pry it out of my hands.” 

In the summer of 2007, Apple launched the iPhone, which proved immediately successful with consumers but failed to notably displace RIM’s market share. RIM management viewed the iPhone as materially deficient and struggled to understand why consumers would want a product that lacked the functionality of the BlackBerry. From Losing The Signal: The Untold Story Behind the Extraordinary Rise and Spectacular Fall of BlackBerry:

‘  “The iPhone’s popularity with consumers was illogical to rivals such as RIM, Nokia and Motorola. The phone’s battery lasted less than eight hours, it operated on an older, slower second-generation network, and, as Mr. Lazaridis predicted, music, video and other downloads strained AT&T’s network. RIM now faced an adversary it didn’t understand. “By all rights the product should have failed, but it did not,” said David Yach, RIM’s chief technology officer.’

Despite this new competitive threat from Apple, whose iPhone market share grew from zero to 18% by the end of 2009, RIM continued to grow and doubled its own share from 11% in 2007 to 21% by 2009.

However, by 2010 the iPhone had easily surpassed the feature and technological advantages of the BlackBerry, and RIM’s market share began to decline. In addition to making a better physical product, Apple was busy forming a multisided network of users, applications and app developers. From Losing the Signal:

“Now RIM was forced to play catch-up. Unlike RIM, Apple had an army of outside developers who had already built consumer apps for its computers and iPods and were primed to do the same for the iPhone. By the time BlackBerry launched its app store in spring 2009, iPhone customers had already downloaded 1 billion apps.”

With the installed base of iPhones growing faster than any other smartphone platform, more software developers were interested in making more apps for this growing ecosystem. Apple made it easy for developers to monetize their efforts while taking a fat 30% cut of the pie. A virtuous circle developed and led to compounding network effects that sucked talent and capital away from the BlackBerry ecosystem and into the iPhone ecosystem.

In 2012, RIM’s co CEOs departed and a new CEO tried to remake the company, growing into different product areas where the company had limited experience. Culminated by naming Alicia Keys as the company’s creative director, RIM was widely panned as having lost its way. In 2013, an activist shareholder emerged and suggested the company change its product focus, sell parts of itself, and return capital to shareholders. Finally, in 2016, the company changed direction once again and announced its focus on services over hardware. From a September 2016 article in AppleInsider:

“After yet another unprofitable quarter, BlackBerry CEO John Chen has announced that the company will rely on partners for hardware, will no longer design smartphones internally, and will shift to a services-only model to insure the company's survival.”

Challenges Facing Apple

Apple is not Research in Motion… yet. In addition to failing to innovate its primary existing product, RIM also failed to expand into adjacent product areas, while Apple has proven it can adapt. RIM failed to create an ecosystem in which to entrench itself, while Apple has done this superbly. Finally, email network outages in 2009 and 2011 upset existing users and exacerbated RIM’s decline, while the quality of Apple’s products has never been higher.

But there are cracks in the armor. For the first time since its launch, year over year iPhone unit volumes declined in 2016 at the same time unit price declined by the largest annual amount on record. Much more worrisome, however, is the continued market share growth of a competing platform: Android.

For a company’s whose primary moat is the network effects of its ecosystem, a declining user base combined with the accelerating user base of your primary competitor is more than a bump in the road. When competing physical products of equal or better quality sell for prices 70% cheaper, and provide access to equivalent or better apps not exclusive to Apple, network effects erode rapidly.

Closed Ecosystem Does Not Play Well With Others

As of 2017, the largest tech industry players (eg Google, Amazon, Facebook, Microsoft, Netflix) create and develop products and services that interoperate with the products and services of their competitors, allowing for multiple company's ecosystems to grow and flourish at the same time. In varying degrees, these companies share consumer user, preference, buying history, geolocation etc data among each other. Apple is the major exception, as it operates its ecosystem in isolation from others, and attempts to collect a steep tax for any outsider to access its ecosystem. This shortsightedness, understandably viewed by management as protecting their moat, has driven other companies to create competing ecosystems that disintermediate or replace Apple, increasing the value of those ecosystems while decreasing the value of Apple’s.

In addition to a declining user base, time spent by existing Apple consumers on Apple ecosystem apps has also materially declined. Currently 80% of time spent by all mobile users (regardless of operating software) is allocated to Facebook and Google products, two large, well capitalized companies who have and continue to disintermediate Apple’s services and products. Both of these companies have attempted to build their own feature phones and both continue to develop competing ways for the consumer to easily access the internet without the use of a smart phone at all.

The primary example of successfully opening one’s ecosystem is Google acquiring the Android mobile operating system technology and making that software freely available for all smartphone manufacturers, while continuing to advance the technology and provide updates to the existing global user base for free. Google created an industry standard software that it controls without building any hardware.

Other, recent examples of successful network partnerships are Visa opening its platform to new technologies (see PayPal agreement) and Amazon opening its Alexa voice recognition software (to, for example, Google's Nest home monitoring tools). The open system Google fostered encouraged more and more developers to build onto the base platform, thereby increasing the products available on the platform, thereby increasing the users on the platform, thereby increasing the overall value of the platform, at limited additional cost to Google.

Apple’s largest competitors are offering their own substitute products and services as loss leaders to increase and protect their other, more valuables services. Google ($570 billion market cap) and Facebook ($370 billion market cap) are protecting their growing advertising streams, where they control 100% of digital advertising spend. Amazon ($380 billion market cap) is protecting its online marketplace, where 30% of all online retail purchases are made in the US. In addition, all of these companies offer the consumer one of more forms of digital media services (eg music, video, picture sharing, data storage) that compete with services that are core to Apple’s bull thesis. Collectively, these companies have larger scale and firepower and can keep reinvesting in these competing products, while offering them for very cheap or free, over an indefinite time period. As the Android platform continues to scale, Google can also underwrite a materially lower cut of app revenue in its ecosystem over time than the 30% that Apple is dependent upon, further redirecting software developer talent away from Apple’s ecosystem.

Smartphone Declining Relevance

As the scale of computing power dedicated to the cloud continues to grow exponentially, the smartphone is increasingly becoming a "dumb terminal" and not a "pocket computer." Many technologists argue that in the not too distant future, the majority of the compute function that smartphones perform today for consumers and businesses will be replaced by compute processing performed remotely on a server in a datacenter, with the output connected in real time to the mobile terminal via rapidly fast mobile internet service. In this scenario, the incremental buyer of a mobile terminal will not pay $700 for an iPhone, and maybe not even $100. The largest growth market for mobile devices over the next five years is India, followed by China. Based on current economic conditions, the iPhone is prohibitively expensive in India (one phone equates to 25-30% of GDP per capita), confirmed by its existing 2% market share. Subsidized by some combination of the government, carriers, banks, and local internet companies, phones (running on Android, not Apple software) are literally being given away for free (eg the Ringing Bells Freedom smartphone) in India.

Overly Dependent on One Product

Apple’s installed base of phones equals 15-20% of the global market by units, yet it took 103.6% of the smartphone industry's profits (per BMO analysis) during the third quarter of 2016 as Samsung’s industry leading smartphone suffered a very public quality issue. Thus, Apple is dramatically over earning versus its peer group, and mean reversion theory supports this dominance not continuing indefinitely. Longs point to the low relative market share and claim there is much room for this to grow, in addition to volume growth that should come from simply maintaining existing share. I think if the company already earns >100% of the entire market's profit, it cannot materially increase from that level, and has nowhere to go but down. If the company cannot rely on increased smartphone profits to increase its market valuation, its going to need to develop new products and services with correspondingly huge market opportunities. In every current identifiable large consumer or technology vertical (outside of smartphones), Apple has no existing, competitive offering, while all of its peers have successful products growing rapidly.

Leadership

Apple's success was driven by a product design genius and founder, a once in a generation, Edison type of inventor. That genius has been dead now for several years, and never created a sustainable culture that will allow the company to continue to create and develop new products and services that consumers desire, or attract the best employees that other successful technology companies are simultaneously recruiting. Owner / operators (companies managed by their founder, who still has a large amount of personal capital at risk) tend to perform much better than company's managed by agents. Facebook, Google, Amazon, and Microsoft's founders are all alive, heavily involved in their company's operations, with most of their net worth at risk.

Over the prior four years, insiders have collectively reported $675 million of gross stock sales in 101 reported trades versus just one $470k purchase. Its important to note the culture that exists among Silicon Valley companies re excess stock compensation and frequent insider selling, so its not like Apple stands apart here in a materially negative way. But this just highlights for me that no senior leaders in the company do see or have seen dirt cheap, margin of safety type value in the company’s shares for a long time. Everybody likes the idea of having more money, even people who already have lots of it. So it surprises me that no insiders are willing to commit even a small percentage of their liquid net worth back into the stock if it is such an amazing value.

More alarming than this steady insider selling, the company’s competitors have announced steady poaching of Apple’s top engineering talent over the past two years. Tesla in particular has raided Apple’s nascent car project. Other notable departures include the original Siri team, the former heads of Apple’s online retail business, and the manager who led the company’s recent music service investments.

Capital Allocation and Lack of Reinvestment 

While admirably returning capital to shareholders, management's reinvestment of capital has been poor over the last several years. In continuing to focus on its smartphone platform and related ecosystem, Apple has watched peer firms take the lead in every recent tech industry advance: payments, retail, social media, music, cloud, etc. Where the company has delivered or announced new products, consumer demand has been lackluster (watch) or timing has been continually delayed (car). Recent acquisitions in the music space have also been severely criticized by analysts as overvalued and non additive to the company's existing service, such as acquiring Dr Dre's Beats Music for $3 billion when it had just a few hundred thousand users, and eventually shutting down the unit less than 18 months post acquisition.

Over the prior five years, Apple’s return on invested capital has steadily been cut in half as unit sales declined and pricing power eroded.  Management has failed to create attractive reinvestment opportunities to offset legacy products, and has instead focused capital spending on gimmicky line extensions and overpriced acquihires. As a result, the company has only produced an incremental $2 billion of profit on an incremental $125 billion of shareholder capital since 2012. If that sounds like coupon clipping a US Treasury Note, that’s because it is: 94% of the company’s capital base at fiscal year end 2016 was cash.

If we assume a required cost of capital of just 8%, then the company has been destroying shareholder value by continuing to operate, given its recent average annual return on incremental invested capital of 7%. The best capital allocation strategy for management to pursue under these circumstances would be to aggressively return capital to shareholders. To remove cash from the invested capital base and calculate ROIC / ROIIC excluding cash, an investor needs to believe management will return cash to shareholders in an extremely aggressive fashion over a short time period and have no future need for that cash to fund reinvestment. Neither of these seem likely in Apple’s case. Despite the increasing stock repurchases and dividends paid over the past few years, the company’s sheer scale presents the greatest challenge regarding accelerated capital returns. An analyst can conclude either 1) management is destroying shareholder value by continuing to operate and not return cash even faster, or 2) management in in the process of liquidating the company.

To management’s credit, they do appear to be following this logic. In their own words, compare management’s “Fiscal 2014 Highlights” with their “Fiscal 2016 Highlights.”

The 2014 commentary contained 447 words, 78 (17%) of which discussed return of shareholder capital, while the 2016 commentary contained 145 words, 82 (57%) of which discussed return of shareholder capital.

Apple is a company in slow liquidation mode, and should be valued that way.

What is the Equity Worth?

Two scenarios are presented below: a base case of gradual decline and a downside case of self disruption. Liquidation value determines worth in the former scenario while a going concern value is assumed for the latter scenario.

In the gradual decline scenario, management attempts to protect its current hardware / software / services bundled offering and maintain its prestige brand image. This scenario is most likely because it presents the least amount of near term pain for management while maintaining a static installed base in anticipation of a future product lottery ticket. Current pricing and volume decline trends continue, but each major product produces an additional, successful refresh cycle, driving a mild volume ramp followed by management taking price. Services revenue growth outpaces product revenue growth as the flattening installed base spends more per user than in the past, and the higher margins inherent to this revenue line bolster overall gross profit margin despite declining company revenues. Management continues to accelerate R&D spend ahead of the refresh cycles, and rewards itself when year over year comps turn positive.

Five years from now, Apple would have an accumulated cash balance of $347 billion assuming no incremental share repurchases. Assuming 10% frictional costs, shareholders would receive $313 billion of the cash in a liquidation. Assuming an acquiror would cut R&D and SG&A spend in half, pay 7x for proforma operating income (or ~4x gross profit) in 2021, pay with cash and assume all working capital, the operations’ cash generating ability would be valued at $171 billion or $145 billion net assuming 15% tax. Adding the net cash to the sale proceeds, and discounting that sum back to today at a 10% discount rate equates to $284 billion, or ~$54 per 5.3 billion shares outstanding. For simplicity, the company’s portfolio of ~15,000 patents are assumed to offset existing debt of $80 billion (assuming they were decoupled from operations and sold to a group of bidders), valuing each patent at greater than $5 million compared to the ~$700k Google paid for each of Motorola Mobility’s 17,000 patents in 2012 (note: based on subsequent events, Google likely paid a much lower implied valuation). Apple’s brand certainly has some independent value, but if the company’s operations enter secular decline, the brand probably would not be disconnected from operations in a sale or liquidation.

In this scenario, there is a $350 billion gap between the company’s realizable equity valuation and its current equity market value, equivalent to approximately one entire Facebook or one entire Amazon.

In the self disruption scenario, management recognizes its existing multi sided network of users / subscribers / developers / apps is more valuable than lumpy hardware revenues. This scenario is less likely because it presents the most amount of near term pain for management and carries a high risk of public failure. The end game for all of Apple’s primary competitors is scale and service based, recurring revenue. Due to the company’s premium hardware product strategy, Apple is severely disadvantaged here, and need’s to grow its installed base as fast as possible just to protect its existing services businesses and their high relative margins from being disintermediated. For enough unit volume to meaningfully grow the company, the company would need to alter its premium pricing strategy and introduce lower margin mobile devices. Its largest opportunities for user base growth are China (10% current share) and India (2% current share), where the price points for competing products are 70% lower than the company’s products.

This scenario assumes management first cuts the iPhone price in half in 2018, with only a tepid response in volume. Now all in on its radical strategy shift, management further cuts price down to a level commensurate with competing smartphones, and volume growth surges to 425 million units by 2021, giving the iPhone a market share (21%) equivalent to Samsung’s in 2015. More importantly, service revenue expands 50% faster than overall unit volume ($41 billion incremental growth, or the creation of five Netflixes), and a full third (up from 11% in 2016) of the company’s revenues are now generated by recurring services. Gross margins for the company’s hardware products decline into the mid 20s, but the expanded services revenue stream more than offsets this compression.

This scenario assumes a perfect threading of the needle: competitors stand still, product quality remains high, existing users do not defect from the brand, additional manufacturing capacity is easily accessible at favorable prices, and gross margins actually increase. Despite this hail mary success, operating income would still be 45% lower in 2021 than it was in 2016.

Valuing 2021 operating income of $31 billion at 15x, the company’s operations would be valued at $467 billion. Adding accumulated cash of $345 billion to the operations’ value and discounting that sum back to today at 10% equates to $503 billion of enterprise value. Deducting $80 billion of existing debt provides a current equity value of $425 billion in this scenario, or ~$80 per share.

In this scenario, there is a $200 billion gap between the company’s realizable equity valuation and its current equity market value, equivalent to approximately five entire Tesla’s.

I think I am being very generous with the margin assumptions here, especially given the experience of Nokia and Blackberry. A critique could be made regarding R&D spend continuing to grow in such large absolute terms, but I am not sure what choice Apple management has. Note: competitor R&D as a percentage of revenue for 2016 was as follows: Facebook 27%, Google 16%, Microsoft 14%, Amazon 12%.

Pre Mortem

Management doing something large and inorganic with its existing cash hoard is the biggest risk to the short thesis. Because of its long history and culture of only developing products internally, I think the likelihood of this event is low. Further, due to sheer scale, its hard to determine what acquisitions the company could make that would be both available for sale and accretive to existing operations.

o   Due to their similar focus on product quality and brand image, as well delivering media digitally and controlling content, an acquisition of Disney could make a lot of sense. Disney wants to create a Netflix competitor by the time its contract runs out with Netflix in a few years (hence its investment in MLBAM last year, the entity which operates the back end for HBO Go). Disney also owns a high quality portfolio of media content that it has proven it can successfully reinvest into, even at larger and larger scale. Disney needs an operating platform to reach consumers over the internet; Apple has it.

o   Similar commentary for Disney, but instead: Netflix. While debatable if Netflix’s current content spending is creating value for its shareholders, it certainly has a need for a large amount of cash and believes it can keep reinvesting it at a high return. Netflix needs cash; Apple has it.   

While iPhone unit trends look set to continue declining, especially as Samsung returns to the marketplace humbled and hungry, Apple could introduce another successful iPhone upgrade cycle in the US, providing the company more time to develop line extensions for other products and services, or create new products with markets big enough to impact the company’s current $630 billion market cap.

Even in decline, the company should continue to deliver large amounts of free cash flow and return cash to shareholders. At its current valuation, management is likely destroying value by repurchasing shares, but will likely continue to do so and provide support to the current stock price. If management announced plans to pay an immediate >$100 billion return of capital dividend and did so with minimal tax impact to shareholders, I would need to re underwrite my views on the company’s capital base and capital allocation.  

Catalyst

• Unit volumes continue to decline
• Samsung returns from the penalty box
• Management makes aditional, brand dilutive acquisitions 
• Google and Amazon ramp India investments
• High profile executives continue exiting the company