Ensemble Capital Client Call Transcript: Apple Update

20 October 2017 | by Sean Stannard-Stockton, CFA

We recently hosted our quarterly client conference call. You can read a full transcript HERE. Below is an excerpt from the call discussing our investment in Apple (AAPL).

Excerpt (Sean Stannard-Stockton speaking):

We’ve talked about Apple in past calls and it’s a stock we’ve owned for a long time because our research has shown that it’s a company with competitive advantages, especially in its iPhone franchise.

Recall that the last time we spoke about the company on one of these calls was a year and a half ago when the stock was trading at about 10x earnings, near a low point, as the market had become disillusioned with its recent iPhone business trends. This had also occurred in 2013 for similar reasons. Our contention had been that Apple’s products are sticky with customers because it stirs emotional connections with its technology products and brand while its operating system, ecosystem of apps and services, and integration across product lines make it easy for its users to really integrate technology into their increasingly digital lives.

As a result of its simplification and integration of technology, and its brand, status and ecosystem, Apple has been delivering tremendous value to its customers even as it extracts a great profit. It’s the ideal type of business to own; selling a product that customers can’t live without, that is differentiated from the competition, and provides so much value to customers that it allows the business to generate high profits while leaving quite a bit of excess “surplus” value for its customers to enjoy as well, leaving them “delighted”, as Apple refers to the emotional state they seek to achieve. That emotional word is so associated with Apple’s products that it may as well be trademarked by the company!

Having said that, the stock is up over 40% since our call last spring (leaving shareholders “delighted” as well!) and more appropriately reflects the value that we’ve recognized in the company. While the market tends to have a fair bit of volatility in its assessment of what Apple’s stock is worth from one iPhone cycle to another, our assessment of its value has been consistent, with only small changes over the last year as we obtained more information about the company’s financial results.

Apple’s sales from one iPhone cycle to another tends to have some degree of volatility to it as the overall smartphone market has matured and slowed its growth to a low single digit rate while customers’ specific purchasing behaviors when it comes to upgrading has been “peaky”, depending on the timing of their need or desire to upgrade to the next iPhone.

As a result, we had a big surge of customers whose first iPhone was the 4S in 2012 followed by a major upgrade cycle in 2015 with the iPhone 6 and now market expectations are that many will find the recently announced iPhone X and 8 models to be compelling enough to upgrade again, causing optimism as to what sales numbers will be.

From our perspective, these peaks and valleys around iPhone cycles represent cyclical, but predictable, sales and profit trends that can be “normalized” across 3-year product cycles so long as we can be confident that Apple will retain the majority its existing customers when they next choose to upgrade their phone. As its base of iPhone customers grows every year, subsequent peak cycles should represent higher sales levels as should the sales valleys and that is the pattern we’ve historically witnessed and seems to be true today.

Interestingly, the iPhone X represents a more aggressive push for Apple’s pricing model, one in which the company is sub-segmenting its already high-end base of customers. We believe the applicable market for $350-$1,000 iPhones represents about 20% of the world’s most affluent customers. When Apple released the iPhone Plus models at the end of 2014 with the launch of the iPhone 6 Plus, it increased the price of the larger 5.5” screen model by $120 over the base 4.7” screen model, its first experiment with price segmentation. The larger screen was adopted with enthusiasm, with nary a complaint about pricing and nearly half of the last iPhone 7 cycle comprised the larger, more expensive Plus model.

With the iPhone X, Apple is proposing a $200 price increase over the Plus models on the back of a new form factor that features a new edge to edge higher quality OLED screen and sophisticated 3D Face ID technology replacing the Touch ID fingerprint security system. But really, the iPhone X is all about further sub-segmenting the 600 million base of iPhone users and getting 10-30% of the most affluent, status and technophile centric users among them to pay more for the most advanced iPhone Apple can create today. These are also the users who have the highest “surplus” value accruing to them given their relationship with the brand and the phone. And now Apple is trying to capture a greater portion of that surplus value by delivering a new iPhone at a 25% higher price.

And it’s not just the iPhone X that is seeing a higher price and rebalancing of the value share between Apple and its customer. The latest “regular” iPhones, the 8 and the 8Plus also see a $50 and $30 price increase, respectively. The combination of a new iPhone form factor driving more of the existing user base to upgrade their iPhone 6 and 6s’ and the higher selling prices has resulted in a dramatic closing of the gap between Apple’s share price and our assessment of the company’s intrinsic value, since last April.

As many of you may have noticed, that has led us to target a lower weight for our Apple position in client portfolios. Our opinion of the company hasn’t changed, and we still believe the company is worth more than the current price, however the discount to our fair value estimate has shrunk significantly as that value has become more widely recognized by the market, which means that the risk/reward trade-off has changed as well, effecting the amount of Apple we want to own for clients.

The old adage “buy low and sell high” is as true as ever, and despite it sounding very simple, practicing it is anything but that. The implementation of that adage often means buying great companies when its uncomfortable in the midst of negative headlines and poor near term trends, while selling high is also just as uncomfortable amid higher market enthusiasm and increasing sales and earnings estimates. We try to accomplish this by keeping our intrinsic value estimates grounded in data, research and analysis, and a long-term understanding of the qualitative business fundamentals to guide our buy, sell, and hold decisions.

You can read the full transcript HERE.

Clients of Ensemble Capital own shares of Apple (AAPL).


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