Is Apple Like Microsoft in 1995, or Like Research in Motion in 2008?

Morningstar’s Matt Coffina discusses the bull and bear cases on Apple.
By Morningstar |  24-06-13 | 
 

Not surprisingly, the company I am most often asked about by subscribers to our U.S. newsletter Morningstar StockInvestor is Apple. Apple is down around 40% from the all-time high of $705.07 it reached last September. More importantly, it is trading at about a 30% discount to Morningstar's $600 fair value estimate. While the moat is only narrow, the moat trend is positive, indicating a strengthening competitive position.

By most normal standards, Apple looks cheap. Consensus estimates call for the company to earn around $40 per share in fiscal 2013, giving the stock a P/E multiple around 10. Better still, Apple ended the last quarter with $145 billion in cash and investments and no debt. That's nearly $153 per share in cash earning little interest. If we exclude this amount from the stock price, Apple is trading at a P/E closer to 6.5. Even the dividend yield isn't bad at 2.9%.

Based on Apple's current valuation multiples, the stock market believes the company's fortunes are about to take a dramatic turn for the worse. This is despite the fact that Apple's main businesses--smartphones and tablets--are still in the middle stages of one of the greatest secular growth stories so far this century. Global smartphone unit sales are projected to experience a 14% compound annual growth rate during the next five years.

Others are fearful--should we be greedy?

The Moat and Moat Trend Matter Most

The key question, in my mind, is just how strong Apple's economic moat is, and whether the moat trend is truly positive. Apple recently came up for review by our internal economic moat committee, and after a very interesting discussion, the five committee members (myself included) voted to maintain our rating of narrow/positive. However, the case is far from cut-and-dried.

The history of consumer electronics companies is certainly not promising. BlackBerry-maker Research in Motionenjoyed a 57% compound annual growth rate in revenue in the five years leading up to 2011. Then revenue promptly fell 44% in the subsequent two years and record earnings turned into annual losses.

Other former high-fliers such as Dell and Nokia have suffered similar fates. So there are legitimate reasons for investors to be worried. Although Apple's revenue improved 11% in the most recent quarter, earnings per share fell 18% as margins contracted from last year's record highs.

If Apple were like any other consumer hardware company, my interest would end here. The company has had a string of hit products and made lots of money for investors in the short term, but if its economic profits aren't sustainable, I'm not interested.

However, Apple stands out from the companies that have come before it. Unlike BlackBerry, a robust ecosystem has developed around Apple's devices, with iOS at the center. Hundreds of thousands of apps have been specifically developed for iPads and iPhones. There is a mild network effect here--developers only want to spend their time making apps for the platforms that people use, and people only want to use the platforms that have a lot of apps (although admittedly app development costs may be falling). Only Google's Android has attracted a similarly broad community of developers, and Microsoft and BlackBerry are finding it extremely difficult, and costly, to replicate this success.

More important, households have been buying an increasing number of Apple devices over time, and services such as FaceTime, iTunes, and iCloud make it convenient to stay within the Apple family. The more Apple devices and services people use, the higher the switching costs. In this way, Apple may be more like Microsoft in 1995--the heart of an ecosystem--rather than BlackBerry in 2008.

What Would Cause Apple Customers to Switch Platforms?

That's not to say it's unthinkable that people will abandon Apple. If Apple were to come out with a string of lousy products in a row, I have a feeling the apparent switching costs would evaporate pretty quickly. But so far there is little evidence that Apple will release even one lousy product, let alone a whole series of them. With the vicious competition in the consumer electronics business, companies often engage in a race to the bottom--skimping on quality in an effort to cut costs. Apple has wisely taken the high road; focusing on quality above all. More than a decade after the first iPod, nobody has been able to touch Apple's dominance in portable music players, and the company seems to be carving out a similar niche in the high-end laptop market. Branding is just as important as technological specifications here; if I'm going to make a two-year commitment to a phone, I want to go with a product I know and trust.

Investors' biggest concern with Apple seems to be the competitive threat from Samsung, which has been gaining market share even more rapidly than Apple. I don't think this should come as a surprise to anyone. Higher-income people were the early adopters of smartphones, and they have gravitated to Apple's premium products. Lower-income and emerging-market consumers account for the incremental smartphone buyers, and they are more price-sensitive.

Existing customers seem to be satisfied, and likely to become repeat customers when it's time to upgrade their devices. Given the secular industry growth, Apple can afford to see its market share gradually decline, as long as it doesn't experience a BlackBerry-style collapse. I don't think competitors' incremental technology improvements will be enough to make that happen--Apple would need to suffer a much more severe technological blunder, along the lines of BlackBerry's slow embrace of touch screens.

What Do You Think?

Apple looks cheap under a variety of possible future scenarios, ranging from modest earnings declines to industry-level growth. If it can continue its streak of hit products, the stock valuation is almost ridiculously low. On the other hand, product cycles are extremely short in this business and the history of consumer electronics companies is not promising. A major falloff in sales is not impossible, though it seems unlikely. Margins appear to be headed lower, and a key unknown is where they will settle.

What do you think? Do you own an iPad or iPhone yourself? Do you think there are switching costs? Are switching costs increasing over time? Leave a comment below with your thoughts.

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