Does the iPhone have a Moat?

When you buy a stock, you are exposed to two risks:

  1.  business risk
  2. investment risk.

The first risk is related to the performance of the business. The second risk is related to the price you pay as an investor.

When you buy a “wonderful business”, business risk is generally (hopefully) low. However, you may overpay, and expose yourself to investment risk.

When you buy a cigar butt; you know that the quality of the underlying business is not particularly great. But if you can buy it at a large enough discount, you can protect yourself from investment risk – especially if you pool a bunch of such bets.

In the last post, I valued Apple at about $120/share, based on a no-growth assumption.

If Apple doesn’t grow, and I buy it at $120/share, I should expect returns equal to my discount rate (here, 10%).

If the thesis of a profitable, no-growth, high-end player is intact, then we can control investment risk by demanding a sufficient margin of safety: “I need a 20% margin of safety, I’ll only buy AAPL if it falls below $100!”

But what if the no-growth rate itself is optimistic. Apple’s value is predicated on the iPhone.

If the iPhone dies, Apple sinks.

There are plenty of good reasons to bet against the iPhone:

  • The smartphone market isn’t growing as explosively as it once was. The market penetration in developed economies is almost complete.
  • The low hanging fruit has been picked. When Apple launched initially, it was only available on AT&T. Then it expanded to other carriers, and around the world. Then came China. Then came bigger iPhones. Then came cheaper iPhones. Every perceived pocket of demand now looks like it has been echausted. We may be past peak iPhone.
  • Apple’s focus on the high-end is not a position of strength in picking up the remaining smart phone holdouts, which are generally concentrated in relatively poor countries.
  • Smartphones have become good enough. A good $150 Android smartphone offers most of the smartphone features that an iPhone does. Capitalism has worked. Apple’s high margins have attracted other players, and commoditized the business.

On the other hand, one can conjure good reasons why you shouldn’t bet against the iPhone just yet:

  • This is a personal observation, but I believe that the mobile phone is a durable format. If the screen gets too big (-> tablet), it doesn’t fit into our pockets/purses. If it gets too small (-> watch/glasses?), it becomes difficult to read/interact.
  • Some people think that wearables/VR will eventually supplant the iPhone. Perhaps they will. But I remain somewhat skeptical that this will happen soon. Consider Google Glass for instance. Wearing glasses is not something people generally do willingly (think Lasik). Besides, head-sets are intrusive. Unlike a phone, it can’t be conveniently stowed away.
  •  Perhaps, voice (ala Echo) is the next frontier. My suspicion is that voice will be another layer, not a substitute. Some things (think graphs or cartoons) are hard to communicate in words. “A picture is worth a thousand words”. As an input method, I can work on a document for 8 hours a day. But I would not be able to dictate for the same amount of time. Besides, voice is not discreet: which is a problem in a coffee shop, airplane, or an open office.
  • It is possible to make the case that Apple doesn’t play in the same field as other Android makers. Due to its differentiated software and services, it offers a complete user-experience. While hardware may be commoditizable; user-experience might be harder to replicate.
  • Currently, Apple has a powerful virtuous cycle going on for itself. It builds high-quality products. “Rich” people are willing to pay top dollar for quality. Even though iOS has only ~15% market share, app developers think that the most “desirable” consumers are on iOS. This results in high-quality apps for iOS, which strengthens the quality of “ecosystem”. As long as Apple builds high quality stuff (something it can control), this cycle can be expected to persist. This is how universities like MIT maintain their edge. The best students want to go there, because the best professors are there, and vice versa.
  • Yes, iPhones are expensive. But imagine the value that they (smartphones in general) provide. When you consider the number of different tasks that phones enable us to do, paying a dollar or two for those services doesn’t seem too burdensome. Apple has been able to do something similar with the Mac. Although it is more expensive then a “comparable-spec” PC, it has been able to maintain a ~15% marketshare in the US, a larger fraction of mindshare, and nearly half of the industry’s profits.

Another reason is “Apple-creep”. How one Apple device primes you to make your next one another Apple.

I’ve owned Macs almost continuously since 2000. I like their quality, their longevity (I usually squeeze 5 years without any problem), and their ability to let me inhabit the world between Linux and Windows.

Then in the late 2000s I bought an iPod, because I don’t like to lug around a big phone when I am running. I’ve bought two more iPods, two MacBook Pros, a Mac Pro, two iPads, and am contemplating my first iPhone. We will see.

I am not saying the iPhone can’t fail. In fact, if you ask me “will the iPhone be around in 50 years?” – I probably would say “No!”. But, if you ask “will it be around in 10 years?”

Probably.

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