Apple: The Definition of a Great Business

I wanted to write a few thoughts on Apple’s earnings. This isn’t comprehensive nor exhaustive. If you would like to discuss Apple in more detail, feel free to email me below to schedule a call.

A good business produces enough cash to do two things.

First, the business will be able to reinvest a portion of its profits back into its business to maintain and potentially grow its competitive position (its moat).

Second, the business will have excess cash to pay the company’s owners. In other words, a good business produces owners’ earnings. Owners’ earnings is cash in excess of the requirement of the business to continue to maintain its competitive position.

Some companies must use every last dollar they make to reinvest in their company to only stand still. These companies might maintain their competitive position, but there is nothing left for the owners.

Imagine a golf course that collects $1m in “profits” each year, but must spend that entire $1m maintaining the course grounds, otherwise it will lose its customers to the golf course on the other side of town. This golf course has no excess cash above its “maintenance” requirements. The golf course provides no “cash” for its owners. This may be a great golf course for its customers, but it would be a lousy investment for the owners.

Apple is the definition of a great business. In the past 5.25 years, Apple has produced operating cash flow of approximately $450B. Apple has used that $450B to fund $75B in capital expenditures, inclusive of acquisitions, and spend the other $375B on share buybacks and dividends. Apple has re-invested $75B into its business to maintain its competitive position and grow its revenue by over 40% and increase its operating cash flow by almost 30%.

In short, Apple produces owners’ earnings (enough cash to maintain its competitive position and still provide cash to its owners).

This idea of owners’ earnings is so important that I plan to write a separate post on this subject.

Wearables
Steve Jobs passed away in 2011. The last full year Jobs was the CEO of Apple was in 2010. The 2010 full year revenue number for the iPhone was roughly $25B. In 2020, Wearables, which includes Apple Watch and Airpods, will exceed $30B in revenue. These products didn’t exist when Jobs passed away. The critics will never give Tim Cook credit, but the numbers tell a different story. Cook has created another iPhone, you just wear it on your wrist and in your ears.

Pricing Power
Speaking of Airpods, Buffett has said the ability to raise prices is the hallmark of a great business.

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

When I first bought an iPhone, I got free headphones. In fact, I still get free headphones. Apple has managed to “raise” the price of the hearing device from free to $130 for regular Airpods. And recently, it raised the price of regular Airpods from $130 to $249 for Airpods Pro.

If you can raise the price of your product from free to $250, that’s is a wonderful business.

Quality of Business
Apple has an installed base of 1.5 billion devices and 1 billion iPhones. The predictability of those 1.5b people buying another Apple device is strong. This makes it much more difficult for an upstart to get a leg up on Apple. Apple’s consumer focucs makes it easier for an investor to judge the quality of Apple’s business going forward.

An investor in Apple needs to focus on two questions.
1. Will a competitor make a phone that is meaningfully better than the iPhone, such that large amount of users will shift to the new product?

This question is important. The qualifier “meaningfully” better is the key factor. The difference between a Blackberry and an iPhone was meaningful. This difference was “meaningful” enough that customers switched to Apple. Samsung and Google make great phones. But their phones are not meaningful better to make customers to switch devices.

2. Will a new product make the phone less vital to everyday life?
This iPhone brought about this change to the PC era. Will another product impact the phone in the same way?

These are the two most important questions for Apple going forward.

Buybacks:
I am burying one of the things I dislike about Apple at the bottom. I guess if you read this far, you deserve to hear the bad with the good. At the end of 2018 and early 2019, when Apple stock crashed to 52 week-lows, Apple essentially turned off its buyback program. Yet, one year later towards the end of 2019 with its stock trading at all-time highs, Apple bought back a record high of $20B in shares. This is my least favorite thing about Apple and I have essentially no explanation. I think their buyback activity is most likely driven by the fear they see in the immediate near-term results of their business. With China’s demand collapsing at the end of 2018, Apple did not take the long-term view of the value of its business and repurchase shares at all-time lows.

Apple is a great business with a B- capital allocation strategy.
(B- is still better than the F grade I would give to companies focused on “moonshots.”)


Matt Brice can be reached at matt@thesovagroup.com

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