Why is Warren "Cook"ing an "Apple" "Buffet" ?

This appeared in  The MINT dated June 02, 2016 as an Op-Ed article under Columns > Opinion

Two recent events related to Apple caught my attention over the previous weekend.

Berkshire Hathway's large investment in Apple of  $ 1 Bln last week made headlines the world over. It was indeed an iconic moment as Warren Buffet has religiously avoided technology stocks throughout his illustrious career. What could this be attributed to and, more importantly, did this portend a shift in favor of technology investments? At a time when the NASDAQ is near its all time highs ? !

Tim Cook, the CEO of the most valuable company on earth, lands up in India soon thereafter. For the first time ever ! So late in the game when India is no longer an emerging story ? Compare this with Bill Gates, John Chambers, Michael Dell and Scott McNealy.... all of whom visited India in the early part of 2000s. I still remember the energy and enthusiasm which was prevalent in their closed door meetings with business leaders in Bangalore and the huge interest demonstrated on both sides in learning from each other......these visits resulted in significant investments into India couple of years down the line from these companies.

Is the timing of these two seemingly unrelated events merely a coincidence ? Or is there a larger picture lurking behind the canvas ?

To understand this I first attempted to analyze Warren Buffet's surprising change in approach towards investing in technology stocks. Firstly, by his own admission he does not understand technology and does not own stock even in his best friend’s iconic company....Microsoft. It is highly unlikely that at this stage in his career he would have developed an in depth understanding of technology to make such a large investment. Secondly, he had also once said that though creative destruction is great for capitalism, it is not so for the certainty of investment outcomes....thus industries prone to disruptive technologies did not figure in his investment philosophy. Apple is clearly in this category of companies prone to a high risk of disruption. iPhone contributes about 65% of Apple's profitability and is in its 8 th year. Compare this with the current state of irrelevance of the erstwhile companies dominant in this space over the last decade: Nokia, Blackberry, Motorola, Sony Ericsson, etc and the drift should be clear. Thirdly, if we are to analyze the pattern of investments of Berkshire, the underlying theme has  conventionally been one of consistency and predictability of cash flows...Businesses related to public utilities, energy, foods and drinks, retail, etc. After all, utility companies are natural monopolies (as demand for electricity will always be around with no alternative to cables running into our homes) as will the need for food products….with changing food habits being a huge entry barrier for competitors of his investee companies like Heinz, Coca Cola or See’s Candies !  

Apple just does not fit into this hypothesis! Unless, Buffet is giving a message that Apple is not the high growth stock it used to be and is now to be deemed in the same category as a boring utility/FMCG stock with stable cash flows..... His investment forte. Something he did with IBM .... his only technology investment......in 2011 after its metamorphosis into a services organization. By the way, returns from that investment is still in negative territory after 5 years. 

This leads me to Tim Cook's visit to India.....significant, given that Apple consistently ignored India from its inception. Apple's difficulties in China are well known and is now reflected in its poor results just announced in April, post which the stock tanked by 30% from its peak of $133 to sub $ 90 level. No CEO can ignore such a catastrophic fall in its market cap in the global markets. It is quite obvious that India is perhaps the only market with the potential to alleviate Apple's growth concerns in this situation. And, being a neglected market, the benefits of low hanging fruits are too tempting as a quick fix solution for any American CEO. Hence “humbly approaching India" with visits to Siddhivinayak Temple and Shah Rukh Khan ! A far cry from his public statement in 2012 that ‘India had less potential than other markets’. As if such gimmicks would endear him to the powers that be for special incentives or garner affinity of the masses !!

The challenges Apple will have to overcome as a result of not being meaningfully present in this market are huge. The eco system for i Phones  is under developed and the sales of the product so far is largely due to the 'status symbol' paranoia of the up market, kitty party going Indian buyer. Spotify, for example, does not exist in India ;  neither does a customer centric service offering where a faulty product is simply replaced across the counter in Apple stores. Accessories are terribly overpriced leading to a flourishing grey market. Indians by nature are cost conscious though there is a segment, regrettably, which will go to absurd lengths to outdo his or her neighbour.....but that is not a large number. Though "Apple's U Turn from arrogance to servility" was reported in qz.com post his visit, I did not quite hear anything substantive from Cook  which reflected a climb down from his high pedestal necessary to meaningfully break into the Indian market.....notwithstanding some breathless and starry eyed  anchors on popular TV channels swooning at the imminent opening of hundreds of Apple stores in India with their full range of products. For example, the fact that i Phones are more expensive than in the US due to higher taxes here, but with far less functionality due to lack of eco systems, is a serious challenge surmountable only, in part, by pricing initiatives specific for India till these issues are resolved. However, he insisted that the quality and "value" being highly superior, pricing will remain at international levels and Apple will not participate in the Rs. 12k Smartphone market. Yet, Apple aspires to increase its share of India business from less than 1% of its total revenue.  Secondly he, rather contemptuously, proposes to sell refurbished phones in India to reduce the price points and the permission for which has been rightly refused by the Government. His latest request for waiver from policy conditionalities of 30% local sourcing for single brand retail, ostensibly for being a "high technology" company, was rightly refused by the FIFB whilst clearing its proposal to participate in the Indian market on a level playing field. Mind you, this request was made without any commitment for setting up a manufacturing capacity in India and would have resulted in large scale "dumping" of used phones in the US into our markets. Remember PL 480 of the mid sixties when US dumped contaminated wheat in the name of aid into India ! Simply shocking that this ancient thinking is still being applied to contemporary India !

This entire approach of what is right for US is right for the world, and premium pricing based on "perceived value" rather than what the market can bear, is fundamentally flawed and is the same mistake many MNCs made in the 90s and early 2000s including marquee companies like Digital Equipment (DEC), Lucent and GE....all three companies I had the good fortune to be associated with or observe very closely.  GE learnt from it and survived, Digital and Lucent did not. I still remember the arrogance of Dick Poulsen, Chairman of EMEA and the General International Area and member of the core team of Ken Olsen, the legendary founder Chairman of DEC,  when I made a presentation to the Board on why Digital's cost plus pricing model cannot survive in the post liberalization environment in India in 1993, and needs to migrate to a revenue minus pricing model to match the advent of low cost PCs unleashed by IBM, Compaq, etc. in the emerging open architecture world. His arrogant answer, which rattles me till today, was "these are playthings and not 'real', high technology products for serious enterprise applications which a petty finance manager should not attempt to understand". We could not convince him that the age of super minicomputers was seriously threatened by the advent of powerful 32 bit systems, and that the opportunity to cash in with DEC's revolutionary  Alpha 64 bit RISC processor with attractive pricing for this huge market was limited. He did not agree.... and we all know how Intel, and clones like AMD, reacted in a few years time with the x86 chips  at extremely attractive price performance points. Lucent pretty much did the same folly by ignoring repeated pleas from the local management not to exit the high potential GSM business in India in 2002 due to competitive pricing pressures from rivals like Ericson and Huwaei. They did... and opted for  CDMA instead purely due to its ability to price it higher.... Lucent does not exist today.

Even 2-3 decades later in a vastly interconnected world, Tim Cook very much echoes this same philosophy of intransigence many American managers are infamous for. Both Digital and  Lucent ( legendary Bell Labs was part of Lucent after the trifurcation of AT&T) had awesome research and innovation capability, believed in proprietary operating systems to extract exorbitant prices from its cult following and had huge cash flows. Apple too is strikingly similar at this moment in all these respects. Apple is also perhaps making the same mistake with respect to its arrogance, ignoring large markets like India and trying to play the game without learning from either the past experiences of other MNCs or seeking inputs from its local management team.

Perhaps Warren Buffet has seen through this and believes Apple will not risk a disruptive change in its business model and, given its high innovation capability and strong franchise, will still continue to grow safely at FMCG rates in the secured confines of its existing markets. He is perhaps playing on the belief that  Apple would be akin to a solid income generating utility given that growth is not likely at the company any time soon….however, Cook is perhaps looking to introduce all forms of services  to capitalize on its cult following amongst its hyper loyal consumer base who are unlikely to migrate to an Android platform.  These services will potentially cater to the ongoing need amongst its 400 million plus customer base for apps and connected services like Apple Music, Apple TV, Apple Watch, leasing options, shopping platforms ( both online and offline)  like Apple Store, I Tunes, physical Apple Stores, etc.  This is, therefore, essentially a play on the retention of its cult stature amongst its followers and their customers’ ability, and indeed willingness, to continue supporting the hilarious pricing proposition ( rather than more rationally priced options of competitive brands ) for Apple’s largely undifferentiated current product range.  Of course, it’s massive cash balances allow it the flexibility and time to experiment for a few years.  However, how  this will prevent an erosion of value due to the risk of disruptive competitive technologies  is not clear.... maybe this will be his second technology investment after IBM which will test the patience of his investors. At a PE of 10x there is not much downside, or upside, to the stock……and with huge cash flows, a vintage Buffet investment after all ! 

(PRABAL BASU ROY)

A Sloan Fellow from the London Business School and a Chartered Accountant, the writer presently manages a PE fund and has formerly been a Director and Group CFO in various companies.