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Why Investors Hate Apple — and Are Dead Wrong
In this article I don’t discuss Apple’s valuation, balance sheet, or financials. I covered these topics in great detail in these articles a few months ago (Part 1: Psychology and Part 2: Value of Ecosystem). Nothing has really changed since, except that Apple announced an enormous share buyback. This article focuses on Apple’s products, innovation, emerging markets … and Syrian rebels.
It is easy to understand why Apple’s stock is hated so much (despite this morning’s early rise in its share price). The pain inflicted on investors by Nokia and BlackBerry is still too fresh. Both were spectacular successes that dominated their space, and then they burned out and went from high-growth stocks to disasters.Apple’s growth has slowed, and in the minds of investors the company has gone from a growth stock to a value trap. But though it’s easy to draw parallels, Apple is neither Nokia nor BlackBerry; it is still the same innovative company that growth investors could not get enough at $700 a share a year ago.Investors were not swept off their feet when Apple introduced its two latest iPhones during a media event at its Cupertino, California, headquarters on September 10. There were no surprises, no Steve Jobs’s “one more thing” — no iWatch or iTV.Part of the flatness of the event had to do with CEO Tim Cook’s biggest failure to date: his inability to live up to his promise of “doubling down” on secrecy. As Apple’s supply chain becomes ever bigger and more complex, it gets leakier.Pundits and Apple fanatics knew exactly what Apple was going to announce; we just did not know the pricing. But in reality even this failure is hardly lethal — the surprise factor really matters only for Wall Street. Apple’s success or failure will come down to the quality of the company’s products, in both the absolute and relative sense, and the perception of its brand.This iPhone product introduction was evolutionary, not revolutionary. But if you look back, the previous versions of the iPhone were also evolutionary; every one included incremental improvements that created an “insanely great” user experience (Jobs’s words, not mine).The nonrevolutionary, “expensive” iPhone 5s is still getting glowing reviews.The Wall Street Journal’s Walt Mossberg calls it “the best smartphone in the market.” According to Mossberg, with its Touch ID, Apple was able to achieve what others tried but failed at: a reliable fingerprint recognition technology. As always, Apple is moving methodically (though the company would not admit it), and Touch ID is still at the beta release stage, so your fingerprint will unlock only the phone and Apple Store. But it is only a matter of time before Touch ID is opened up to developers, and it will likely revolutionize many industries.In fact, if you think about it, the genius of iPhone was in creating hardware and software that enabled thousands of developers to innovate on top of it. I can imagine how in just a few months we’ll see hundreds of apps designed to capitalize on Apple’s new motion chip, which packs a gyroscope, compass and accelerometer into the iPhone.Investors’ nervousness is understandable. Since Jobs’s death in October 2011, Apple has introduced no revolutionary product. Everyone is concerned that world-shaking products like that died with Jobs. That’s unlikely. Over the past two years, Apple’s annual R&D spending has almost doubled, from $2.4 billion in 2011 to $4.2 billion. Considering that Apple, aside from the Mac computer line, for which most of the hardware R&D is outsourced, makes only one major product in different sizes (the iPod), the $1.8 billion increase in R&D must have gone into revolutionary products that are not yet out.Admittedly, there is little guarantee that the money was not wasted, and if that is what you choose to believe, I cannot prove otherwise. In fact, if you think Apple is a Nokia or BlackBerry in the making, then the R&D increase means absolutely nothing, since both of those former tech leaders experienced rising R&D expenses but poor product innovation.However, we do catch small glimpses of an Apple that can still innovate. In June the company announced the Mac Pro computer. Though this product is not very important for Apple financially — PCs and laptops are only about 15 percent of sales — it clearly shows that innovation is still very much alive. With the exception of the operating system, all the components inside the Mac Pro are the same commodities you’ll find in your sucky, garden-variety Windows PC.Despite that, Apple has managed to create a brilliant product in a category that has seen little innovation. In addition to a cool look, the Mac Pro features a unique cooling design that also allows easy access to the guts of the system.I keep thinking that what might kill Apple is not Microsoft or Google’s Android; it’s arrogance. Apple had to be arrogant in the past — you have to be if you’re inventing categories of products people don’t know they want. But this arrogance could be dangerous if you start ignoring what customers want, and today they want larger screens. At first Apple dismissed larger screens, the same way Jobs dismissed smaller tablets; but as larger screens became more popular, Cook’s posture changed. On the company’s second-quarter conference call, he made it clear it’s a question of when, not if, Apple will come out with a larger-screen phone: “Some customers value large screen size; others value also other factors such as resolution, color quality, white balance, brightness, reflectivity, screen longevity, power consumption, portability, compatibility with apps, and many things…. Our competitors had made some significant trade-offs in many of these areas in order to ship a larger display. We would not ship a larger-display iPhone while these trade-offs exist.”As an Apple junkie, I’d like a large-screen iPhone to be released yesterday; but from a strategic perspective, if Apple is a few months or even a year late to this party, its competitive position should not suffer much — the current screen is large enough, and the iPhone’s other features make up for it.Wall Street is concerned about the pricing of the iPhone 5c. Analysts thought cstood for “cheap,” but it doesn’t; the 5c is only $100 less expensive than the top-of-the-line iPhone 5s. Actually, c stands for “color” (and plastic). Right away, analysts bemoaned the fact that the 5c is not cheap enough to compete with less costly Android phones, especially in developing markets like China.That’s ridiculous.First of all, in developed markets, retailers capitalizing on Apple’s halo use the iPhone as a loss leader to lure shoppers into their stores. Also, in developed markets the price is not so important because most phones are subsidized by carriers that look at Apple as a gateway drug to higher mobile data addiction (consumption). Carriers trying to lure new customers discount iPhones heavily — Sprint just announced an additional $100 off the iPhone 5s for new customers. Those with iPhones and iPads consume more data than Android users. iPhone users are more profitable for carriers, and that is why they are willing to subsidize iPhones more than Android devices.Apple users spend more money in the App Store, and this is very important.Apple has taken a “We’d rather make better, not cheaper, devices” stance, but this strategy involves a risk, because as Android gains market share, in theory its ecosystem becomes more valuable — there are more users to consume apps.Fortunately for Apple, Android users buying Google Play have a craigslist, not a Nordstrom, mentality: They expect to pay very little. In addition, Android powers a lot of low-end smartphones or high-end dumb phones. (Remember when a phone was just a phone?) Though the Android-installed base has surpassed the iOS-installed base, Apple app developers are still making more money than Google Play developers.Developing markets present a challenge for Apple — their populations are poor, and subsidies from carriers are much lower. Most people in China cannot afford to pay $550 for a phone (that is how much many of them make in a month).However, I would not quite write off developing markets. Even though China Mobile — the largest cell phone company in the world, with more than 700 million subscribers — doesn’t officially support the iPhone, it already has 42 million iPhone users. Apple’s strategy in China is most likely going to be selling its refurbished phones. That is why they have announced a buyback of their old phones at their stores; they will refurbish them and sell them in developing markets.iPhone 4 or 4s is great gateway (drug) phone to a newer version. Apple is as much a consumer company as a brand, and price is an important part of the brand. Pricing its products down to competitors’ levels may make the quarter but undermine the brand. Owning an Apple phone is aspirational for consumers in developing markets. The company’s penetration will probably never be as high as it is in developed markets, but Apple will likely capture a large portion of the smartphone dollars in developing markets.Finally, we know Apple will be successful in emerging markets, because its products have even been endorsed by Syrian rebels, who use iPads in the guidance systems of their mortar launchers — I kid you not! You cannot ask for a better endorsement of quality, durability and ease of use.On a serious note, it is easy to second-guess Apple management decisions and rant and rave about how the company should price its products. But unless you think Apple is run by Nokia- or BlackBerry-caliber management, which most agree it is not, you have to believe Apple executives know how to find China on the map and that they’ve heard it is home to nearly 1.4 billion people. If they discover that their phones are priced too high in developing countries, they’ll change the pricing. But so far the new (“expensive”) iPhones are already sold out in China.Apple is followed by 51 analysts, who can recite iPhone prices in every country and know by heart every component that goes into the iPad. They have very detailed and precise models; it is hard to have a new, great insight into Apple.But you don’t have to; just follow the advice of economist John Maynard Keynes, who said, “I’d rather be vaguely right than precisely wrong.” Here is my vaguely right insight: Once a customer buys an Apple iProduct, they tend to stay within the Apple ecosystem. On the latest call, Tim Cook quoted a study by research firm Kantar Media: Apple users have 93 percent loyalty to its products, significantly higher than competitors’ figures. This loyalty creates a tremendous recurrence of revenues.Apple is playing a long game. It is incrementally and strategically improving its hardware, which is now far superior to the competition’s (though the competition will catch up). It is also implementing new technologies that the competition doesn’t even know how to spell, and it is redesigning its software, over which it has complete control (unlike the Android folks). Finally, Apple is pouring billions of dollars into R&D, which, like many investments, probably won’t have an immediate impact on the company’s results — or on Wall Street sentiment. But investors willing to take a longer view on Apple will likely be rewarded for their patience.
I am the CEO at IMA, which is anything but your average investment firm. (Why? Get our company brochure here, or simply visit our website).
In a brief moment of senility, Forbes magazine called me “the new Benjamin Graham.”
I’ve written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. (I’m working on a third - you can read a chapter from it, titled “The 6 Commandments of Value Investing” here).
And if you prefer listening, audio versions of my articles are published weekly at investor.fm.