Apple's Business
Apple's Business
Written in early 2018
In business you can usually separate businesses into two baskets: high margins and small customer base (LVMH) or low margins and big customer base (Amazon, Walmart). In this respect Apple is an outlier, not only do they have a huge, very loyal and growing customer base but they also get to enjoy high margins. Apple has gone from the go-go years of the iPhone to building an ecosystem of hardware and services which provides for a much more stable business model that gets stronger as time goes by, thus deepening their moat.
As John Huber puts it “The market continues to value Apple as if it were a typical hardware manufacturer, destined to see its margins erode as competitors develop a better mousetrap. But Apple is a computer company that got into the music business, then phones, then tablets, not to mention software.”
Right now, there are roughly 1.3 billion Apple active devices around the world, a number which has seen a 30% increase in two years. Like John Huber put it these devices are like “digital storefronts” and they are producing an ever-growing stream of revenue from apps, storage and music. As more hardware is sold, service revenue increases which increases likelihood that users will return to buy another iPhone (over 90% of customers return to buy another iPhone).
It’s also unlikely that the services Apple sells, and customers buy will deteriorate in value. To get a clearer idea of how this virtuous loop feed on itself we can take the AppStore as an example. Developers prefer to develop apps for iOS rather than for Android. This is because when creating an app for Android you must keep in mind that there are thousands of different models of phones with different hardware and varying software versions, thus some phones may not be able to run the app at all whereas other phones will run it perfectly. On iOS however, there are perhaps some 15 different models of devices that developers need to keep in mind and most run on the same version. This allows apps to be optimized for iOS so – all things equal in terms of hardware – third party apps will run better on iOS. Beyond that it’s also natural that as Apple sells more hardware and therefore the market gets bigger iOS developers will be more attracted to it. This will only further enhance the experience that Apple already delivers when using the phone.
The quality of Apple’s, the brand and their ecosystem of devices are among the factors that have contributed to Apple having pricing power. Apple increased the average selling price of their iPhones by $100 whilst still selling 77 million iPhones in the 1Q of 2018, only one million lower than highest number of sales per quarter. Since 2010 Apple has increased the average iPhone selling price by 30%. This period was marked by very little inflation.
Despite the appreciation in stock price over the past few years, Apple is still fairly priced. They’ll earn about $60bn of free cash flow this year, and there’s about 6bn shades out, so about $12 per share. A lot of which will go back to shareholders through dividends or stock buy-backs. The company has $270bn in cash and $125bn in net cash, coming to about $25 per share. This means that at $220 per share right now, excluding net cash, the business is being priced at a ~16 P/E. The historical S&P500 P/E ratio is 15. No value is being given to Apple’s very, very valuable brand.
This enormous amount of free cash flow wasn’t partially due to any cost-cutting practices in capital expenditures or R&D. Over the last two years they generated $100bn of free cash flow after spending $24bn on Capex (that’s about what they invested, combined, between 2008 and 2013) and $22bn on R&D (about the same, combined, as they invested from 2010 to 2015).
A slightly higher valuation combined with dividends (roughly $3 per share) and a much lower number of shares outstanding could yield high returns in a few years. Since 2012 Apple’s share count has decreased by roughly 5% every year. Apple also announced they plan to use all of their net cash meaning an acquisition, a share buyback or a dividend is due. Perhaps a combination of the three. That’s $125 billion ready to be used up.
