Why We've Downgraded Apple's Moat Trend
Switching costs are strong, but not necessarily getting stronger.
After taking a fresh look at our thesis on Apple (AAPL), we are reducing the firm's moat trend from positive to stable, while maintaining our $175 per share fair value estimate and narrow-moat rating. We still view switching costs around the iOS ecosystem as Apple's primary moat source, and while we believe such costs remain strong today, we don't necessarily believe these switching costs are strengthening, thus the shift to stable.
Apple's competitive advantage stems from its ability to package hardware, software, services, and third-party applications into sleek, intuitive, and appealing devices. This expertise enables the firm to capture a premium on its hardware, unlike most of its peers. Despite its admirable reputation, loyal customer base, and bevy of unique products, the consumer hardware space can be unforgiving to firms unable to consistently satiate the customer's appetite for more features. Given the short product cycles of Apple's products and army of firms targeting its dominance, we do not believe Apple has a wide economic moat.
Switching costs and intangible assets support Apple's narrow moat. The firm enjoys stellar returns on its devices by offering a unique user experience with its iOS ecosystem. Contrary to its peers in PCs and smartphones that rely on relatively open operating systems, Windows and Android, respectively, Apple's walled garden approach for its popular iOS allows it to charge a premium for relatively commoditized hardware not too different from that sold by Samsung, Dell, and others. Customer switching costs are elevated for Apple users as a non-Apple iOS experience does not exist, unlike computing platforms for the Windows or Android ecosystems that boast PCs and smartphones from many firms.
We view the iPhone as a revolutionary product that created the smartphone ecosystem and transitioned computing habits away from the PC. The robust app store helped foster iPhone adoption and grow Apple's user base, with applications ranging from productivity, social media, gaming, music, and so on. We foresee Apple's ongoing business coming from existing customers versus new smartphone adopters. With hardware becoming increasingly commoditized and replacement cycles potentially elongating in the long term, we expect Apple to focus on newer software and services to augment the user experience and retain customers. The firm’s additional products and services (Apple Watch, iCloud, HomePod, AirPods, Apple Pay) act as both supplemental revenue opportunities and, more importantly, critical enhancements to the iOS ecosystem that support Apple’s crown jewel: the iPhone.
About That Moat Trend Rating
We still view switching costs around the iOS ecosystem as Apple's primary moat source. Apple's relatively stable iPhone unit sales, along with stable to rising prices (which bucks the trend within the smartphone industry), are a good sign that the firm is retaining users. While we believe swtiching costs remain strong, we don't necessarily believe they're strengthening.
The number of iOS-compatible products has increased in recent years with brand-new products (AirPods and HomePod) and updates to existing ones (iPad, Apple Watch, Apple TV) both serving to lock in customers who are less likely to move to a non-Apple device if they just spent a few hundred dollars on an Apple Watch. Even though iPad sales have dipped in recent years, the emergence of the Watch and AirPods illustrate that Apple iPhone users are buying ancillary devices. Given their pricing premiums and lack of full compatibility with the Android ecosystem, we believe that the vast majority of Watch and AirPod buyers are iPhone users.
Meanwhile, certain applications and services (iMessage, FaceTime, Apple Pay, Car Play) continue to create stickiness, in our view, although such stickiness is less tangible than other auxiliary products. IMessage and FaceTime are networks where the departure of one iOS user would require recruiting friends and family to move to alternative platforms. While many apps are free and prevalent on both iOS and Android ( Facebook (FB) and Netflix (NFLX), for example), switching to Android requires fresh downloads and logins on a bevy of apps. Finally, we think customer switching costs are elevated for Apple users as an alternative non-Apple iOS experience does not exist, unlike computing platforms for the Windows or Android ecosystems that boast PCs and smartphones from a bevy of firms. Familiarity matters, and unless users see significantly compelling alternatives (whether it be device ASPs or hardware or software features), we think customers are likely to stick with their incumbent over time, as evidenced by the aforementioned Fluent survey.
Nonetheless, the rise of products such as the Amazon (AMZN) Echo that are compatible with both iPhones and Android devices have the potential to hurt the sales of iOS-compatible products. Similarly, Apple contends with the presence of platform-agnostic applications. In lieu of Apple’s homegrown apps for music, photos, video, streaming, email, messaging, maps, cloud storage, and so on, alternatives such as Spotify (SPOT) , Google (GOOG) Photos, YouTube, Netflix (NFLX), Gmail, WhatsApp, Google Maps, and Dropbox that can be used on both iOS and Android devices have become more prevalent. Consequently, we believe these core applications could ease the transition for a customer moving from an iPhone to an Android device, as they infiltrate the walled garden Apple has built and sought to fortify.
Abhinav Davuluri does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.