Apple Still Worth Picking, Despite Smartphone Transition
Easy growth has passed, but near-term risks are more than baked in to this narrow-moat name.
We believe Apple (AAPL) has developed a narrow economic moat, based on a variety of switching costs around the iOS platform that will allow the company to retain a good portion of its current user base. However, we think much of Apple's outsize growth in recent years has stemmed not from the firm's moat, but rather a first-mover advantage associated with creating a truly revolutionary smartphone and associated ecosystem. Looking at the near-term picture, our thesis focuses on Apple's ability to entice new customers away from basic flip phones and competing platforms, instead of relying on switching costs to retain current iPhone users. We think this story will begin to evolve over the next several quarters, as more and more potential iPhone customers come from repeat buyers, and we think Apple's moat will play a critical role in retaining these iOS users.
We acknowledge several risks around the Apple story today, but we believe these concerns are more than priced in to the stock. While we recently moved our fair value uncertainty rating to high from medium to account for greater uncertainty around competition and Apple's ability to attract new users, we are maintaining our $600 fair value estimate and continue to view the firm as attractively valued.
Apple Is Still a Story of Attraction, Not Retention...for Now
We believe that Apple should retain a good portion of its current customer base, provided it doesn't build notably inferior products or otherwise impair its brand image in the future. However, much of Apple's growth in recent years has come through attracting new users to its platform, all while facing little direct competition. We readily acknowledge that Apple initially benefited from a dominant position in the portable music player market, which acted as a catalyst to draw customers to its nascent smartphone platform. Looking back, however, we view Apple's growth, as well Android's growth today, as being driven by the secular shift in the handset industry toward more-advanced smartphone devices.
By our estimates, 2013 will be the first year in history when more smartphone units will be purchased by current smartphone owners than by new customers transitioning from basic phones. Still, many of these current smartphone users are upgrading from antiquated devices and operating systems, such as Nokia's Symbian (200 million units sold in 2010 and 2011) and BlackBerry's BB7 and prior devices (101 million units sold in 2010 and 2011), which represents a revenue opportunity. Of course, some smartphone customers this year will be replacing iPhones and older Android devices as well. But for the most part, we still view the Apple iPhone story in early 2013 as a focus on enticing new customers away from basic flip phones and competing platforms, rather than leveraging its narrow moat and switching costs to retain current iPhone users. Fewer than 30% of global cell phone users owned smartphones in 2012, which to us suggests plenty of runway for unit growth in the coming years.
With Easy Growth in the Past, Uncertainty Increases, but Moats Matter
Given the cyclical and secular trends in the smartphone industry, we recognize that Apple's easy growth phase is probably a thing of the past. We see greater uncertainty around the firm's ability to attract new users, partially due to greater competition from Samsung, but mostly because Apple's premium pricing strategy may prevent new customers in emerging markets from switching to iPhones. In late 2013, we think Apple will approach an inflection point, where switching costs and the firm's narrow moat will start to matter more.
For historical context, during the strong iPhone 4S launch in the December 2011 quarter, we estimate that Apple sold 13.8 million iPhones in the United States, many of which were tied to two-year carrier contracts that will begin to expire in the second half of 2013. As these subscriptions roll off, we think Apple would be best served to accelerate its production cycle and have a new iPhone ready for market in the coming months. Comments from CEO Tim Cook suggest a fall 2013 iPhone 5S launch instead, which we think adds some risk that some of Apple's current 4S customers may not be able to wait around for the next iPhone and may gravitate to Samsung or other devices instead.
While we assume that many of these 4S users will stick with the iOS platform for their next generation of phone, retention would be easier if customers saw a 5S on the horizon, rather than being forced to decide between purchasing a "new" nine-month-old iPhone 5 or perhaps a Samsung Galaxy S4, or holding on to the 4S for a longer-than-desired period, until the next iPhone iteration eventually reaches the market. We also recognize that, similar to the introduction (and popularity) of sport-utility vehicles in the global automobile market, the cell phone industry has evolved and many consumers have gravitated to Samsung's devices, which offer larger screen sizes. We anticipate that Apple will launch a larger-screen iPhone at some point, preferably sooner rather than later, as it would negate a key differentiator of Android-based devices today.
In our view, Samsung's popular Galaxy phones and Galaxy Note phablets pose significant competitive threats to Apple, but we believe fears of Samsung stealing customers away from Apple are overdone, at least thus far. Data from Kantar Worldpanel suggest that in 2012, an overwhelming majority of Samsung smartphone buyers in the U.S. switched from either feature phones or other Android smartphone models, but that only a single-digit percentage converted from an iPhone. This percentage might not be much higher outside the U.S., either, as we suspect that plenty of former Nokia users switched to Samsung in overseas markets (while Nokia's limited U.S. presence didn't make much of a dent in new U.S. Samsung buyers). Additionally, Apple marketing chief Phil Schiller said that in the fourth quarter, 4 times as many iPhone users switched to iOS from an Android phone than vice versa. We view this statement as a positive data point regarding switching costs and incremental support for our narrow moat rating for Apple.
Apple's narrow economic moat will become even more important in the coming years. Over the medium term, as the smartphone market matures, we believe future iPhone growth will become more reliant on a mix of both new and existing iOS customers. We still foresee Apple as being able to attract new customers to iOS, mostly in emerging markets (and especially with an eventual China Mobile partnership), although we still assume some gains from late adopters in the U.S. and developed markets as well.
We expect new smartphone buyers to be increasingly price-sensitive in the years ahead as they either reside in emerging markets or represent late adopters in developed markets; each potential customer category carries its own risks. We currently assume that Apple will continue to reach its more price-sensitive customers through the sale of older iPhone models, rather than introduce a brand-new low-priced iPhone. The majority of early smartphone sales were made to customers in developed markets (higher per capita GDP) who could afford significantly higher-priced phones. As smartphone prices decline as a whole, most of the smartphone industry's growth in the next few years is likely to come from emerging markets. Even if Apple were to still see robust iPhone unit growth, concerns about a less favorable mix toward lower-priced models that could drive gross margin compression are warranted, in our view.
Apple will also need to retain its existing premium iPhone customers. This is where the importance of switching costs and the firm's narrow moat will come into play. While we don't believe that any single aspect of the iOS platform is insurmountable or (on its own) enough to guarantee repeat purchases, we think a variety of modest switching costs will allow Apple to retain a healthy portion of its iOS user base today, as long as future products are equivalent to the competition. From music and media transfers to operating system familiarity to interoperability and syncing among iPhones and other iOS devices via iCloud, we believe significant switching costs would prevent at least some iPhone users from migrating away from the platform. We contend that such switching costs are strengthening today, as we believe that every incremental Apple product sale (iPad, Mac or any future iWatch or Apple TV) to an existing iPhone user makes it less likely that the customer will gravitate toward a different smartphone platform.
Apple will continually need to develop smartphones equal to or better than the competition (either in perception or reality), so that switching costs, rather than inferior hardware or antiquated software, can be amplified and become the differentiating factor as users consider staying on iOS or jumping to a competitor's product and platform. We continue to believe that Apple is up to this challenge in the long term.
Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.