Understanding Apple, Part 1 of 2

on October 21, 2013

If you follow Apple in the press and talk to analysts, you’re probably confused. There are three conflicting narratives being presented: Apple is doomed, Apple is disappointing, or Apple is dominating. So many journalists have written about Apple’s lack of innovation without Steve Jobs that, “Apple is doomed,” has almost become a meme. Most financial analysts are in the “Apple is disappointing” camp – the P/E ratio of Apple’s stock price is certainly depressed relative to the competition, yet market analysts – including yours truly – describe Apple as dominant today and highly dangerous going forward. How can all these be true?

Apple is Doomed

There are certainly media sources overwhelmingly friendly to Apple, and much of the tech press gets accused of being overly cozy with Apple and Google and Microsoft simultaneously. However, the treatment of Apple in the general press is often quite negative.

It has become a cliché that the press enjoys building people and companies up, only to tear them down again (…and sometimes build them up again – which I like to call the full Behind the Music cycle). Some of this is basic human psychology, but there is also an element of cynical capitalism at work – anything controversial that is written about Apple generates healthy page views which generates advertising revenue. The press sees incremental improvements as less newsworthy than entirely new products, even if the upgrades are wildly successful. Mainstream journalists are also wary of being caught in an Apple “reality distortion field,” and are so scared of being perceived as biased towards Apple that they end up highlighting the negative.

Most negative coverage of Apple includes quotes from disappointed financial analysts (more on this below), but the biggest proof point used in anti-Apple coverage is the lack of Steve Jobs. At the time of his death, Apple had absolutely transformed consumer technology, making media players, smartphones, and tablets mainstream objects of desire. It is impossible to refute the fact that Jobs was the catalyst for Apple’s decade of success. So without him, Apple must be doomed. Just keep in mind that if Apple continues to grow and introduce new hit products, the story line will shift to “Apple is Back.”

Apple is Disappointing

There may be some financial analysts who say things to move the stock and profit off the movement – and since Apple is the subject of so much scrutiny in the press, this is easier to do with Apple than probably any other stock. However, even if you discount any ulterior motives, it is clear that financial analysts are not happy with Apple’s strategy. The PE ratio of Apple’s stock price – even after the runup following the record-setting iPhone 5C/5S sales – is significantly lower than other tech firms. In other words, the market is not valuing Apple as highly as other companies. This is hard to reconcile with Apple’s run of incredible profits. What is going on?

Apple has a huge amount of cash on hand and makes enormous profits – financial analysts do not deny this, and they will be the first to point out that Apple is already one of the largest companies in terms of market capitalization. However, financial analysts value companies based on future profit growth. Thus, they don’t believe that Apple can grow profits any further. Apple targets the top end of the market, and they maintain that this segment of the market is saturated. They further point out that Apple now has nearly every major carrier in the world already selling the iPhone. The problem is not that Apple is not successful, the problem is that they believe Apple is too successful to grow any more.

In fact, the consensus among financial analysts seems to be that is that Apple’s profits will almost certainly fall over time, either due to competition (Android phones which provide a “good enough” smartphone experience at a lower price) or by Apple listening to the financial analysts who want Apple to sell lower margin iPhones to expand market share and snag entry level phone buyers. That might also mean Apple would cannibalize its own high end iPhone sales as some of its own customers choose the “good enough” model in Apple’s line instead of the latest and greatest.

Financial analysts are not stupid. There are at least two valid reasons why Apple might need to expand its market share even at the expense of profits.

By focusing on the high end of the market, Apple has left the fastest growing portion of the market to Android in both phones and tablets. Apple’s advantage in apps is a key differentiator; it is possible that Android’s larger aggregate user base will eventually cause developers to focus on Android first and iOS second, eroding Apple’s value proposition.

Apple is aware of this possibility, which is why Tim Cook highlights Apple’s strong usage statistics every chance he gets. Apple argues that as long as iOS users spend more money and time on their iOS devices than Android users do on theirs, Apple should maintain developers’ attention.

By leaving the entry point to mobile unguarded, Apple is allowing other brands to establish themselves. It is possible that as emerging market consumers buying power grows, they will stick with the brands they grew up with. Japanese auto manufacturers followed this strategy when they courted the entry level customer in the 1960’s and 1970’s and launched luxury brand extensions in the late 1980’s.

Apple seems willing to take that bet.

Financial analysts value companies based on future profit growth, and successful companies are constantly investing in new markets to create new revenue sources. Apple is the most successful company to have employed this strategy. In just the past decade it introduced iTunes, the iPod, the iPhone, and the iPad (while also reinvigorating its PC line – another product Apple invented in an earlier era). Journalists discount Apple’s ability to create new products because Steve Jobs is gone. Some financial analysts are likely doing the same, but others simply do not know how to value future innovation until they see it being sold. If you think that Apple cannot possibly grow its profits and you cannot put a price tag on any future products that Apple might introduce, you will find Apple quite disappointing.

To be continued.

The final section of this article will cover how market analysts see Apple, and where future profit growth will come from.