Monday, 28 January 2019

Apple's strategic dilemma

After a heady run, Apple has been a poor performer over the past several months, and has de-rated to levels that have started to attract value investor interest. Peters-McGregor, for instance, recently purchased shares, outlining all the traditional strengths the bulls have historically identified with Apple (brand, customer lock-in, growing services), and that the stock is now on only 13x (and 11-12x ex cash).

They might be right, but to my mind, Apple is facing a number of rapidly-growing strategic issues that are not going to be easily soluble in coming years, and so I'm not convinced the stock is cheap. It also needs to be remembered that the historical strengths identified by the bulls are already reflected in the company's lofty operating margins, so applying a high multiple to those very high profits does come with the risk of 'double counting'.

The first issue Apple faces is a maturing global smartphone market - not just in terms of penetration (most people in the world now have a smartphone, and those that don't are the world's poorest and will probably buy a cheap Chinese brand as their entry-point), but also in terms of the quality of the product itself. There is a saying in the world of devices/appliances - "in the long run, everything is a toaster" (i.e. everything becomes commoditised and incapable of further functional improvement). With each generation of iPhone, it is getting harder and harder to come up with meaningfully improved features that justify customers quickly upgrading - particularly at higher and higher prices.

Back in the days of the iPhone 3, each new generation of phones was a step-change in terms of improved functionality. Today, each new generation merely contains minor enhancements. The learning curve is flattening out, and it probably won't be long until each new generation is barely better than the prior one at all. I recently bought a iPhone X after previously having an iPhone 6s, and frankly, while it is better, it's not that much better.

Now, I acknowledge customer loyalty rates are high, and that customers' desire to not lose access to their prior app purchases acts as an important source of consumer lock-in. The value offered by a >US$1k phone is also high on a per-hour-of-use basis, given how much value we get out of our phones, and how often we use them. Retention rates are therefore likely to remain high. However, this high retention rate notwithstanding, what this product maturity means is that replacement cycles are going to lengthen. Instead of upgrading every 1-2 years, Apple fans are probably going to start upgrading every 4-5, or maybe even longer in time. This could conceivably cut Apple's global sales volume in half in coming years, even if customer retention rates remain high.

Perhaps recognising this, Apple has tried to instead focus on raising prices and further premiumising, hoping to compensate for falling volumes with higher margins. But recent sales trends indicate that they may already be approaching the practical limit of this strategy - i.e. the point where it is self-defeating in that it just further lengthens the replacement cycle. Tellingly, the company both missed calendar 4Q revenue expectations (pre-announced earlier this year), and also recently announced an intention to stop providing the market with iPhone sales volume data. This can only be interpreted as a sign that volumes have peaked, and that Apple expects them to decline precipitously.

Reflecting this peaking-out in hardware earnings, the company is pivoting to 'services', and has been careful to scream from the rooftops about rapid ongoing growth in services revenue. The company wants investors to stop seeing it as a hardware company, and view it as a toll-booth company, where it's large installed base of devices (some 1.4bn) are basically an 'electronic storefront' that promises to be a perpetual cash machine as customers buy more and more apps/in-app purchases over time, as smartphones are increasingly used to do everything (this, I believe, is what Buffett saw, in conjunction with high customer loyalty).

But here is the problem: there is an inherent strategic tension between trying to run a business model that focuses on having an electronic store front in front of everyone's nose, and a hardware strategy that focuses on having an exclusive, premium product that only a minority of the world can afford. If you're going for the razor and razorblade model, you want everyone to have a razor, and you want to sell those razor's cheaply, so everyone has one. That's what Google has been doing in giving away its Android OS for free. They want to sell razorblades (apps, as well as secure carriage for their browser and search engine).

However, by pushing for more and more premium prices on its hardware/OS bundle, Apple is limiting its potential pool of razorblade sales. This is true of both third-party and first-party services. For third-party apps, you limit the breadth of your storefront, while for first-party services, you suffer from diseconomies of scale vs. competing providers that target both iOS and Android users. This is one reason Apple Music has been losing ground to Spotify. Spotify's target market is the entire world, not just iPhone users, which gives them a structural advantage.

Now, that doesn't mean 1.4bn Apple device users are going to suddenly abandon them. They can still have a nice business selling apps to their existing user base. But even this business is probably not too far away from maturity, in the absence of a growing user base. The average device already makes more than US$30/year in app purchases (US$45bn in services revenue on 1.4bn devices), and as time goes by, consumers will increasingly have enough apps providing enough services, and the pace of new app purchases will likely begin to level off, or even decline.

However, it get's worse. Apple takes 30% of all sales conducted through its app-store, and there are some potential pressure points/risks to the sustainability of this. For a start, there are antitrust risks, and there is currently already a case proceeding through the Supreme Court. Microsoft was heavily fined and censured in the late 1990s for abusing its market position, in having a monopoly operating system that it used to push Netscape Navigator browsers out of the market, in favour of its own Internet Explorer.

While the situation with Apple is not exactly analogous (Android phones are more numerous than iOS powered phones), there are some similarities. Apple is charging Google US$9bn a year to make Google the default search engine for Safari (vs. just US$1bn in 2014). That is arguably equivalent to Microsoft charging Netscape Navigator a fortune to be the default browser in Windows. And Apple is also denying its users access to many apps unwilling to pay the 30% toll fee. Many people believe 30% is an unreasonably high cut, and that Apple has too much market power to unilaterally set this rate. The political zeitgeist is starting to turn against big-tech, so regulation/anti-trust is a growing risk.

Furthermore, Epic Games - following its huge hit with Fortnite - has assembled some 200m user accounts, and is leveraging that user base to create its own storefront for a variety of games/apps, where it promises to charge only 12%. When it recently launched a mobile version of its hit game Fortnite, it announced that it would not be selling the app through either the Apple or Google Play store, but rather through its own online store & billing set-up. Both Netflix and Spotify have also evaded Apple's 30% cut by having users sign up on their own websites, rather than pay through the Apple App store. These apps have been too popular for Apple to block, as has Fortnite, and doing so would risk raising the ire of antitrust regulators in any case. In addition, there have also been some news reports that Google has decided reduced its own take-rate on apps purchased in its Google Play store in response to emergent competition from app stores such as Epic.

So here is the potential problem for Apple's services business: Sales could start to migrate off its app store onto other platforms such as Epic's, who take only a 12% cut, and if they block such apps, they risk anti-trust retribution. But even if antitrust was not an issue, it could have negative consequences, because if Google Play was to match Epic's 12% take-rate (or simply not block such apps), it would mean that not only would Android users potentially enjoy lower prices on app-store purchases, but that it would also become far more profitable for developers to develop and distribute apps via Android than Apple as well.

Given that Android's user base is larger than Apple's, Android-compatible apps would potentially start to be given priority by developers. This has generally not been the case to date (Google Play took 30% as well), and Android was not given priority. Steve Balmer famously screamed "developers, developers, developers, developers, developers, developers...." for a reason. You need a lock on developers to keep a lock on people using your operating system (and in Apple's case, the bundled device).

If platforms like Epic starts to become a storefront used to access and pay for a wide variety of games and other apps, it is going to be very hard for Apple to block access to them all, if they are popular and available on Android. And what if Epic says, you can only access these apps on an all or nothing basis? Want Fortnite? You need to take everything else as well, and not charge for carriage. And if Apple says no, they open themselves up to antitrust concerns.

Customer loyalty to Apple has been high in the past for many reasons, but one of the reasons has been because the App Store had virtually every app customers might want, and at a similar price to competing platforms. But if that changes, and Android phones have a wider variety of apps, available sooner, and at lower price points, at least some of Apple's customers could start have second thoughts.

Lastly, the 'freemium' model is growing in popularity - you give the app away for free and then try to charge for ad-ons later - and with this model, it is inherently easier to direct customers to your website to sign up and pay for ad-ons, rather than doing it directly through the Apple store. And as some of these freemium platforms grow and provide more and more services within them, less and less entirely new apps are required/demanded by customers. This has already happened with WeChat in China, for instance, which has become the portal consumers use to access a wide variety of other services. When this happens, the phone's app store is effectively disintermediated.

I'm thinking out loud here. I'm not an Apple expert, and I'm not short, and nor would I go short at current prices. I'd probably actually rather go long than short at current prices if I absolutely had to pick one side (which I don't). The stock is not exactly expensive, so I don't think the risk-reward is asymmetric. However, I'm not convinced the stock is cheap given these various risks/issues. If both hardware sales and services revenue go into reverse, there is a lot of potential downside.

Comments welcome,



  1. Great stuff. I think this sort of list of factors is the kind that will often account for when stocks get "even cheaper." In other words, the true value investor is perhaps the one that resists the urge to buy in at 11x (even while acknowledging that it represents a decent, even slightly cheap price) because they understand on some level that there is a reasonable chance that there will be a day in the near future where it trades at 8x, often for some or all of the reasons that could easily be listed as of today. The patience and faith is difficult and often goes unrewarded, but as you've mentioned, with a large enough pool of potential investments, even the rare events will occur. If you ask me, this is the real secret you are giving away on this blog. As an added bonus (one that I'm not sure I've personally ever heard someone really address, incidentally), if that future opportunity to buy at 8x transpires, it will mean it has saved you the time-value between now and then of buying too early, even though it was at a price that seemed attractive and other investors are excited about today. But this is why I think people like Buffett and Munger say that it is very easy to do what they do, but also very, very difficult. Who really has the patience, the faith, the focus, and the willingness to look and watch and look and watch, and for years and years?

    For what it's worth, when I looked at Apple and did some work, I think it was something closer to $110-120 that started to meet the kinds of thresholds I use (and as always, $90 would be even better). In such circumstances, it is easy to feel as if and lament that, "Oh, it will never get that low!" But I've found that I am often surprised in the end by how much stocks can fall, and how quickly. In the meantime, one has to learn to cope with all of the times when the $145 stock runs to $220 and you look dumb and feel like you missed out. One potential solution – focus only on aggregate performance, and only over many years, and the same for the performance of anyone else (also helpful, one would hope, in dealing with the "seeing one's dumb neighbor getting rich" syndrome Munger has discussed). If you don't eventually get the aggregate returns you want, then you will know that either you are doing it wrong or it is impossible. If you do get the aggregate returns, then any individual decision to trade or not is only useful as a means to learn and improve even further.

    And to add one last thing, if only from an urge to return the favor from all of your writings, the observation about being wary of "double counting" when factoring in both qualitative and quantitative factors is one you've made before but is again perfect here, and the phenomenon also helps to explain just how stock prices can swing so much more than people imagine, especially when the double counting can not just unwind itself but also eventually go in the other direction. Apple's margins are particularly interesting, since you highlight them, when one sees just how they have evolved over the past 15 years or so. For all of the confidence some people profess in the stability of the business going forward, there certainly was a lot of variance in the economics of the business in the past.

    Anyway, thanks, as always. In addition, this is the sort of post that it will be fun to look back on many years from now, after seeing how it all plays out.

    1. There! You've inspired me to start giving away what I think are some of the secrets, too. Now, what? Should one hope that your own blog doesn't become even more widely read, which seems paradoxical now that you've gone to the trouble of writing it?

      I suppose on the other hand, if there is social value in what value investors are doing, it's presumably in reducing volatility and keeping prices closer to fair values for the benefit of less careful, experienced, or intelligent allocators of capital and to enhance to marginal propensity to invest, so that if your ideas were to finally wring out the last of the available excess returns, you really will have accomplished something great for the world. (A separate debate is the one on social value, and there's a contrarian position in there that has it that someone like a value investor might be contributing quite a bit of value to society, as opposed to the "leech on the system" view that even some investors themselves appear happy to concede. Perhaps that would be a topic for another time.)

      But say there weren't anymore excess returns to be had. Any thoughts on what you would do instead?

  2. Thanks for this great post. I think you very well explained Apple's current dilemma... however, the company has surprised the market several times already in the past. Do you have a view on the impact of the "health strategy" (Apple Watch acting as a health tracking device)? Cheers, Axel

  3. Don't know how anyone would be checking back in this thread (except for you, LT, perhaps), but interesting to get a relatively clear view into where Buffett would like to be buying AAPL at as of 4Q18/1Q19, if only from a valuation discipline standpoint: