Why Apple’s iPhone Franchise is Sustainable

5 May 2016 | by Arif Karim, CFA

Apple has recently reported its first revenue decline in over a decade fueling concerns that we’ve reached “peak iPhone”. Similar concerns arose in 2012, however iPhone sales are now 60% higher than they were in 2012. These concerns have led to Apple’s stock trading at a PE of just 11x (or just 8x if you remove what we estimate is the ~$25 in excess cash on their balance sheet). This is equivalent to a 7x enterprise value to free cash flow ratio (EV/FCF) for a 14% cash yield.

If Apple can maintain its current free cash flow levels and uses most of it to pay dividends and buy back its shares, as it has over the last 2 years, then over the next 7 years (basically 3 iPhone upgrade cycles), the company will have returned all of its current enterprise value to its shareholders. We believe that the continued loyalty of its current users along with increases in its user base is likely over that period of time and beyond.

While Apple reported its first decline in iPhone sales and guided for another decline in the June quarter, we recognize the high degree of seasonality and cyclicality iPhone sales exhibit. The popularity of design features and the average age/functionality of existing iPhones will impact the exact replacement rates and the cadence of new users switching over from one model to another. In addition, market growth and penetration rates are also important factors to consider. We therefore prefer to look at unit sales over a longer period of time than just year over year for insights and trends. When viewed on this more relevant time frame the trend continues up, albeit at a slow single digit rate as the global smartphone market matures.

iPhone Market Data

AAPL Q Growth

AAPL TTM Growth

In the charts above, you can see that the iPhone business is growing when viewed on a multiyear time frame. Only when viewed on a year over year basis, does the business show a decline. Given that most consumers upgrade their iPhone every two to three years, we think the recent decline is primarily a function of outstanding year ago sales, rather than a decline in core demand.

We estimate Apple’s total addressable market (TAM) to be about one billion consumers worldwide, who buy a new phone every 2-3 years, yielding a unit market size of 300-500 million units annually. So far, Apple has managed to capture a 40-60% share of this market. With the release of the $399 iPhone SE, it has now opened up the potential to sell into an income tier just below their current market. This gives them access to potentially another billion consumers, many of whom likely lust after a new iPhone of their own.

By combining the capabilities of technology with key elements of high-end design, usability, personalization, and an integrated services experience, Apple has been the most successful company in bringing technology to the consumer in an elegant, intuitive, and easy to use interface that allows even toddlers and grandmothers to use its products. It has a history of creating technology products that consumers desire, rather than simply filling a utilitarian need as most other technology companies typically address. The power of this strategy is demonstrated in the lines of people waiting overnight just for the privilege to be the first to hand over a money to access the latest product first.

Across industries, companies which address wants and desires, as opposed simply to consumers’ needs, often exhibit much stronger profit trajectories and returns on capital. Fundamentally, we believe that the market values Apple as if it is the traditional type of technology company that addresses needs when, in fact, it is in the far more lucrative business of fulfilling desires and aspirations. While staring at the massive revenue and cash generation capability of the iPhone franchise in awe, investors also stand in disbelief that the company can sustain those numbers, either because they believe the iPhone will be displaced by another competing product or that fickle customers will move on to the next thing or competition will force it to lower prices, margins, and return. It is only if you believe that the iPhone franchise is at risk of imminent decline that you can justify the ultra-low valuation that the market is currently assigning to their stock.

While technology companies (and all of the cell phone companies that came before Apple) have a history of steep decline rates, luxury brands such as Louis Vuitton, Hermes, Porsche, BMW, Rolex, and Cartier have managed to keep their connection with customers and grow value over much longer time periods. Their customers pay large premiums for aspects of the products that go beyond basic utilitarian needs, resulting in strong returns on invested capital.

Smartphones, mobile devices, and computers are the biggest technology markets around the globe and Apple has the best brand, easiest to use and highest quality products, all integrated into a services ecosystem that migrates seamlessly as the user upgrades from iPhone to iPhone. Because Apple puts technology in service of function, it emphasizes capabilities that matter to the user as opposed to the feeds, speeds, and megapixels its products deliver.

This brings the focus on the well-designed device, its capabilities couched in a simple intuitive interface, its elegance, and the daily needs it fulfills as well as aspirations it can help the user attain. It’s a brilliant strategy that emphasizes the brand and emotion that creates the connection with its users while de-emphasizing the technology that can be threatened by the latest, greatest, cheapest competing gadget.

In addition, by adding new functionality to the iPhone over time, Apple has sucked up consumer budgets from adjacent markets in service of its flagship device. You no longer need a separate point and shoot camera. Or a camcorder. Or a Walkman/MP3 player. Or a PC. Or a second TV. All those billions of dollars get reallocated to Apple’s market and its bottom line while adding value to its customers’ lives with high quality, easy to use, always accessible devices.

The result has been very high customer satisfaction and retention rates averaging 85-90%, rates that are significantly higher than its competitor’s products and among the highest rates across all product categories even beyond technology. Making a switch even harder is that users would have to learn to navigate another operating system and reacquire all of the apps that they have spent time and money downloading on a non-Apple device. Furthermore, in many parts of the world, they are also a status symbol given their high upfront cost relative to more basic or cheaper products that countrymen in less fortunate circumstances can afford.

That brings us to the next point, the value of Apple’s products. Again focusing on the iPhone, while expensive at a face value of $650-$850, the iPhone and smartphones in general, are the most important and personal discretionary device the consumer owns. They serve as the gateway to your entire digital life that has grown to be a very important part of yourself. It is your most used device and will only increase in importance over time.

And, with a life span of two to three years, the cost of the average iPhone translates to less than $1 a day. This is an incredible value per hour of usage for the average smartphone user in any developed country as well as a significant number of users in emerging market countries.

Given how much time owners of smartphones spend using their devices and how important a part of their lives they play, paying up for a premium, more secure, easier to use smartphone is one of the most practical luxuries they can pay for.

In many ways, it’s a lot like a car, in that a Honda Civic will get you from point A to B, but a BMW or Porsche will do it in style, with better performance, arguably safer, with more comfort, and with a higher status (the last is key for many if not most owners). And while many will opt to keep their cars for 10 years, many also opt to replace theirs every three years by leasing them for the best available features, better performance or refreshed styling. We believe exactly the same motivations apply to the smartphone market.

Just as BMW and Porsche have expanded its product lines profitably from their flagships and without diluting their brands, Apple has now released the iPhone SE, its first sub $400 product. We believe this is what Apple needed to do to really start to expand and penetrate into a broader TAM than it’s heretofore opportunity at the very high end $500+ part of the smartphone market. With global smartphone growth coming to a halt recently, Apple’s avenues for growth are through market share gains within its existing TAM or by expanding into the next tiered segment, which still can be very lucrative from a margin and return on capital perspective.

Whereas you could own an iPhone 6S for $1/day (an income segment we estimate at ~$20K/yr and higher), the iPhone SE can be had for just $0.50/day (~$10K/yr and higher) with all the important benefits of the flagship iPhone user experience. We think this will be a tremendous product for Apple if screen size can be considered a secondary feature for the user experience. With about a 10% reduction in product margins by our estimate, the volumes this product could sell would be very accretive to the bottom line with only a modest decline in Apple’s extraordinarily high return on capital, greatly expanding the company’s bottom line profit and shareholder value. However, the utility tradeoff between screen size and the lower price point is the big unknown, since the larger iPhone 6/6 Plus screen sizes were such a big hit in Asia and around the world.

With the rollout of the Apple Upgrade program, customer can lease an iPhone just like a car and trade in their old one for equity value as well (iPhone have much higher resale values than competing smartphones, making trade-ins/leases viable programs). This brings the still sizeable upfront investment into much more palatable monthly payments while also introducing convenient annual or biannual upgrades to new iPhones economical and hassle-free. Now you can literally own the latest iPhone for less than your monthly coffee budget!

While this program is only available in the US, we suspect Apple will roll it out in many parts of the globe over time. We believe the combination of the lower entry price point for an iPhone SE and the upgrade program will unlock a lot of latent demand among those who would like to have one but until now couldn’t afford one as well as driving a higher frequency of replacements, though to what degree remains to be seen.

If one believes that the combination of Apple’s strong user loyalty, market expansion, brand and marketing, and financing capabilities ($200B+ of cash on their balance sheet creates options!) are material sources of competitive advantage then Apple represents a phenomenal growing (on a bi/triennial basis given upgrade cycles) annuity-like business. Its repeat sales to customers delivers tremendous value to the user, while its differentiation allows it to earn significant profits on every device it sells. When multiplied by 200-300 million devices sold every year, Apple becomes a tremendous cash generating machine.

Ensemble Capital’s clients own shares of Apple (AAPL).

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