This is the third segment in an 8-part series on Unlocking the Value in AAPL.
- The Irrational Market Theory
- The Law of Large Numbers
- Market Share
- Apple's History
- Business Model
- A Dollar A Day
*Disclosure: The author owns AAPL.
One of the most common reasons cited for Apple's extremely conservative valuation is the law of large numbers. This discussion arises because a quantitative measure (Apple's market cap) appears to be at an extreme value and is far more likely to revert to the mean rather than move to a further extreme. Apple is the most valuable publicly traded company in the world. Skeptics ask “How much higher can the stock go?”1
The answer depends, of course, on our expectations for Apple's future earnings. In other words, citing the law of large numbers in reference to market cap doesn't really mean much if we don't look further. It is really just another way of observing that current market expectations are that not only will Apple's business not grow, but will see decline in the years to come.
If we turn our attention to quantitative measures of Apple's business and growth potential we see a completely different story. iPhone, iPad, and MacBooks make up the vast majority of their business. I will consider each in turn.
Much of the discussion around iPhone lately has focused on declining global market share. If you didn't know any better you could be forgiven for thinking iPhone sales were in sharp decline. Of course the truth is that iPhone sales continue to increase.
The market share decline is actually happening because some smartphone vendors are moving downmarket and very low cost Android phones continue to replace more and more feature phones. Despite much protest by analysts and pundits Apple does not currently compete in this segment of the market. This leads to the common belief is that Android is winning and Apple is pricing themselves out of the market.
Regardless of the merits of that argument (which I will address in the next segment) nobody is arguing that Apple's market share is too large to grow. There are both new markets and new market segments available for Apple to enter when the time is right. Whether this growth is realized or not, plenty of potential for growth exists. The law of large numbers is certainly not a limiting factor for Apple's business in the phone market.
The tablet market is much different than the phone market. Tablets are not subsidized by carriers. Carriers are not even an important sales channel for tablets. As Ben Thompson noted, the tablet market shares more similarities with the music player market than it does with the phone market. Apple's strategy in this market already shares many similarities with their iPod strategy. They have already begun to move down market with the iPad mini. The message from Tim Cook is clear:
One thing we’ll make sure is that we don’t leave a price umbrella for people
Critical market forces at play in the phone market simply do not exist in the tablet market. While Apple's share of the tablet market has declined over the past year2 iPad remains the largest selling tablet around.
The tablet market is expected to continue growing very rapidly for several years as tablets replace laptops for many consumers and become a complement to them for others. In fact, many analysts have begun to view the tablet market and the laptop market together as one large portable computer market. When viewed in this light it is clear that there remains enormous potential for growth in Apple's iPad business.3
The MacBook is perhaps in the most interesting position. Unit sales have begun to decline along with the rest of the industry yet Apple's position in the market that remains is strengthening. I believe both of these trends can be expected to continue. The good news for Apple is that the decline in unit sales for MacBooks will mostly consist of customers opting for an iPad rather than a MacBook. The sale still goes to Apple. More importantly, this will also be true of customers choosing between a Windows laptop and a tablet. The shift from laptops to tablets is a net win for Apple.
The Law of Large Numbers does not appear to provide a sufficient rational explanation for Apple's conservative valuation. Their market cap may be quite high by historical standards but it is built on tangible earnings derived from businesses with room to grow, not speculative excess or monopolistic market saturation.
Of course what looks like room for growth to some may look like niche status to others. In the next segment I will discuss the declining market share of iOS in more detail.
This question is often accompanied by references to previous technology companies that temporarily held the market cap crown followed by a steep decline in stock price. Microsoft and Cisco are commonly cited.
What is not stated is the fact that this occurred during an enormous bubble in tech stocks. Microsoft was valued at 74x earnings when it peaked, Cisco at 200x earnings. These valuations were so extraordinary that they could not be sustained even if the business performed with perfection. Stocks which peak with such extraordinary valuations are destined to stagnate at best and more likely see a precipitous decline before stagnation sets in.
When AAPL peaked a year ago it was valued at about 15x earnings. Exactly in line with the historical S&P 500 average. It was certainly not experiencing a valuation bubble in the same way that previous tech company market cap champions were.
Accurate market share figures are difficult to arrive at in the tablet market. Data from most vendors references shipment and channel inventory rather than actual unit sale data. This has resulted in many apples-to-oranges comparisons and misleading market share numbers. Daniel Eran Dilger recently covered this in depth.
It is worth considering the implications of Apple's aggressive, unexpected move to 64-bit with the A7 as well as the 17-watt power supply they are developing. Both seem to indicate that we may see Apple release a product that sits nicely between the iPad and the MacBook Air in Apple's product line. Such a product is likely to be an iOS product rather than a Mac product. It would aim to meet the productivity needs of those who would like to replace a traditional laptop with a tablet, but for whom current tablets are close to but not quite a sufficient solution.
Robert Cringley has some interesting speculation along these lines. News of Bluetooth mouse support in iOS 7, if true, is especially interesting. The one place I believe Bob is off base is in the idea that Apple may ship a product that functions as a remote display and input device for iPhone but does not function on its own. I do not believe Apple would ship a device with a display and input that cannot function on its own. Remote display and input may be a feature, but not the only feature.