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Understanding Apple Requires an Analysis of Fundamentals and Psychology

So many articles have been written recently about Apple — defending it or explaining why this glorious fruit will turn into a shriveling pumpkin by midnight (with Samsung’s help) — that I really haven’t felt the need to contribute to the unending debate. But then Apple’s stock crashed to $450 last month, and we bought a little for our clients. After receiving an outraged e-mail from one of them calling the purchase “irresponsible” and proclaiming that everyone (including his neighbor) knows that Apple is going down to $300, I decided it was time to join the discourse. Clients rarely (almost never) contact us about stocks we own in their accounts. More important, this is far from the most “radioactive” stock we own or have owned.

Here, in the first of two columns on Apple, I have no intention of defending or prosecuting the company, but I would like to share some thoughts about it that many pundits have either overlooked or ignored.

What makes Apple stock difficult to own is psychology. The company’s success since 2000 is a black swan. We tend to think of Nassim Nicholas Taleb’s black swans as significant random negative events, but Apple is a positive one. When co-founder Steve Jobs came back to the company in the late ’90s, Apple was about to take its last breath. Jobs pulled off a miracle. He revived the company’s computer product line, making Macs exciting again, and then came out with three revolutionary “i” products in a row: the iPod, iPhone and iPad. You could argue that the success of each “i” product in itself was a black swan, exceeding all rational expectations and revolutionizing, transforming and in some cases creating new categories of merchandise that had never existed before.

Apple’s revenue and market capitalization deservedly surpassed those of almighty Microsoft Corp. — the hairy monster with stinky breath that performed CPR on dying Apple in the late ’90s by injecting liquidity into the company by buying its preferred stock. We have a hard time processing this highly improbable success and an even harder time imagining that there is another black swan about to take flight from the Apple labs, especially with no Steve Jobs around to sit on the egg.

Black swans come out of nowhere, unannounced, but their impact may be long-lasting. The wildly successful “i” gadgets dug a formidable moat around Apple.They created the most valuable and still most inspirational brand in the world, funded an enormous research and development effort, enabled huge buying power (Apple locks up supply and pays much lower prices than many of its competitors for parts), filled out a mature product ecosystem and stuffed Apple’s debt-free balance sheet with $137 billion — half the market capitalization of Microsoft. The moat is wide, deep and unlikely to be breached any time soon.

One reason the psychology of owning Apple stock is so difficult: its high price.(Note: I am talking not about its valuation but purely about its price.) Apple has had only one stock split since the late ’90s, when it was trading in double digits, and it now changes hands at about $450 (down from $700 just a few months ago). Stock splits create zero economic value in the long run — absolutely none.Apple could split its stock ten to one and you’d have ten $45 shares, and nothing about the company or its business would change. But I’d argue that a 3 percent “slide” of $1.35 would grab fewer headlines than a $13.50 “drop” — there is a media magnification factor that is hard to ignore.

Is Apple a hardware or a software company? This is a very important question because Apple’s net margins of 25 percent are dangerously higher than those of Microsoft, a software monopoly that, with the minor exception of the Xbox and its new venture into tablets, sells only software, which has a 100 percent incremental margin.

Apple is either a smart hardware company or a software maker dressed in hardware company clothes. Take a look at the PC businesses of traditional “dumb” hardware companies like Dell and Hewlett-Packard Co. (I am not insulting these companies, I am just highlighting their lack of PC-directed R&D.) They buy hard drives from Western Digital Corp., graphic cards from Nvidia Corp., processors from Intel Corp. and an operating system from Microsoft, then they have contract manufacturers put together these parts in Asia and ship PCs all over the world. Dell and HP engineers design the PCs but contribute minimal R&D to their boxes; most of the R&D is done by the suppliers. Dell and HP are really asset-lite marketing and logistics companies — this explains their razor-thin margins. (Side note: Because of a lack of fixed costs, Dell and HP can remain profitable despite the ongoing decline in PC sales.)

On the surface, Apple’s personal computer business is not that much different from Dell’s or HP’s: It uses the same highly commoditized hardware and it also outsources manufacturing, but Apple spends much more on the R&D of its own operating system and creates distinctive, innovative products. Apple gets to keep a slice of revenue that would otherwise go to Microsoft for the operating system.Also, Apple is able to charge a premium (usually a few hundred dollars per PC) for the aesthetic appeal and perceived ease of use of its products.

However, when it comes to the “i” devices, Apple is a much smarter hardware company; its value added goes further than just basic design and software.Though there is a lot of commoditized hardware that goes into an iPhone or iPad, Apple’s skill at fitting an ever-growing number of components into ever-shrinking devices constantly increases. Add world-class touch and feel, superior battery life and durability, and you have a package that turns what would otherwise be commodity items into highly differentiated, and undeniably sexy, products. Apple has even gone a step further and is designing its own microprocessors.

But — and this is a very important “but” — as phones and tablets mature, processor speed, battery life and weight will tend to become uniform across all devices. It is arguable that the competition has already caught up with Apple in the hardware race. As the hardware premium goes away, there will be only two premiums left: Apple’s brand and its ecosystem. (I will go into detail about the “i” ecosystem and what it means for Apple’s margins and profitability in my second column, later this week.)

Note that I did not mention the software premium. Unlike Microsoft, which charges for the Windows operating system installed on PCs, Google gives away Android to anyone who dares to make a phone or a tablet. Unless Apple can maintain the operating system lead against Android, that premium will go away.Recently, I spent a few days playing with Nexus 7, Google’s Android-powered 7-inch tablet, which retails for $200 ($130 cheaper than Apple’s iPad mini). Nexus 7 is a good product, but I kept remembering that humans and monkeys share 98 percent of their DNA, and the Android operating system is missing the 2 percent that makes Apple iOS so special.

Next: I’ll explore the competitive advantage of the Apple ecosystem, insult some of its competitors and analyze what the company’s shares could be worth under different scenarios.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

This article was originally written for Institutional Investor Magazine…. 

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