#13 Apple's adventures in wonderland
"Apple does not innovate anymore", yet its results have skyrocketed in the last few years. The secret behind a successful transformation.
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From the moment Tim Cook took control of Apple back in 2011, the bitten apple company seemed destined for failure. The death of Steve Jobs left the company without the visionary leader who twice had led the world to think differently.
The story has been proven to be quite different. However, Apple is constantly criticized for its lack of innovation and how its share price is overvalued. In this article we are going to see how Apple has been involved for years in a business model pivot and how it has led them to be much more efficient with its invested capital. In addition, we will analyse the paradigm shift that Apple has achieved in the luxury brands world and try to answer the question of whether or not the share price is overvalued.
Change of paradigm
“Apple has not innovated in a decade”
It is true, there hasn't been a technological breakthrough like the iPhone or the iPod. There has been no radical product innovation. But that is far from saying that there has been no innovation. Apple management took a risky one betting strong on the transition from Intel to their homemade M1 chips. The results have been very positive, but this vertical integration was a huge gamble in an extremely innovative and dynamic industry. Besides, we have to acknowledge that during Tim Cook's tenure as CEO, Apple has presented two products that have opened new markets, and where Apple has taken the dominant position. Apple has a 30% market share worldwide in smart watches and again, another 30% in wireless headsets.
We are talking about 30% market share worldwide, for a premium brand and with a premium price!
Besides, and due to strategic constraints, Apple cannot (and should not) match the radical innovation, nor the continuous product release cycles that other brands do. I am thinking here of any of the other big tech companies (Amazon, Microsoft or even Google) or any other of the competitor brands in any of the segments Apple has a product. Google and Amazon can continually put out products and test their product-market fit.
Apple could embrace the famous build-measure-learn innovation cycle., but they decided to take a different approach many years ago. A bold move. Apple has a brand to keep and can only release a product when it is ready for an unique user experience. Otherwise, it could harm their brand image.
“It takes 20 years to build a reputation and 5 minutes to ruin it”.
Apple is in another league. Luxury brands have very particular dynamics. However, something that really amazes me about Apple is this:
Premium brands are normally only accessible for a very small part of the society. They need to generate this perception of scarcity and exclusivity to charge you a premium price. It happens with Louis Vuitton, Tiffany, Ferrari, Rolex, and many others. It is the way it works. Not for Apple. It is incredible and it is the only brand I know that is considered premium and still “everybody” has it and loves it. It is the first luxury brand that is everywhere. They have broken the paradigm of luxury and scarcity. This, to me, is the latest competitive advantage.
Needless to say, the “first” one who saw this was the G.O.A.T.
Shift to services
“In the long run, most product companies add on services to increase profitability and most service companies productive their offerings to make them easier to sell.”
We all know Apple for its great ecosystem and for its flagship product, the iPhone. This dependence on the iPhone has also been highly criticized. However, the company has been immersed in a change of business model for years. The transition from a luxury retail company to a model with half asset light software services, half mix of “luxury” retail products. And to be honest, Apple's strategy is producing spectacular outcomes. There is no ecosystem as closed and with these high degrees of satisfaction. Not surprisingly, services revenue has compounded almost at 20% annually for 9 years (increasing the rate even lately) and it is already almost 20% of the whole annual revenue for Apple. It is the fastest growing segment within the company and guess what: it has the highest margins of all. A non-negligible 70% gross margins. This is to say Apple is becoming a better business due to a lower capital intensive requirement.
The impact on the business
Apple has been reducing the capital invested in the business since 2017, achieving during this period of time a total reduction of 25%.
At the same time, and surprisingly, revenue has increased by 50% and has almost doubled its Free Cash Flow! This is simply spectacular and speaks highly of Tim Cook, the management and the business competitive advantages.
I consider this an underappreciated change that I have not seen anyone comment on.
A small stain in the wonderland
All that massive FCF they have been generating in recent years has increased the company's cash balance enormously. Apple has been simply printing money. Not as much as the FED, but almost. Therefore, it is interesting to see how the management has deployed all this cash.
And here it comes, one of my greatest concerns: Despite the fact Warren Buffett has been saying many times, how happy he was with Apple's share buyback programs, I am not.
As you can see in the chart below, Apple has been “investing”, buying back shares, between 1.3x and 3.5x of the FCF generated. It is “burning” its cash reserves to buy back stock at rates I have never seen in any other company.
Furthermore, I am concerned, all these repurchases have been done at quite high and demanding share prices. Let me rephrase it. I am confident to say they were not at bargain prices.
I have the impression that the price has become very sensitive to share buyback programs. It can be easily verified if you compare the price evolution and the amount repurchased by the different buyback programs.
Not all share buybacks are the best capital allocation strategy and many times, these buybacks can even destroy shareholder value. With Apple's high ROIC, management should try to find new levers to deploy capital and grow new segments. Easier to say than to do, I know.
However, in the worst-case scenario, and despite the fact that I am reluctant of dividends payout, there are certain occasions where dividends are the right capital allocation decision for a company. Time will say if these repurchase programs did create or destroy value.
What lies ahead: valuation and optionality
All these financial metric improvements, the astonishing and skyrocketing FCF plus the oversized stock repurchase programs have led share prices to new highs year after year.
Are the price levels justified? Many have been complaining or criticising how expensive Apple was. After a 20% drop, Apple is priced at 25x earnings. It does not sound extremely expensive for such a good business and all the optionality associated with it. Not surprising, Buffett added some more millions to his portfolio last quarter.
Apple has compounded FCF at a 15% rate during the last 5 years, without any major product breakthrough.
At current prices, I consider an investor is buying one of the best luxury-retail businesses ever, at a fair price. Add later as margin of safety an infinite optionality for new products, a high-growing asset-light business snowballed by the best ecosystem of technological devices and new business models like the iPhone as a Service.
Tim Cook might not be the visionary Jobs was, but he has led Apple to new domains which Jobs did not even dream of.
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Disclosure: I have part of my portfolio in Apple. Everything expressed here is only my opinion. Always do your own research.
#13 Apple's adventures in wonderland
Great writeup! I just got the epiphany today (like WB, no comparisons other than that) that Apple might just be an investment for me, because of the great financials, consistent ROIC and great products (we are an Apple family since 15 years and I love their products). Will do some more thinking and analysis, but right now I feel good about it. Valuation is the problem of course, but like you say, it does not seem overvalued right now. Margin of safety is the moat and the optionality as you say. I will wait for earnings the day after tomorrow before making any moves. Keep up the good work. You've got a new subscriber!