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Apple (AAPL) Stock | NASDAQ: AAPL

The iEcosystem

Apple designs a wide variety of consumer electronic devices, including smartphones (iPhone), tablets (iPad), PCs (Mac), smartwatches (Apple Watch), and TV boxes (Apple TV), among others.

The iPhone makes up the majority of Apple's revenue. Apple also offers its customers a variety of services such as Apple Music, iCloud, Apple Care, Apple TV+, Apple Arcade, Apple Card, and Apple Pay, and others.

Apple's products run internally developed software and semiconductors, and the firm is well-known for its integration of hardware, software, and services. Apple's products are distributed online as well as through company-owned stores and third-party retailers.

Growth

37

Valuation

82

Quality

85
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Where Are We Now

Updated on: 11/6/2021

Conviction Score

8

Apple currently remains the “luxury” brand of consumer electronics that always keeps us on our toes. It forces us to think forward by always being one step ahead of the competition, fostering an ever-growing ecosystem of products and services that work together seamlessly. We think the company is fairly valued today but see better opportunities in other “big tech” businesses.

  • Mac, iPhone, iPad, AirPods, Services, you name it – consumers can’t get enough. All segments are growing tremendously as the company crossed $365 billion in revenue in 2021 and nearly hit $100 billion in profit.

  • We think the company is one to own for as long as great new features, services, devices, and product lines are being introduced. The company benefits from the most committed consumer base on the planet.

Investment Thesis

  1. One of the truly great businesses of today, Apple has created an ecosystem of elegant technology products and services that consumers around the globe love.

  2. Apple has created a powerful ecosystem of products and services that work together providing additional utility the more devices and services consumers purchase.

  3. The business flexes pricing power year over year for products that customers cannot imagine their life without. These products demand premium prices for Apple’s commitment to excellence in product design. Everything just works.

  4. Apple owns both sides of the tech ecosystem, hardware and software. Apple has created a monopoly-like market when it comes to services operating on their hardware, like the App Store which Apple charges a large take-rate of publishers on the store.

  5. The Apple Ecosystem has created a network effect and high switching costs allowing them to print free cash flow at never seen before figures. The cash flow can be used to fund optionality in the ecosystem and reward shareholders by continuing dividend increases and share buybacks.

The Basics

Apple is a hardware and software company focusing on creating revolutionary technology for consumers. They introduced the world to the idea of a smartphone after the iPhone release in 2008. It changed the way we think of communication and technology, paving the way for more innovation down the line. Apple's well-known brand and stellar product design changed the way consumers think of technology, holding an exceptional standard of quality.

The business is divided into two main segments — Products and Services.

Apple has integrated these two business segments to a level at which the success of one is dependent on the other. The products and services offered cannot even be called "complementary"; the product requires Apple services to function and vice versa.

Apple has designed its "ecosystem" in a way that the well-known premium quality of Apple can only be obtained from Apple.

Unlike Android devices or PCs, Apple created and uses its own operating systems — iOS for the iPhone, macOS for the line of Mac computers, and iPadOS for the iPads.

Recently, Apple even removed Intel processors from its Mac products and replaced them with its own line of internally created M1 processors. This moved is enabling faster speeds on its computers and longer battery life, a win for Apple as its users will have access to arguably the best computers in the world.

These are some examples around why it is so difficult to compete against Apple. It hosts a seemingly impenetrable ecosystem that users love and cannot get enough of.

Apple Annual Revenue ($M) (Q4 2021)

Source: Apple Investor Relations

Under its hardware business, Apple sells the iPhone, iPad, MacBook, and accessories. These accessories include AirPods, Apple TV, Apple Watch, Beats, HomePod, iPod touch, and other accessories.

On the service side, Apple generates revenue from platforms such as the App Store, iCloud, Apple Music, Apple TV+, and Apple One through subscription models. Services can be further broken down into the following categories:

  • Digital Content (App Store & Subscriptions)

  • Advertising & Licensing

  • AppleCare

  • Cloud Services (iCloud)

  • Payment Services (Apple Card & Apple Pay)

These services are highly complementary to Apple's products and are used by every Apple product user in some capacity. For example, you cannot use an iPhone and download apps without using the App Store, or Apple TV without a subscription to its content library.

Other services like Apple Card and Apple Pay are more discretionary, but the convenient access and payments abilities they enable make it highly compelling for Apple users to use a digital payments service already within the "iEcosystem".

Apple Product Segment Revenue (Q4 2021)

Source: Apple Investor Relations

Apple Service Segment Revenue (2020)

Source: Trefis

Financial Overview

Apple generates a ton of revenue with consistently high margins despite operating in a highly competitive product market. Several forces in effect that help keep Apple's margins afloat amid intense competition and rising research & development costs as a percentage of revenue are hardware price increases, growing revenue share captured by the higher-margin Services segment, and operating leverage from the growing installed base of services.

Apple Revenue ($M) (Q4 2021)

Source: Apple Investor Relations

Apple Free Cash Flow ($M) (Q4 2021)

Apple's revenue and free cash flow actuals have hit historic highs in 2021. Over the past decade, the trend is clear — up and to the right.

However, beneath the surface, there is a fair bit of volatility. iPhone revenues (Apple's largest segment) hit a high in 2015 that had not been surpassed until this year.

Apple's iPhone sales ebb and flow with its "product cycle". iPhone users have been increasing the duration they hold onto their old iPhone models for as the average price point rises consistently. However, every three years or so, the general iPhone population is due for an upgrade. When this moment hits, Apple will see a large jump in sales, similar to 2015, 2018, or 2021.

The ideal situation for Apple would be more consistent and steady sales growth, but this is the nature of a hardware-majority business.

Despite this volatility, Apple is a cash flow generating machine that persistently rewards shareholders. Share buybacks and dividends have been consistently part of Apple's "shareholder return formula".

Apple's Capital Return to Shareholders ($M) (Q4 2021)

Building Revolutionary Technology

The origin of the name Apple was simple. Steve Jobs loved apples, because they were “fun, spirited, and not intimidating”. He took that idea and merged it with his passion for computers, thus the beginning of the Apple Computer.

On April 1st, 1976, three entrepreneurs, Steve Jobs, Steve Wozniak and Ronald Wayne founded Apple Computer Company. They released a product called the Apple 1, a hand-built motherboard with CPU and RAM, going on sale for $666.66. The market loved the product because it was a basic kit, with all the needs to act as a computer. The product was a hit and Apple Computer Company started getting more traction from bigger investors.

Apple released more iterations of their computer, such as the Apple 2 and Apple 3, all having substantial upgrades compared to their predecessors such as the use of cell-based colour graphics.

By the end of the 1970s, Apple had a full staff of computer designers and a dedicated production line to produce these computers.

In 1984, Apple stunned the world with its revolutionary technology of the Apple Macintosh. It was the first personal computer with a built-in screen, a graphical user interface along with a mouse and keyboard. The public loved the product, and it took a new look at the personal computer.

As the years went on, Apple was not able to successfully bring forth products such as their Macintosh and went into a period of decline and restructuring.

After about 15 years of restructuring, Apple released a product that changed everything. In 2007, Steve Jobs introduced the iPhone, the first handheld phone with touchscreen capabilities. This product took the world by storm, selling 270,000 units within the first 30 hours of selling. The company introduced the idea of the now known smartphone.

As the years went on, Apple continued gaining momentum from the iPhone, releasing products such as the iPod, MacBook, iPad, and more.

To date, Apple has revolutionized the way consumers look at technology through their breakthrough of the personal computer, smartphone, and tablet.

Competitive Advantages

The Apple Ecosystem

Since the iPhone's introduction in 2007, Apple’s total revenue has skyrocketed. What's more is that its customers appear to take their collective loyalty to a new level with every additional product or service Apple comes out with. What is allowing this company to maintain such high dominance in a world with tons of other choices? The Apple Ecosystem.

This ecosystem allows any recent Apple product to communicate with one another and connect seamlessly with any of Apple's services. It gives the consumer a convenient and efficient experience with enhanced capabilities when using products and services within the Apple family.

Apple Devices TogetherSource: BuisnessInsider

Apple's strategy is to get as many users into its ecosystem and hold as many of their personal assets (i.e., photos, videos, content, music, streaming services, messaging, and other services) within the Apple ecosystem. As a user gets acclimated to the ecosystem, they will generally ramp up usage of Apple's main products and services, as well as any other ancillary services.

Users find that the Apple Ecosystem allows for an increase of marginal utility as the more products one owns, the more add-on features one can access. This is why the ecosystem is incredibly sticky and Apple product users are extremely loyal to the brand. The more you own, the less likely you are to switch to its competitors, who do not benefit from the same effects (i.e., switching from one Android phone to another is generally easy and does not impair experience).

We can see the effects of this stickiness in our daily lives. For example, users can access all of their photos in a single place, regardless of the Apple device they use, through iCloud.

Another interesting feature is the level of integration between an Apple Watch and MacBooks. If a user owns an Apple Watch and a MacBook, the Watch can unlock the MacBook if they are under the same Apple ID and are in close vicinity of one another.

Apple's ability to utilize exercise optionality, by encouraging users to buy more of their products, ensures consumers continue to use Apple products while also buying more of them.

Today, there are now over 1 billion iPhone users. While the growth rate has been slowing, Apple has captured 1/7th of the world on its ecosystem through iPhones alone. The number is obviously higher when considering the number of Mac, iPad, and other Apple product users.

Apple is an exceptional hardware and software company with numbers that show for it. We think Apple provides a highly compelling ecosystem that grows in utility. The longer users stay on it, the more difficult it is for existing users to cut ties with Apple for competing products and services. The ecosystem is the main reason (next to high quality of products) behind Apple's pricing power that is its ability to charge premium and rising prices with each new model.

Apple iPhone Installed User Base (M)

Source: aboveavalon.com

Vertical Integration

Unlike other hardware manufacturers, Apple is vertically integrated to an extent that others simply are not. Apple owns each aspect of its ecosystem — hardware, software, services, and sales.

Not only does Apple have near-full control over its entire product and service stack, it also opens up opportunities like economies of scale, non-conflicted sales (i.e., Apple only sells Apple at its stores), and highly optimized software and services for its products.

No other company can compete with Apple's level of vertical integration. Although there are other great products out there, they are not as optimized, seamless, and integrated within an ecosystem to the extent Apple products are. With that, we think Apple's vertical integration has been, and will continue to be a key to success.

Simplicity

"Simple can be harder than complex: You have to work hard to get your thinking clean to make it simple. But it's worth it in the end because once you get there, you can move mountains."

Steve Jobs loved simplicity and his legacy has lived on. Apple prides itself on its attractive aesthetic design and embedded product / service simplicity. These intangible traits have also contributed to Apple's strong brand and loyal user base.

Making things simple is almost always a great business. Apple's focus on usability, design, seamless integration, and flexible functionality captivate new customers and keep existing ones within the ecosystem. "[Apple's] devices just work", as Steve Jobs had famously said.

The Ecosystem Cycle

Apple today is clearly a different Apple than it was in the 2000s. Many new products and services exist today that many users cannot imagine living without generate billions of dollars for Apple.

A prime example of this is Apple's AirPods.

AirPods now generate as much revenue as entire companies, like Netflix. They also generate more revenue than uber large companies like Adobe, Nvidia, AMD, Spotify, and many others.

AirPods took the market by storm due to their ability to efficiently interact with a user’s Apple devices. These wireless in-ear headphones were the first of their kind to go mainstream. The technology enabled users to place the Airpods into their ears and connect automatically to their Apple devices with a headphone jack.

Apple Airpods Against Other Companies RevenueSource: StatsPanda
Airtags with other lost item beacon productsSource: BusinessInsider

Another example is Apple’s recently launched product, AirTags. These tiny devices are attached to commonly lost items, such as wallets and keys, to act as lost item beacons.

If someone were to lose an item with an AirTag attached, surrounding iPhones that pass by the tag can actively update the location of the missing item through the cloud, creating a powerful network effect (once again, a link to broaden the iEcosystem).

Considering the fact that there are nearly 1 billion active iPhones right now, this technology is more enticing to purchase compared to competitors, such as the current market leader, Tile.

Even though the product was recently released, it is set to dominate the lost item beacon market by a large margin.

Everything connects seamlessly. Everything just works.

Aiding Apple is its users' near-inelastic demand (users are willing to pay higher prices for Apple products merely because they are Apple products) for its products. As it innovates and makes seemingly minor tweaks to products we know well, they tend to take off in popularity and occasionally become a fashion or status statement (think AirPods vs. other wireless in-ear headphones). Apple's customers' immense brand loyalty enables Apple to enter any technology market or create any product and be successful.

We think Apple products and services are highly compelling offerings to existing and non-Apple technology users. As long as Apple continues to draw users and expand its ecosystem with highly sticky secondary products, features, and services that draw on network effects, we think Apple will continue creating highly profitable product lines that we could not have imagined. This is what optionality is, and it is extremely difficult to model in a DCF (i.e., discounted cash flow) model.

The Bottleneck Effect

Aside from dominating the hardware side of the industry, Apple has created a monopoly-like market when it comes to software through its App Store.

The App Store is a built-in program in all Apple products that gives users access to download applications onto their devices.

The App StoreSource: MacRumours

Today, there are nearly 2 million apps on the App Store. In order to make this service profitable, Apple charges a hefty 30% fee for all transactions made on apps hosted. This is incremental to a Developer Account Fee that Apple charges each user to publish apps on the App Store.

With Apple having over 1.6 billion active Apple devices, companies target the App Store to distribute their software. The App Store is one of the most popular ways to get the app in front of consumers' eyes. Despite having other options such as Google’s Play Store, the reach, popularity, and network effects inherent in Apple's ecosystem encourage developers to leverage Apple's platforms.

The App Store creates a bottleneck as most third-party software revolve their business around it and iOS. This "bottleneck effect" effectively gives Apple control over what apps and software enter the App Store, and it takes a large cut of the resulting revenues. In a way, Apple is helping spur the "creator economy" present in the app development world and will inevitably benefit from its growth.

Risks

Can the Reign be Sustained?

There are concerns around Apple's ability to continue its momentum going forward.

Will Apple’s iEcosystem prevail? Will users be willing to give up Apple for competitors? Will the iPhone continue to dominate? These are questions investors should continue to ask as they look at the long-term goals of this company.

We continue to think Apple will foster an impenetrable ecosystem for years to come. Its highly sticky and superior products, strong network effects, and consistent innovation provide value to existing and potential users despite the high price point(s) for many products.

We are, however, concerned about Apple's tendency to raise prices. While we believe prices have generally been raised commensurate to the quality of product offered, there could be a tipping point after which users begin to switch for competing products. We are watching the installed base of products closely for signs that users are switching. Fortunately, there are no such signs yet.

The Risk of Leakers

A near-term risk is Apple’s upcoming releases. As this company is at the core of all things technology, Apple is frequently in the news. Many individuals dedicate time and effort to uncover Apple’s new products and to see what the company has in store for its next release. This information is always released to the public to stir some excitement and discussion.

The issue with these leaks is they oftentimes attract too much attention. This could be potentially destructive if articles and news release inaccurate information. Consumers might anchor themselves to a higher or currently unattainable expectation of the product or service. Apple may then disappoint the collective Apple community if it were to omit features in the final design of the product that were perceived by customers to be a certainty. Customer frustration or fatigue could lead to poor sales while competing products gain customers.

Legal Implications and Regulatory Scrutiny

Apple's "bottleneck effect" has essentially created a monopoly around app monetization. This has unfortunately stirred many issues with large companies like Epic Games and Facebook.

Companies believe Apple's 30% cut of in-app transaction fees while also having sole control over what can be sold on the platform are restrictive and a potential abuse of power. There is no other alternative for Apple users, which represents a group of over a billion people.

Although Epic Games lost its case against Apple recently, we believe these sorts of cases will continue to arise as other companies attempt to scale through the App Store. These cases could eventually lead to rate cuts and other amendments that impair Apple's ability to monetize the App Store as well as it has been doing.

Apple Against Epic GamesSource: TechStory.in

Privacy and War with Zuck

Apple’s new software update gives users more freedom in who is allowed to access their data. Facebook, being an extensive data collector, is troubled by this as it affects the business heavily.

In the last few years, Apple has been under legal scrutiny by the Department of Justice for its practices in monopolizing the software market. If large companies are hurt by Apple's moves, this may attract a lot of attention from regulators that could once again impair Apple's ability to monetize the App Store as effectively.

Bottom Line

Apple has changed the world.

Its reign began with the Apple Macintosh, revolutionizing the way we think of personal computers. This momentum carried on with the iPhone, iPad, and iPod. Overall, Apple has changed technology and product design for the better with its innovations.

The company’s iEcosystem opens opportunities to exercise explosive optionality and encourages users to buy more products due to its rising marginal utility effect. Apple has also created a strong moat and network effects through its App Store, controlling essentially all software distributed through Apple’s devices.

Despite risks around the App Store monopoly, regulatory scrutiny, and consumer pricing fatigue, Apple still continues to dominate the tech industry with its exceptional brand image. As long as it continues to improve the iEcosystem by introducing new products and sticky, useful services, we think Apple will continue to be a global leader in technology hardware and software.

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