Hello, and Happy 2022!
Elevator Pitch
If one had to deliver an elevator pitch for an investment thesis in Apple, it might sound like this:
Apple has 17 Competitive Advantages, which have doggedly, wonderfully, and remarkably strengthened in 2021 and in recent years. The company spits out a new disruptive product offering every 5 to 7 years that grows to be the size of a Fortune 500 business. Apple boasts 1.65B+ active installed devices, with 1.0B+ active iPhones, giving it unprecedented popularity, reach, and monetization opportunities.
The Services business segment has 745M+ paid subscriptions as of FY Q4 2021. The growth in this business in the coming decade will contribute to a lucrative expansion in gross margins. Apple's iPhone, iPad, Mac, and Watch enjoy ludicrously high 85% to 90%+ customer satisfaction ratings. With smartphone penetration globally at only ~80% and with the iPhone's share of the market at only 15.2%, the growth of Apple's core business segments is very likely to continue.
Even when discounting any future product releases, Apple shares trade at an attractive fair valuation [4% to 16% undervalued] when considering the sheer dominance of this Consumer Titan and the pervasive role the company's products play in our daily lives.
...and when the next Apple branded product is released, unless Apple intentionally designs it to explode in your hands, does anyone earnestly believe that millions of innovation eager consumer creators won't devour the product offering as if it were a new flavor of ice-cream or coffee?
-Investing For The Future
Based on my proprietary research, Apple possesses at least 17 moderate to strong competitive advantages (and may have more weak ones). This article discusses the first and strongest competitive advantage for the company.
Introduction
Competitive advantages are a crucial deciding factor in the future success of a business, as they allow a company to create and to sustain an economic moat against the competition, leading to improved revenue profiles, profitability (gross, operating, and net margins) and outsized stock investment returns.
The below ranking system assesses Apple's competitive advantage as weak (1 to 3), moderate (4 to 6), or strong (7 to 10), with 10 being the strongest and 1 being the weakest. A weak competitive advantage presents little benefit to the company against competitors, while a strong competitive advantage presents a substantial moat and barrier to entry for competitors.
The Early Warning(s) allow a diligent investor to assess if each of Apple's competitive advantages are weakening year over year and to exit or to adjust their position as needed. Due diligence is essential to avoiding stock investment losses!
1. The Ecosystem (Strong Moat - 10/10)
Apple's ecosystem is the core reason consumers buy the products. Apple's mission statement is "to bring the best user experience to its customers through its innovative hardware, software, and services." Apple achieves this in such a rudimentary and common sense way that is absurdly elegant: they make the products as simple to use as possible.
Consider the following prescient quote from former Apple CEO John Sculley:
Stay the course and keep building an Apple ecosystem of iPhone + iPod + iMac + iTunes + App Store + Apple TV. No one has demonstrated they understand how to create an 'experience-based ecosystem' as well as Apple.
While there is certainly drama associated with Apple's history and the rivalry between John Sculley and Steve Jobs, both CEOs grasped the keen insight that Apple's ecosystem is unique, pervasive, and a tremendous selling point for existing and potential consumers globally compared to competitors like Samsung (OTCPK:SSNLF), Alphabet (GOOG) (GOOGL), and even Microsoft (MSFT).
Source: US Economics Review
When you purchase an iPhone, iPad, Mac, Apple Watch or any other Apple product, you enter an ecosystem of interoperable hardware, continuously updated software, and use-case specific services that become increasingly sticky. Simply put, the further you explore Apple's ecosystem, and the more money and time you invest in it, the less likely you are to leave.
Alphabet's Attempt
Alphabet (Google) attempted to replicate Apple's ecosystem with products like Google Home, the Pixel Smartphone, and Chromecast Smart TV, yet the results left a chaotic impression on consumers as Android is an open-source phone operating system. When consumers were offered products from Alphabet's many partners, they simply did not always understand the confusing product pairings or what company they should go to for support.
Alphabet never initiated and sustained the massive customer engagement and zeal exhibited by Apple consumers, and it never solidified its brand to be synonymous with high-quality customer-centered hardware products. While Alphabet still offers the Pixel 6 smartphone, the company has ultimately failed to capture market-share and smartphones are now appearing free of Android.
Source: Statista
Alphabet's attempts at replicating Apple's ecosystem in smartphones, computers, watches, and tablets sometimes feel like an afterthought: the company appreciates the extra sales and revenues, yet it prioritizes web browsers (Google Chrome), social media platforms (YouTube), Google Cloud, and advertising, and it seems too scattered to pose a concentrated and focused risk of severe competition and disruption to Apple.
Source: Finshots
Samsung's Attempt
Samsung attempted to create an ecosystem via its smartphones, tablets, TVs, wearables, laptops, SideSync, Samsung Pay (a replica of Apple Pay), and SmartThings, yet it missed a few key differentiators: namely, a dominant App Store and a seamless experience and integration across the product offerings.
While Samsung makes competitive (and some argue higher quality) smartphones to match the iPhone family, the issue arises with pairing of the smartphones with nearly every other product grouping: in particular, laptops and smartwatches. Furthermore, Samsung is distracted.
Source: Khaveen Investments - Seeking Alpha
Not only is Samsung not renowned as a computer company, Samsung's laptops do not have their own OS similar to Apple's MacOS - instead they rely on Windows. Samsung's phone OS relies on Android and on the Google Play Store, in part because Samsung's apps are seldom considered best in class.
Even Samsung's Watch, the Galaxy Watch 4 series, lags the Apple Watch in market-share - which is unprecedented as Apple usually retains the minority of the market-share for their product offerings!
Source: Statista
Samsung's dependency on other major S&P 500 companies such as Alphabet and Microsoft has essentially precluded them from replicating Apple's ecosystem advantage and remains a sore point for the company. Investors should realize that this is a structural feature of Samsung's business - if the company suddenly tried to refuse collaboration with Alphabet and Microsoft, this would have adverse implications for the business (and in any case, as it will be revealed shortly, Samsung is not attempting to strike out on their own in an attempt to steal Apple's profits).
Microsoft's Attempt
Microsoft would have loved to usurp Apple as the Consumer Titan, given the longstanding rivalry between the two companies. Yet, Microsoft's focus is increasingly focused on enterprise and away from Apple's core niches.
Source: Tech Behemoths
Devices account for only a small portion of Microsoft's total revenues in FY 2020 and FY 2021, and the company seems disinterested in trying to tackle Apple directly, instead opting for alleged support of Epic Games in their trial and for a partnership with Samsung as of 2020.
The Samsung-Microsoft partnership offers improved integration of Samsung smartphones with Microsoft Window's operating system and associated devices. In other words, this partnership is more of a competitive threat to Alphabet / Android than it is to Apple.
Microsoft's prestige and renown, as well as competitive advantages, are focused primarily on Operating Systems / Software / Cloud offerings (and to an extent, gaming, though the company sells XBox at a loss). It is difficult to envisage Microsoft suddenly reversing course and displacing Apple's ecosystem, especially as investment in S&P 500 and technology companies are increasingly being geared toward the Metaverse, or the Web 3.0.
Xiaomi's and Huawei's Attempts
Some investors may recollect a few years ago when a slew of articles and predictions came out about how China's smartphone industry would not only exclude Apple from the lucrative market, yet also displace their leadership position globally in key markets such as the EU and perhaps even the US. This has not occurred and seems unlikely to barring a major reversal by China on its policies towards Apple.
Source: Counterpoint Research
As it stands, Xiaomi (OTCPK:XIACF) has 13% of global market share in Q3 2021, stealing the share from "Others" while Huawei does not even appear on the graphic, in part because of the devastating US sanctions.
Vivo secured 10% of the global market share in Q3 2021, yet Apple continues secure and to defend its smartphone market-share both globally and in China despite increasing competition.
The key issue as most western investors realize is that consumers in the EU and USA (as well as governments) are incredibly skeptical and cynical when it comes to "privacy" on Chinese-branded smartphones. Apple has certainly noticed and leveraged this to their advantage.
The Ecosystem Competitive Advantage for Apple is Stronger in 2021 than in Prior Years
A global study in 2021 by research firm GfK shows that 84% of current iPhone owners plan to purchase another Apple handset when they replace their cellphone, with many smartphone users saying the ecosystem of a mobile OS is a determining factor when upgrading.
Source: Apple Insider
Apple's brand loyalty is increasing, and the Ecosystem is cited as a critical lock-in factor. As of a 2021 USA brand loyalty survey, only a mere 8.1% intended to switch to a different brand. This compared with 9.5% of users that intended to switch to a different phone brand in the 2019 brand loyalty survey.
Survey reveals the brand loyalty for Apple is at an all-time high of nearly 92% (up from 90.5% in 2019).
A combined 61% see no reason to switch as they like their brand best or never had an issue with it. 21% prefer to stick with Apple because they are too locked into the ecosystem.
Of the Samsung defectors, a majority (53%) will switch to an iPhone the next time they upgrade, with most (31.5%) indicating privacy concerns as the main reason for the switch.
26% of current Samsung users, 34.8% of current Google users, 62.6% of LG users, and 71% of Motorola users intend to switch for their next smartphone purchase in the United States.
The devilish beauty of this competitive advantage cannot be understated: so long as Apple maintains the expected quality of seamless user experience, the costs of switching are too high for most rational consumers to contemplate alternative standalone products (this in part explains Apple's success with the Apple Watch). Competitors [Xiaomi, Huawei, Samsung, Alphabet, Meta Platforms (FB), Microsoft] would need to continue investing aggressively to replicate Apple's secure, closed ecosystem and to appeal to existing very loyal Apple consumers.
Early Warning(s) to watch: persistent and unresolved product quality complaints, confirmed reputable surveys of rising iPhone user intention to switch, passage of new regulations forcing interoperability of software between numerous competitors and ecosystems, the rise of a new Web 3.0
Valuation
In a previous article, I debunked the use of historical P/E for the purposes of valuing the shares of Apple stock. I included Dividend Valuation Models and Discounted Cash Flow models as well as pessimistic, realistic, and optimistic scenarios for growth for the next 10-year period. To put it simply, Apple's TTM P/E of 31.7 is in-line with the Information Technology industry P/E of 37.31 and with the Technology Hardware, Storage & Peripherals sector P/E of 30.91.
For the purposes of this article, I am providing updates on the Dividend Valuation Models and Discounted Cash Flow models. I am happy to re-run the models for you with your own assumptions and to provide the results.
A P/E of 30 is assumed in next 10 years' time. A 9% discount rate is applied, and the growth rate estimates sit at 10% and 9% for the first five year and second five year periods, respectively. Keep in mind that Apple can sustain such EPS growth rates via share buybacks even if revenue growth is small.
Source: Author's Calculations
For the DCF Model, next year's FCF is assumed at $97.6B, or only 5% greater than FY 2021. A 9% discount rate is applied, and the growth rate estimates sit at 15% and 14% for the first five year and second five year periods, respectively. The perpetuity growth rate rests at 3%.
The model runs for 10 years, yet only the first 5 years are displayed for ease of visibility. The model does not account for further reductions in the # of shares outstanding to allow for an additional margin / buffer of safety in the valuation calculations; better to be conservative and be proven wrong, thus achieving better than expected results, than to be aggressive and be proven wrong, thus seeing investment losses.
In order to improve upon the above approach and to account for human error in growth assumptions, Reverse Dividend and DCF models are applied. In essence, the following questions are asked: how quickly do Apple earnings need to grow over the next ten-year period for Apple to be fairly valued today? Is the growth rate returned by the model achievable? How quickly does Apple's FCF need to grow over the next ten-year period for Apple to be fairly valued today? Is the growth rate returned by the model achievable?
For the Reverse EPS Model, Apple needs to grow earnings by ~9.05% for the next 10-year period to be fairly valued today. During the past 10 years, Apple grew earnings per share by 14.7% per year. During the past 5 years, Apple grew earnings per share by 18.8% per year. During the past 3 years, Apple grew earnings per share by 21.5% per year, with EPS growth accelerating to 71.0% (exiting the pandemic) during the last twelve months.
Based on such comparisons, if you believe the company can sustain a growth rate of ~9.05% for EPS for the next 10-year period (hint: you should), the business is currently fairly valued.
The Reverse DCF Model is even more revealing; note that it is easier for companies to manipulate EPS than it is to manipulate free cash flow. Apple needs to grow FCF by ~11.68% for the next 10-year period to be fairly valued today. During the past 10 years, Apple grew FCF by 13.9% per year. During the past 5 years, Apple grew FCF by 17.6% per year. During the past 3 years, Apple grew FCF by 19.8% per year, with FCF growth accelerating to 31.7% during the last twelve months.
Based on the Reverse DCF Model, if you believe the company can sustain a growth rate of ~11.68% for FCF for the next 10-year period (hint: you should), the business is currently fairly valued.
Conclusion
Apple Inc. is a fundamentally strong business with fortress-like prestige when it comes to the company's competitive advantages. These fundamentals and competitive advantages are only improving YoY, as evidenced by FY 2021 financial results. The company's growth prospects, even when discounting any future product releases, justify the current stock price valuation.
While many speculate about the potential drawbacks in Apple shares in the event of a recession or poorer-than-expected growth in a given year, these two risks apply to nearly every single company one would invest in.
For investors curious about the risk-opportunity profile specific to an investment in Apple, you may refer to the risk register [52 risks / 14 opportunities] from a prior article.
For investors aiming to build wealth over a respectable period of time, you could do much worse than this Consumer Titan. I wish all investors the best of fortunes in 2022 and a very Happy New Year. Good luck, and invest wisely!
Investing For The Future
Avid long term oriented investor with an interest in value, growth, and special opportunity (spin-offs, insider trading) investing styles. Strong believer in identifying companies with competitive advantages in order to avoid stock investment losses. Self-educated.My expertise and unique investing style has arisen as a result of nearly a decade of professional experience in three highly regulated industries (aerospace and defense, medical devices, and pharmaceuticals) inclusive of work experience within the telecommunications and customer service industries.An engineer by education, a project director at work, and a writer at home, I am meticulous and apt at both the qualitative and quantitative aspects of investment. Income statements, balance sheets, and cashflow statements are for me a pleasant read.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
As always, investors are dutifully reminded to conduct their own research prior to the investment of hard-earned money into any stock, AAPL included. This article should not be interpreted as a solicitation to sell or to buy shares; please consult your financial adviser. I strongly encourage you to challenge my thesis, ask questions, and to share information with all readers - this benefits all of us. If you appreciated and found this article of value, you can pay me no greater compliment than to click the "Follow" button. Thank you for reading and for engaging in the discussion, and best of luck with your investments, wherever they may be!
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