Is There a Worm in Apple?

“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.”

— Charlie Munger

Here are the reasons why Apple is not a good investment at roughly $500B, give or take a few billion.

It’s a technology company and everyone knows that value investors don’t invest in technology companies.  Why? Well, that’s easy, as Yogi Berra said, “It’s tough to make predictions, especially about the future.”  Apple’s value will be determined by its future products and how these products compare to its competitor’s products.  Keep in mind, we have no idea what these products look like, and it is virtually impossible to predict who will win a technological arms race.  This line of reasoning posits that Apple will become some version of Motorola, Nokia or Blackberry, all of whom once had huge advantages in phones sales, yet are virtually non-existent today.  Nokia sold as many as 150 million phones as recently as 2009.  Blackberry had peak sales of 50 million phones just 5 years ago in 2011.  Apple’s iPhone debuted in 2007, so after a historic 9 year run, it is time for the leader to start looking over its shoulder.  Technology is hard and Apple will eventually lose the war….(and the next champion will someday be dethroned as well).  In short, Coke is potentially a good investment (at the right price) because it sells roughly the same product it did in 1890.  On the other hand, a company that gets over 50% of its profit from a product that didn’t exist 10 years ago should not be considered a good investment.  

If this doesn’t kill Apple as an investment, let me introduce four additional reasons why Apple isn’t a good investment.

  1. Smartphone saturation
  2. Upgrade Cycle
  3. Samsung
  4. Open vs. Closed Ecosystem

Smartphone saturation:
This isn’t a complicated argument.  Basically,  all the low-hanging fruit has been picked. This low hanging fruit came from two areas.  First, upgrades from dumb phones (or no cell phones) to smartphones.  Apple has exhausted the supply of non-tech parents and grandparents who have given in to the new fangled devices.  Second, the developing world provided both higher bandwidth customers along with new entrants to the middle class capable of affording an iPhone.

“The user base isn’t going to grow all that much for the foreseeable future. Smartphone ownership has reached peak levels in key markets worldwide, Carolina Milanesi, chief of research at Kantar Worldpanel ComTech, said in a report back in late February. In North America, 65 percent of consumers own a smartphone. In Europe, that number jumps to 74 percent. In China, the figure rests at 72 percent.”

Upgrade Cycle:
If you had the original iPhone, you almost certainly coveted a shiny new iPhone 4 with LTE coverage and a lighting fast operating system.  However, if you have an iPhone 6 with a large screen, does the iPhone 6S really do anything for you.  How about the iPhone 7?  Who knows, but probably not.  If the 7 doesn’t get your motor running, the 7S might not do anything either.  Now, we are moving on to the iPhone 8 and all of a sudden a customer who once bought a phone every 2 years is now a once every 4 years buyer.  Apple has effectively lost a customer in the process.  

Upgrade Cycle Part 2:
Carrier subsidies have driven a large portion of the iPhone and general smartphone demand.  Mass adoption of the data heavy smartphones would not have occurred at an average sticker price of $700 per phone.  However, a free phone (in some cases) or a $200-$300 iPhone has allowed consumers to spread out the costs of the phone over a 2 year phone contract.  Embedded in this 2 year phone contract was an additional $20 per month “access line” fee that allowed the carrier to recoup the upfront carrier subsidy, however very few consumers knew or understood what this additional fee represented.  The availability of a  “discounted” phone every two years has ingrained in users’ habits the 2 year upgrade cycle.  Within the past year, carriers have discontinued this practice and moved to a “device lease”  or payment plan where users can pay a monthly fee to lease the phone or own the phone after 24 monthly payments (Apple also offers a similar plan).  The upside of this option is it allows the customers to “upgrade” after a year, if they desire and continue a new two year “lease to own payment plan.”  The downside is that the payment model makes clear upfront that the lifetime cost of the phone is roughly $30 multiplied by 24 months.  Customers may need their iPhones to do the math, but they are much more aware that the “true” cost of the phone is roughly $700-$800, depending on the model and storage size.  

Whether it is the adequacy of the current technology or the more explicit upfront sticker shock of paying full retail price of the phone, customers will not upgrade as often.  A four year cycle will become much more common than the current two year cycle.

Samsung Comparable Technology (gasp, maybe even slightly better):
A third and related issue facing Apple is that any “switchers” from the marginal players (Blackberry, Nokia, etc) were previously confronted with a stark choice, a superior iPhone or an economic Samsung.  The other “switchers” came directly from Samsung. However, in the past 3 years, Samsung has substantially narrowed this gulf between the quality of the Galaxy series and the iPhone.  If you aren’t already tied into the Apple ecosystem (come on in, the water is warm), then Samsung now presents you with a more than adequate option.  Tech reviews have almost universally given Samsung phones fairly strong ratings for the past 3 iterations of the Galaxy series and even the most diehard iPhone fans can’t honestly dispute that.  On a stand-alone basis (i.e. untethered from the Apple ecosystem), the Samsung competes fairly well with the iPhone.  

Open vs. Closed Ecosystem:
A fourth reason is that Android’s open ecosystem allows for integration of other hardware products that would like to integrate with a phone.  For example, Nest’s software might provide more developed functionality because both are embedded with Android-based operating systems (this is not precisely what is occurring, but it is functional shorthand).  Since Android is an open source platform, manufacturers of  accessory products will use an Android based system to better integrate with the user’s phone software.  The parallel in history is the compatibility of software programs across the Windows operating system led more developers to build software on the Windows platform, thus starving the Mac operating system of a rich software environment.  Because Android’s market share is larger than Apple’s, hardware manufacturers will eventually gravitate towards Android-based systems.  

Numbers Against Apple: “Peak”
The quantitative arguments against an investment in Apple focus on the idea of peak sales, peak margins and peak profits, obviously all tied together.  At roughly $500B in market value, the peak profits at $53B from 2015 are only going to slowly decline if you are optimistic about the future or quickly decline if you see the seedlings of a Nokia or a Blackberry story playing out.  Either way, you are paying 10x earnings for a company with significant risk of technological obsolescence.  This may appear cheap on a quantitative basis, but that mistakes the rear-view mirror for the frontward facing windshield of what Apple’s earnings will look like 5 years from now.  In other words, if Apple’s profits decline 50% from here, you will be paying 20x earnings instead of the optically cheap 10x peak earnings.

In summary, the two main arguments against Apple are that the category of consumer electronics is a widow maker and Apple will suffer a similar fate as Nokia, Blackberry and many others.  If this is truly the future of Apple, there is basically no price you should pay for Apple because the death will be quick and painful for shareholders.  On the other hand, if Apple is merely at its peak and will plateau from here, the earnings will be lower do to the upgrade cycle, smart phone saturation, etc.  Thus, an optically cheap 10x earnings is not that cheap on a normalized earnings basis.

I would love to hear any additional arguments against an investment in Apple.  Please share below or feel free to send me an email at matt@thesovagroup.com.

I will be taking the other side of the debate podium in a future post.  Towards the upper right of the screen, you can sign up for future updates from this blog.

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This Post Has 7 Comments

  1. It’s hard for me to evaluate the arguments one way or another, for a bunch of reasons. But more importantly, I’m just left with the impression that as a value investor with limited abilities, limited resources of time and a very modest amount of capital to work with, it’s extremely unlikely that I’m going to make a great investment in the world’s largest company by market cap, right?

    Don’t you worry that this competes against time you could be spending finding a Constellation Software/Transdigm/Pool Corp etc.?

    1. Adam,
      Thanks for the comment. You raise a valid question. I need to address that in a full post. My quick thoughts would be that those two options aren’t mutually exclusive. I do feel strongly that even at the top range of market caps, companies get mis-priced. I have a post a while back where my watchlist had moved roughly 40% year over year from peak to valley. And these were not small companies. Although the upside might be limited with a $500B company, I think the downside has more protection than a company like Pool in its infancy (assuming your analysis is right on the $500B company).

      I am looking for those smaller companies, but not really finding any right now. I am always open to new ideas….are there any you would like to share?

  2. First of all, great post! I’m a big proponent of trying to disprove ones own ideas and seeking out opposing viewpoints. I’ll try to offer an additional argument against an investment in Apple.
    Capital Allocation:
    Apple is obviously hugely successful, and the business generates massive amounts amounts of cash. They currently have $200+ billion of “cash” on their balance sheet (though most of this is held outside the US). However, the allocation of that capital going forward will be an important factor in the firm’s long-term value. Apple has recently increased its dividends and stock repurchases, but they’re also rumored to be working to develop electric and/or autonomous vehicles. They’ve hired engineers from Tesla and Google, and they’re reportedly seeking “large expanses of real estate” for these projects. Given the recent success of Tesla, I can understand why other companies might be eager to jump into the car business, but they’d be wise to consider the long list of defunct US car manufacturers before getting too excited. Apple certainly has a wealth of design and engineering expertise, but building cars is very different from building phones and computers. Of course this is all based on rumors, but Apple’s level of secrecy makes it difficult to asses how efficiently its capital is being allocated. Apple faces huge pressure from investors to regularly introduce new products and innovations. That pressure, along with Apple’s mountain of cash, will likely lead to poor capital allocation decisions. To quote Buffett, ” A full wallet is like full bladder—you may have the urge to pee it away very quickly.”

    1. Hunter,
      That’s a great point. I should have addressed that. It’s actually one of the reasons I do like Apple. Although I sort of dislike their blanket share repurchase program right now, I have found their “acquisition” capital allocation to be extremely disciplined. One of the best in the tech space. Their largest acquisition was fairly recent with Beats. Otherwise, they are very small, tuck-in and specific technologies. If you think about Google and Microsoft buying huge mobile phone companies (Moto and Nokia), you just don’t see that with Apple. I think that is a major positive. That is certainly something to keep an eye on….Thanks!

  3. You might find this blog post interesting. It speaks to the difficulties that AAPL might have trying to transition from a pure hardware company into a services company as they attempt to monetize their installed user base.

    https://stratechery.com/2016/everything-as-a-service/

    1. Thanks, I enjoy his writing and subscribe to that website. Another one that I have enjoyed since discovering a few weeks back is Above Avalon.

  4. Here are two risks:

    (1) Big companies risk becoming bureaucratic, stale, slow-moving over time as layers of management increase. I’m not saying Apple is any more susceptible to this than anyone else – it is just a hard problem.

    (2) Competition. Personally, I’m a cheap skate, so I use a motorola from Republic Wireless. I paid $150 for the phone and pay $10 a month for unlimited text and voice. I get my data on wifi. Since I happen to spend 90%+ of my time in wifi range, I effectively have unlimited free data. What am I missing? I’m honestly not sure. I have Amazon prime music on phone (which allows downloads, so I can listen without wifi), I can text, talk, receive calendar alerts, email, take pictures/videos, surf the web, and even though I don’t have GPS my phone is able to track my location (+/- 10 feet normally) and give driving directions (I just download google maps).

    My point is simply that 3 years ago, I don’t think there were cheap viable alternatives. I think that may be changing, Republic Wireless is an example. My wife and I likely save $1,000/yr using Republic Wireless over an iPhone. Neither of us has figured out what we’re missing yet. For the average household, a $1,000 savings per year is significant.

    So, I can’t confidently say that Apple will be selling the same number of devices in 5 years. For me, I don’t know. It seems like a hard question.

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