The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

13 February 2009

The Big Kahuna

So my brother tells me that a friend tells him to sell his investment in Apple/AAPL, "It is dead money... just like Steve Jobs is dead."

Well, yeah, maybe. Certainly, many investors worry about Steve Jobs' health, not solely for the man and his family, but for the company... and for the stock.

Time has proved Steve Jobs to be a singular force of nature; even while deathly ill he still musters the strength to challenge other CEOs, mano a mano, to a screaming match. All in his visionary quest to get the best deal for Apple, Inc. But we investors and bystanders have the opportunity to see, real time, the mettle of Apple's bench; can the other executives rise to the occasion?

Another worry that plagues many investors is whether Apple's heyday is behind it; that the company's phenomenal cycle of innovation now is a thing of the past. Perhaps. Noone, me included, can really confirm that possibility. Apple's strategy might be best defined as evolutionary rather than revolutionary, with a focus on its three core markets. (iPhone, iPod, and the Mac.) Apple chooses to play in only a handful of businesses that manifest huge addressable markets; the company offers a narrow suite of premium products to these huge markets. Apple is most bullish about its iPhone business, where it has massive opportunity to gain market share (and has done so already); one in which software would be its principal differentiator. (Its operating system and, more importantly, the App store.)

Investing is a discounting mechanism; investors buy today to sell at a higher price tomorrow. And vice-versa. But the process of investing discounts the knowns, the perceptions, and how other investors might react to changing perceptions and changing realities. Sometimes, though, there exist some facts that are little known, if at all.

1) The Apple retail store. Apple has always bordered on a cult, if not a full-fledged religion, what with the Apple fanatics proselytizing the company's products. Someone at Apple had the bright idea to hire the nicest, friendliest, most knowledgable among them, cloak them in the appropriate priestly robes (er, white t-shirts), and have them share with you, gently, the truth, beauty, and elegance of owning an Apple. Each priest -- er, salesperson -- is knowledgable, helpful, and discreet; nary a one pesters you to distraction. God love 'em all. The sales at Apple's stores qualify as a retailer's dream, an amazing $4700/sq ft; leaps and bounds ahead of its nearest competition.

And just today, Microsoft/MSFT announced its me-too strategy, that that company also will open retail stores. Somehow, the cachet of selling goods, damaged while still in the box, does not compare to the Apple experience; i.e., Apple's successful retail sales strategy is a result of its well-designed and lovingly-engineered products and the religious devotion of its consumers. Microsoft offers nothing even remotely similar. Nor for that matter, does any company. Talk about elegance.

) The iPhone. Everyone, me included, splashed water on the notion of Apple building and selling a cell phone. Cell phones were mostly differentiated by shape, color, service provider, and service plan -- until Apple joined the fray. With one fell and resounding swoop, Apple wrested control of the cell phone's destiny from the service provider and placed it firmly into the hands of the phone's builder. Apple dictated terms, and the service providers bullied one another for the opportunity to be the sole seller. In the US, the winner was AT&T, alas, but the iPhone is an instance where the beauty, functionality, and usefulness of the iPhone trump the ugliness of the service provider. Although barely.

But this all is well known. Less well known is Apple's ultra-conservative accounting for iPhone sales. Unlike other cell-phone manufacturers that book 100% of the revenue from each phone sold within the quarter the sale occurs, Apple amortizes the revenue over eight (8) quarters, 2 years! Apple's thesis is to match iPhone revenue with the standard 2 year service contract. This accounting is very conservative, as mentioned, but think about it: iPhone sales reported within any quarter actually represent only 1/8 (12.5%) of the total sales. This means there exists an increasing chunk of revenues yet to report. If accounted for under GAAP, Apple's revenues and earnings from the iPhone would be higher, much higher -- which makes the stock inexpensive, and downright cheap. Go figure.

3) The Applications Store, especially iPhone apps. The Apple apps store upends the entire software business model; previously, a buyer would think long and hard before spending $500 on software; licenses at $30/year also caused buyers to pause before taking the plunge. But at 99¢ -- who needs to think? You buy, and if the program satisfies you, great! And if it fails to work or inspire you, no big deal.

And, suddenly, just like that, everyone has a method to strike it rich, instantly. Write a program, like Ocarina, take advantage of the network effect and sell it to hundreds of thousands of iPhone users, and bling bling, sit back as the cash registers ring. And ring. Yes, you too can be a millionaire.

But I neglect to mention the elegance of this setup for Apple, and Apple/AAPL investors. Apple merely builds and minds the store; non-employees dream up these addictive programs, and sell them on Apple's apps store. The sharing arrangement is 70/30, which means that almost the full 30% of the revenues from the apps store drops to Apple's top and bottom line. The company's SGA for this part of the business is next to nil. Beautiful. The apps store looks only to improve. Who knew?

Oddly, two of the three items above are peripheral to the company's primary mission of making and selling electronic devices. But each also takes advantage of a unique set of circumstances that only a company such as Apple/AAPL, with a visionary leader such as Steve Jobs, can offer.

I could quantify for you even more the value of Apple/AAPL's story, but why bother? You hope to divine the market's every squiggle, a tempest in a teapot, which effort causes you not to see the big Kahuna, the wave that will carry you all the way to shore. Market cycles come, and market cycles go, but value always wins out. Sell Apple/AAPL, if you prefer, because you fear its share price will decline (farther) due to a sloppy market. The best opportunity is on sale at a ridiculously cheap price, growth at a value price. So how about a piece of (apple) pie...?

Full Disclosure: Long Apple/AAPL. And happy.
-- David M Gordon / The Deipnosophist

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