This is the sixth 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.
Lately I have begun to wonder if a widespread and fundamental misunderstanding of Apple's business may be at work. I believe it has and is driving the market's conservative valuation of Apple. Jean-Louis Gassée recently summarized analysis by Horace Dediu:
Some folks can’t get past the “fact” that Apple needs hit products to survive because — unlike Amazon, as an example — it doesn’t own a lasting franchise.
This is certainly the view of many industry pundits and Wall Street analysts. If this view is shared by investors it would explain the discount in valuation. What might drive this view of Apple's business?
Reliability of Revenue
I believe the primary factor is reliability of revenue. If investors do not understand how revenue recurs they will assume it doesn't. Without reasonably reliable recurrence of revenue, each dollar must be earned anew. This naturally leads to the perception of the business as being hit-driven. Growth opportunities don't mean much when this kind of uncertainty is present.1 Great investors know that rule number one is to preserve capital and protect against losses.
Most major companies in the technology industry derive the majority of their revenue from other companies through a variety of means including OEM contracts, corporate IT, and advertising. This revenue has some inherent reliability in the form of large multi-year contracts. There is some additional reliability afforded because most companies are slow to change and changing suppliers can be quite costly. Business-to-business models also have some similarity with other business product and service industries investors have long been familiar and comfortable with. Investors understand how these businesses work and what keeps the revenue flowing.
A few technology companies depend primarily on consumer spending (such as Amazon and eBay) for their revenue and many more depend upon consumer habit to sell eyeballs to advertisers. These business models also have comfortable analogs for investors. Big box retail, consumer staples and traditional media all rely upon the same relatively frequent and habitual behavior by consumers.
Revenue that relies upon frequent, habitual consumer behavior may not be quite as secure as revenue deriving from multi-year contracts but it is still relatively predictable. This is especially true when this habitual behavior is not tied to anything that is likely to change quickly (such as fashion or technological advancements). This is what made Gillette and Coke two of Warren Buffett's favorite investments. Again investors have some reasonable assurance that the revenue will continue to flow.
A very clear and recent example of how important reliable revenue is for investors can be found in Adobe's shift to a subscription model. Wall Street is obsessed with short-term growth yet seems to be content to give Adobe a free pass on declining revenue because subscription revenue will be more reliable than revenue derived from a traditional licensing model.
Another recent example of this is Jeffrey Ubben of the ValueAct hedge fund preferring Microsoft over Apple and explicitly citing multi-year enterprise contracts as a primary factor in this preference.
One of a Kind
Horace Dediu has been talking a lot about how unique Apple is:
One thing that is clear to me is that there is no absorption by mainstream observers of what makes Apple tick. It’s hiding in plain sight because what it is isn’t anything anyone can recognize.
This is true about many aspects of Apple, including their revenue streams and how they recur. This makes understanding the value of Apple as a company very difficult. Familiar models of valuation don't apply.
Unlike other major technology companies, Apple derives the vast majority of its revenue from relatively infrequent big ticket sales to consumers. This is a fundamentally and significantly different business than any other in the technology industry.2 It will be understood and valued by investors in a fundamentally different way than other technology companies. Of course they will use prior experience and data that appears to be relevant in doing so.
It is possible to view Apple primarily as a consumer electronics company. The iPod, which brought the modern Apple to the attention of the mainstream consumer, certainly shared many similarities with traditional consumer electronics businesses3 (particularly Sony and the Walkman). The iPhone can be seen as the latest in a parade of fashionable mobile phones, following in the footsteps of Motorola, Nokia, and Blackberry devices.
Viewed in this light Apple's business is highly volatile and subject to the whims of the consumer. Devices and brands that are popular for a while may go out of fashion. The collapses of Nokia, Blackberry and other phone manufacturers are still fresh in the minds of investors, many of whom may have suffered significant losses along the way.
Making matters worse, Apple does not have the diverse portfolio of products every consumer electronics company does.4 The portfolio approach allows these companies to smooth out the volatility of individual products and even individual product categories. Apple's product portfolio on the other hand is heavily concentrated in a very small number of products. This is the focus that allows Apple to make each product truly great, but it also introduces significant risk into the business. Volatility in most of Apple's individual products will have a material impact on the corporate bottom line.
If this is the business Apple is in, it is likely to decline when some new product captures the consumer imagination. Any investor thinking of Apple in this way would be right to demand a significant risk premium before investing. Today's revenue may be great but tomorrow's revenue is not clear and at some point revenue is likely to dry up.
I believe this view of Apple as a highly volatile, hit-driven business without reliable sources of recurring revenue is largely responsible for the extremely conservative valuation the market places on Apple today.
Where the view of Apple as facing the risks of a consumer electronics company goes wrong is in failing to observe the implications of the fundamental shift that is happening in consumer electronics. Special purpose devices are rapidly being replaced with general purpose digital devices that are part of a platform ecosystem. As with any technology platform there are network and lock-in effects at work.
Apple has been a leader in this transition and arguably has the strongest ecosystem offering the best experience for the consumer. iOS has achieved incredible platform loyalty with customer retention above 90%. This platform ecosystem affords Apple many advantages and is likely strong enough to be viewed as a classic Buffett-style moat.
At minimum, the iOS platform is sufficient to place Apple in a very different business than the previous consumer electronics and mobile industry favorites. The revenue model may be quite similar but the retention model is not - Apple has a platform, not just nice products and a brand. Apple certainly faces risks but they do not face the same risks that these companies succumbed to.
In the next segment I will discuss a different view of Apple's business model. A view that offers insight into how investors can begin to gain confidence in the recurrence of Apple's revenue. This is the key to Unlocking the Value in AAPL.
Of course real, tangible growth does matter. Especially the hyper-growth Apple experienced from 2003 to 2012. Any company showing that kind of growth is obviously going to see a huge increase in valuation. If Apple returned to hyper-growth their valuation would quickly recover temporarily (although it has never matched typical valuations realized by hyper-growth companies, even large ones). However, as soon as growth slowed down again, the valuation conundrum I am discussing would quickly return.
Here I am intentionally excluding companies with a consumer electronics heritage when I say “technology industry”. I do this primarily to highlight the contrast in business model, but also because most are struggling to make the digital transition, Samsung being the notable exception.
While the iPod business did share similarities with consumer electronics businesses it always had strong platform tie in via the iTunes store and FairPlay DRM that traditional consumer electronics businesses never did.
It is telling that Steve Jobs didn't call on the music industry to drop DRM until early 2007, shortly after the announcement of the original iPhone and the change didn't happen until early 2009 after the iOS platform and the App Store had already taken off. The end of DRM for music was inevitable. That Steve Jobs and Apple would publicly push for it to end just as they introduced a new, much more powerful platform was not.
In addition to a product portfolio, many consumer electronics companies also serve as component manufacturers. This guarantees some of their revenue in the form of multi-year contracts.