Is Apple's Momentum Sustainable?

The list of once-great consumer electronics companies is long. Brand loyalty is largely dead, forcing hardware manufacturers to compete on features and price each product cycle. This makes it difficult to sustain a leadership position. Temporary advantages are easy to identify--namely the number of available applications and first-mover advantage on tablets. More relevant and meaningful to a sustainable competitive edge is how a firm applies software to establish user switching costs that will pull clients from one generation of devices to the straightway. The heart of Apple's strategy is to create a bond with the user that transcends device cycles.

The mobile phone market is full of cases where a dominant position proved fleeting. Motorola hit a home run with its RAZR product cycle, nevertheless after a couple of years, it stumbled. More important, there was nothing that compelled RAZR clients to purchase the RAZR2, so they didn't. One stumble at Motorola was enough to send clients fleeing to competitors.

The smartphone market is not immune to this trend

The smartphone market is not immune to this trend, as Innovation in Motion's circumstances vividly demonstrate. Hardware companies must compete for the consumer's attention with the latest and greatest gadgets, and design expertise alone does not convey a sustainable competitive advantage. Vendors are instead turning to software to create a sticky bond with the end user. Failure to keep pace in design and software has crippled RIM, and Apple will have to overcome these same challenges to avoid a similar fate.

Inability to respond to changing market conditions can trigger a catastrophic loss of clients from one device cycle to the then and there. The story of iPod unit sales shares some similarities with Motorola and RIM, nevertheless it has two key differences. First, Apple largely maintained its share even as demand for stand-alone portable music players declined, reflecting decay in the market, not in the firm's products. Second, Apple was able to capture much of its base by offering the device that was cannibalizing the demand. For many iPod-wielding consumers, the ease of transition from the iPod to the iPhone was a material selling point. The Apple family of devices has maintained its momentum.

Moat With SoftwareTo prove its economic moat

Building a Moat With SoftwareTo prove its economic moat, Apple must demonstrate that it has locked-in clients, to put it more exactly than wager on the product development team's ability to hit home runs on every product launch. This lock-in is established by the software. A Dell PC is easily replaced with a Hewlett-Packard PC, nevertheless for decades the user will probably be running Microsoft's Windows software. Apple is replicating what worked for Microsoft, minimizing the risk of losing clients between product cycles by using software to connect the user to an ecosystem of applications and content spanning multiple devices, creating a relationship that transcends the useful life of any single device.

Apple's focus on usability over research will deliver the masses. When the original iPhone was launched in 2007, it ran on the abysmally slow EDGE network in the United States. Even so, the device began winning customers in spite of superior 3G transfer speeds on competing devices, because Apple delivered a device that a nontechnical user could operate without an instruction manual. Even today, Apple's latest phone, the iPhone 4S, offers less cutting-edge research, but it continues to pull new clients into the Apple ecosystem.

The heart of Apple'

The heart of Apple's strategy is to create a bond with the user in other words more powerful than any given device cycle. Current momentum and execution should deliver many years of customer acquisition, nevertheless Apple is building a moat around software that locks in clients. Given the loss of visionary leader Steve Jobs and growing competition from Google, Facebook, and Microsoft, we believe Apple will not be able to sustain its leadership by delivering great design. Great design and execution enable Apple to build its customer base, yet it is the firm's software that makes it difficult for consumers to switch to another device.

Historically, moving your contacts from one phone to the then was a mild inconvenience. Nevertheless as users adopt smartphones, the expanded functionality leads to a transition that includes importing music, photos, video, applications, and other services that never existed previously. Consequently, the transition from feature phones to smartphones is the critical point for driving clients into the Apple ecosystem.

Apple will have its setbacks, nevertheless it is beginning to deliver software and services that should help it navigate future challenges with its customer base intact. The true test of the moat is not how sales are when products are at peak public perception, yet rather what happens to the customer base when flops occur. Such as Microsoft easily weathered the fallout from Windows Vista's incredibly negative reception, Apple is positioned to retain its customer base through challenging times. Opposite, product launch missteps were the beginning of the end of Motorola's temporary dominance. Vista was the byproduct of bad vision and worse execution, nevertheless users all in all could not break free of Microsoft's ecosystem. Instead, they simply skipped the product and moved on to Windows 7.

Apple is building that type of power over its user base by redefining the relationship. In Microsoft's case, the unbreakable bond was between the user and the applications. The unbreakable bond for Apple is the firm's control over users' music, movies, books, data, photos, files, and other services. If the iPhone 8 flops, Apple's clients won't rush into the arms of competitors; they will simply wait for the iPhone 9. Switching costs will enable Apple to weather the storm, like Microsoft, and not end up in Motorola's situation.

Moat Is Narrow nevertheless WideningApple's narrow economic moat is based on modest consumer switching costs. Apple's iOS software immerses the user in an ecosystem of applications and content that makes it inconvenient to subsequently switch to another vendor's device. Many Apple users have already spent significant sums of money on media and apps purchased through the iTunes Store, and during music purchased through that channel is portable to other platforms, movies, TV shows, and apps are not. Competitors will in the end deliver comparable hardware devices, yet we think consumers would require a very compelling reason to switch away from iTunes. Permanently, once the consumer enters the market for a replacement phone or additional device like a tablet, the cards are stacked in Apple's favor. Tomorrow's decision will be guided by the switching costs the various vendors are hoping to establish.

Apple's moat may be widening with new software introductions just as iCloud. With the introduction of iOS 5, Apple has eliminated the PC as the hub for devices, replacing it with the iCloud service. This service breaks the tether between the user and any specific device, replacing it with a bond between the user and Apple's cloud. In this cloud is a virtual presence that encapsulates all of the consumer's communications, preferences, and content. This bond is perpetual and much stronger than the bond with any one device.

The switching costs Apple has established to date are tied to content and not but strong enough to ensure long-term lock-in to the Apple ecosystem. Movies, video, and books are often consumed only once. Multiuse content, just as music, is much less convenient to have split across ecosystems. Ultimately, Apple must establish stronger ties to the customer than just music. Momentum is strong, and we believe the firm is on track with iCloud and SIRI to materially raise switching costs, nevertheless a lack of progress with these initiatives would be detrimental to Apple's long-term success.

Misconceptions About Apple's AdvantagesApple will not successfully maintain its design lead in in every product category. In the long run, comparable substitutes will emerge. Our confidence in the Apple story stems from the firm's dominant share via iTunes, the software controlling user music libraries and establishing itself as the premier online music service. This bond with the user is what survives the decline in stand-alone music players in favor of phones with integrated music players.

The high end of smartphone segment

Although iPhones are dominant at the high end of smartphone segment, more Android smartphones are sold every day than iOS smartphones. The number of applications and the amount of other content currently available to iOS users has increased barriers to entry for new challengers, however Google's Android and possibly others are securing meaningful market share, so a monopoly on developer mind share will not exist for Apple.

Having the largest app store helps Apple acquire clients today, nevertheless it is not a long-term differentiator. Without dominant market share, developers will choose to work with all the major platforms, eliminating the virtuous cycle between developers and end users that propelled Microsoft's success.

Apple users will not restrict their purchases exclusively to Apple products, either. We view the iPhone as a gateway device that, in many cases, will lead to iPad and other Apple purchases, nevertheless many types of content do not need to be shared among devices. We envision a future where a material number of households are likely to have mixed environments, maybe with smartphones from Apple yet tablets from Amazon or other Android providers.

IPhone Is the CornerstoneThe iPhone will be the device most responsible for Apple's ability to generate attractive returns while the then and there decade. We estimate that the iPhone already accounts for about 50% of Apple's gross profit, and we expect this percentage to increase over time as the iPhone segment grows faster than other product segments, during sustaining a gross margin above the company average.

The possibility presented

No other consumer electronics device matches the possibility presented by smartphones in terms of annual unit shipments. Tablets and e-readers are experiencing explosive growth, nevertheless we believe it is unlikely that the ultimate end market demand for these products will exceed the current levels we see for mature segments, just as televisions and PCs. Opposite, the smartphone market is likely to approach the current size of the mobile phone market while the straightway decade. Portability, high daily usage, and subsidies that mask true cost encourage device turnover. As a result, a short smartphone refresh cycle of in broad outline two years will continue to be a key driver for this elevated rate of adoption.

The iPhone is the hub of the consumer's connected lifestyle, because it is the only device in other words always present. In fixed and final form, the iPhone is the most logical device to consolidate content and from which to drive new services, just as the e-wallet. The concentration of services with higher switching costs makes the phone the stickiest consumer device. The iPad or iTV may offer some of these services and even offer a better user experience for certain tasks, however they may not always be convenient to carry, creating a merely optional linkage for the user.

Apple may have unit share of only around 19%, however we estimate it is collecting near 40% of the gross profit in the smartphone market. Apple's premium price point is not saddled with materially higher build or component costs. Conclusively, each iPhone sold delivers a higher gross profit than most competing devices.

Concentrated success in the $600-plus price bands positions Apple for customer growth in the premium segment and by moving downmarket. We anticipate that the smartphone market will continue to grow rapidly as smartphones--which accounted for just 30% of mobile phones while the third quarter--continue to replace feature phones.

Emerging-Market OpportunitiesWith PCs, the Apple strategy never resonated in emerging markets as so then as it did in developed markets. The iPhone and, from what we can tell, the iPad are driving demand. Sales in Asia Pacific have grown from 7% of total revenue to 21%. This is especially impressive given the robust growth Apple delivered across geographic regions; while the past two years, the Asia Pacific region has delivered triple-digit sales growth.

Key driver of Apple'

China is a key driver of Apple's success, growing from just 2% of sales to more than 16% in the most recent quarter. High-end Apple products are a status symbol in countries like China and India, and the growing purchasing power and size of the middle class provides a strong tailwind for sales in these regions. Additionally, we expect Apple's strategy of offering lower prices on older phones and tablets to resonate most strongly in these markets. Often there is no carrier subsidy for the devices, so the difference between the iPhone 3GS and iPhone 4 is often much greater than in the U.S., a difference in other words magnified as Apple attempts to expand the potential customer base to include lower-income individuals.

Uncertainty and Risks to the Apple StoryDespite our enthusiasm, there are several risks to consider with Apple's strategy. The most common factor cited for upside with Apple is the at once great device that we haven't discovered. We have no doubt that there will be new devices down the road, nevertheless we do not expect any to hold the same upside as the iPhone.

Push into TVs

We do anticipate Apple will make a push into TVs. But, this market is incredibly price-sensitive, so it is not clear that Apple can differentiate on the hardware side. To boot, consumers have recently transitioned en masse from bulky CRT technologies to flat-panel screens. And the lines between traditional TV and the Internet are blurring rapidly, with Apple, Google, and other Internet giants targeting the legacy model.

Many emerging trends could prevent Apple from establishing a wide economic moat as then. As more developers reach consumers through platform-independent technologies just as HTML5, Apple's app store could be cut out of the loop as clients gain freedom to transfer their chosen applications from one device to another. Moreover, if music subscription models just as Spotify gain traction, iTunes could be forced to follow suit. Subscriptions are easier to port than a purchased music library. Still, we believe clients will continue to embrace Apple's closed system, considering the lock-in a small price to pay for what is widely perceived to be the best user experience.

The company'

Though we are bullish on the company's nearly- and medium-term prospects, it is difficult to forecast Apple's exact size and market penetration 10 years from now. Our $530 fair value estimate is based on our belief that Apple not only has established a critical mass, however will continue to capture more than its fair share of the emerging markets for smartphones and other portable computing devices.

If we have overestimated the switching costs away from Apple, our fair value estimate would fall to $337. In this scenario, we would expect several solid years previously the shine wears off the Apple ecosystem. At that point, we would anticipate margin declines, with phone and tablet unit shipments falling to half of our original forecast by 2020.

However, there is as well the opportunity that we aren't giving Apple enough credit for the feasible size of the market for handsets, tablets, and other new computing devices. We currently assume that market share gains in smartphones and explosive growth of the iPad will stop afterwards fiscal 2013, and in short have revenue growth slowing into the single digits starting in 2015. Another new product category, furthermore market share gains for the iPhone, or stronger long-term growth in the tablet market would all result in higher revenue growth and higher margins, leading to a bull-case fair value estimate of $775.

We expect Apple's blend of phone offerings to secure just 31% of the total smartphone market in our base case. This reflects our belief that Apple will avoid the very bottom of the smartphone market, in spite of a clear intention to have premium and budget options. The most sensitive variables in our analysis are our estimates of the mix and margins between premium and budget iPhones. Apple must offer lower-cost/lower-margin phones to be competitive in price-sensitive emerging markets, leading to a risk that margins could fall faster than we anticipate.