The 350 billion dollar hole

Why did Apple lose $350 billion dollars in 3 months?

I was intrigued by the nose-dive in Apple's stock price in Q4 of 2018 - it lost $350 billion in 3 months. I wanted to know what about Apple had fundamentally changed? To put $350 billion into perspective - that's the market cap of JP Morgan Chase, the largest bank in the US or the GDP of Norway! The news attributed the drop to slowing iPhone sales, a weak Chinese economy and the US-China trade wars. Most blue-chip tech stocks were probably also due for a correction, yet the magnitude of the drop didn't add up. First, we've known that the smartphone market is at or close to saturation - after all, 4bn smartphones already exist for the 5bn people on the planet. Second, China is important for Apple (its 2nd largest country at 20% of revenue) but its competitive advantage has always been weak - the iOS ecosystem doesn’t lock in users as it does in the rest of the world. Third, the political uncertainty, especially on tariffs seemed to be the new information that the market was trying to price - but if that was the case, why was Apple being punished more than other consumers companies?

Unconvinced, I decided to dig deeper, here's what I learnt.

The end of the iPhone super-cycle

The sheer number of iPhones produced is astonishing - 1 billion have been sold. No other consumer electronics product comes close in quantity, let alone in value. From, 2006 to 2015, unit sales increased from 12 million in 2008 (with the launch of the iPhone 3 model) to 231 million in 2015 at a CAGR of 53%! We are all inspired by Apple design but for a moment, think about the supply chain complexity to achieve this scale of production and distribution. Eg Foxconn, Apple’s primary iPhone manufacturer employes 300k people and depends on parts from 200+ suppliers!

During this time, along with exponentially increasing unit sales, Apple also managed to increase the average selling price (ASPs) (from $300 to $600 per unit) and operating margins from 22%-30%. This resulted in unprecedented cashflows and made Apple the greatest cash machine ever. Apple’s $1trillion market cap (in Sep 2018) isn’t just because of a well designed iPhone, it ’s because that iPhone generated volumes and profits that were unprecedented!

But, (and there's always a but), the iPhone super-cycle is over. Sales peaked in 2015 at 231M and have been flat for the last 3 years. This is not an Apple specific problem, it is true of the broader smartphone market - most people who need a smartphone already have one and the incremental benefit from an upgrade isn't worth it. Investors hoped that Apple would be able to defy the laws of saturation with each new iPhone model but have been disappointed.

Apple probably already knew that they had peaked in 2015, for a number of reasons

• there are 1.2 billion active iPhones (90% of the 1.3 billion iOS devices), so basically anyone who can afford and wants an iPhone, already has one.
• smartphone technology has matured, so improvements are incremental which results in longer replacement cycles. [Which was the best selling iPhone model? Answer - the iPhone 6. So despite Apple's claim that the iPhone X is the "best iPhone yet", for Apple the iPhone 6 was the best and it will probably stay that way.]
• their pricing strategy in the last few years has been to maximize revenue ( by increasing ASPs) rather than drive volume. iPhone users have been fairly inelastic to these increases, however, it results in longer replacement cycles as people try to attain the same lifetime cost, ie. you are ok using a $600 iPhone 6 for 2 years, but will try to replace a $1000 iPhone X after 3 years.
• finally, they've seen this super-cycle play out before with the iPod. The iPod was a blockbuster in its time but pales in comparison to the iPhone. The iPod peaked at 55M units, ? the iPhone peak and at ? the ASP.

So what's the next super-cycle - will it be augmented-reality glasses or an autonomous car? Neither. It's going to be services - less sexy but a whole lot more stable.

The beginning of the Services super-cycle

Services aren't new to Apple, they've had them since the early days of the App Store. But it has never been a priority, therefore it's no wonder that Apple's services are pretty terrible. I think the approach Apple took was to make iOS the preferred app development platform but keep consumer services sufficiently good. For example

• Siri had the first mover advantage (launched in 2011) but has lost out to Alexa (launched 3 years later) and Google Assistant
• iTunes was revolutionary during the iPod era and should have been the default music streaming app on the iPhone (like Internet Explorer on Windows) but ceded leadership to Spotify
• the iPhone camera has always been cutting-edge but iPhotos has been slow to use machine learning to organize, search and surface memories, an area where Google Photos shines
• iCloud is more expensive and less versatile than Dropbox

Why did Apple let its services lose? I use the word "let" because Apple made a deliberate prioritization choice - don't compete on service features and price, rather lock people into the iOS ecosystem with the best software and hardware. The result maybe poorer services today but they have built the most valuable captive eco-system in the world - 1.3 billion active iOS devices. Now as iPhone sales slow, Apple will start to do 2 things to grow revenue - sell ancillary devices (Apple watch, Airpods, Glasses?) and monetize services.

If you've been paying attention, you would have noticed that both these strategies are already in play. For example; I've been sucked into buying more Apple devices - Airpods (which are amazing but my free iPhone headphones were just fine too) and an Apple watch (which again is nice, but hasn't been the fitness game-changer I convinced myself it would be). So I may have skipped upgrading to the iPhone Xs this year but I still bought $500 worth of Apple hardware.

In recent years, Apple has improved some services and I expect the pace to increase - the App store was revamped making purchases and discovery easier [iOS 11, 2017], iPhotos got better editing and AI organisation and memories [2018]. Apple Music and Apple Pay are being marketed aggressively.

In 2018, Apple stopped reporting iPhone unit sales. Sceptics accused Apple of obfuscating information. I have a different view, iPhone sales are not the term business driver they used to be. With the shift to services, the number of active users is the new barometer of future revenue growth. And that is exactly the data Tim Cook mentioned last year - the number of active iOS devices reached 1.3 billion in 2018.

Services revenue has been <10% and was hardly ever talked about. However, growth has been strong (30% CAGR) in the last 3 years and will hit $35 billion in 2018

So, how much is Apple worth?

Circling back to my original question - What about Apple has fundamentally changed and how does it impact Apple's valuation? I've answered the first part - the iPhone super-cycle is over but it has created the world's most valuable eco-system, which sets the stage for the services super-cycle. To answer the second part, I valued Apple based on the DCF method factoring in the impact of this change on revenues and operating margins. I used Prof Damodaran's Apple valuation in Sep 2018 as a starting point.

I value Apple at $860 billion - $1.12 trillion or $175-$228 per share. That's a pretty wide range but is warranted given the uncertainty as Apple switches to services. The good news is that it is significantly higher than the current price $157, so either the market hasn’t priced it in or I’m completely wrong! I've created this scenario table that shows the what the valuation might be holding all other variables constant, based on your assessment of revenue growth and margins, you can pick your own target price/share. Details of my assumptions are in the notes.

The last question I asked was - Why is there such a large disconnect between my valuation and the current price? Prof Damodaran has a great perspective on it, that you can read here. In summary, valuation and price are 2 different values which should converge in the long run. Valuation is each one’s unique assessment of a company, so it will be different depending on your expectation of cash flows and risk. I’m sure a lot of people will disagree with my valuation, which is ok and expected. The price is the point at which the market clears (Economics 101 - demand-supply curves). Though, I’m surprised that the delta is so large for a company of Apple’s size and credibility. Maybe I’m being overly optimistic but the services super-cycle is the only way for Apple to go beyond a trillion dollars. If I’m right, expect much better Apple services but also be ready to pay for them.

Disclaimer - These are my personal views and shouldn't not be taken as investment advice or recommendations. Disclosure - I own Apple stock.

Notes on my valuation:

Prof Damodaran’s base valuation in Sep explains the methodology better than I ever could and is the model I’ve used. The key valuation levers for a DCF valuation are i)Revenue growth ii) Future operating margin ii) Cost of capital.

Revenue growth

• To arrive at total revenue growth, I projected product and revenue individually. The 5-year trailing CAGR has been as high as 40% in 2012 and then dropped to 9% in 2018. I expect product revenue growth to drop further to 3% as the market saturates and there is pressure to reduce ASPs. This is pretty pessimistic but reflects the challenges in China and the overall commoditization of smartphones. I expect accessories (watches, airpods, etc) to be somewhat successful but not blockbusters.
• Services growth will be driven by the number of users and rev/user. The number of devices is about 1.3 billion and will grow slower than the rate of iPhone sales, so 2%. Since users aren’t going to grow, the lever is growing revenue/user - which is about $26/user/year today. I think its reasonable for this to grow at the current 12% CAGR over the next 10 years - that will take revenue in 2028 to $80/user/year - it is high but fairly reasonable for people who pay $800 for an iPhone. There are also a lot of services to monetize - App Store (games, entertainment), Apple Music, ApplePay, iCloud, etc
• This results in a total revenue CAGR of 5% - I’ve used a 4%-6% range for my final valuation. The terminal growth rate is the risk-free, in this case, 3%.

Operating Margin

• Apple's current blended operating margin today is 27%, I’d assume services is close to 30% driven by high app store margins. I expect the mix of services to change and Apple to optimize for total services revenue which will result in lower absolute services margins.
• Product margins (still largely iPhone) will contract as smartphones get commoditized.
• I expect overall margin to be about 20-25%.
• Cost of capital - I assume that the CoC will remain approximately the same, around 8.2%.