Comparing Apples and Oranges

Comparing Apples and Oranges

We often discuss companies that we don’t like. Indeed in about thirty-odd cases, we are so disenchanted with them, that our Montaka Global Fund, sells short these companies in anticipation of profiting from a decline in their share price. And in the five months since July 1 this year, not liking something has been very profitable. What with the iron ore, retailing and coal industries all being resculpted (read; ‘made smaller’) by the invisible hand of disruption, investors have achieved returns in excess of fourteen percent, a not insignificant proportion of which has come from the share price declines of deteriorating businesses.

As we have mentioned before, in this age of rapid and widespread creative destruction it can be easier to identify the losers than the winners as our Barnes & Noble example demonstrated.

Today however I am going to discuss a company the rest of the world doesn’t like, a company whose share price has declined from $US133.00 earlier in the year to a recent low of US$103.00, but a company whose performance doesn’t justify this negative treatment.

When trading at circa US$100 the shares are trading at the same level as they were in September 2012.

The company simply known as Apple will be familiar to you. They sell iPhones, laptops, iPads as well as a host of other gadgets, books, music, apps and peripherals. They have reinvented the devices we use to entertain ourselves with and completely recast the distributions channels and systems and the revenue models of entire industries – think music and movies.

Despite being the biggest company in the world, it continues to defy analysts’ expectations, that constantly fear the company’s growth path will end imminently, and records high double digit increases in sales and profits.

In October Apple reported another quarter of revenue and profit growth, fueled by sales of the iPhone. Apple posted a profit of $11.1 billion in the fourth quarter, up 31 percent from a year ago. Apple grew its third quarter sales by 33 per cent.

The third quarter growth rate was the fastest the company had experienced in more than three years and much of the growth is coming from China – a country where many other industries are suffering from the decline in economic growth. In other words Apple’s devices are so desirable they are enjoying economic immunity.

Of the US$49 billion in quarterly sales revenue, $13.2 billion came from China up 112 per cent. China now represents a quarter of the company’s revenue and profits compared to the US at 40 per cent. China accounted for 60 per cent of the growth, and units shipped grew by 87 per cent versus China’s smartphone market growth in units shipped of 5 per cent.

In China the iPhone 6 has achieved icon or cult status, and globally the company is enjoying the benefits of the network effect.

Apple has the most valuable customers because they are higher spending and more desirable by both telco providers and merchants. Also developers of iOS apps make double the revenue of those on the Google Play store. Amazon’s most profitable customers are on iPhones. Google’s most profitable customers are on iPhones. Phone carriers’ most profitable customers are on iPhones.

And because higher value customers are more desirable for app developers (they can charge more) more apps are developed for iPhone.

Obviously where there are more apps, that is where users will congregate. To use all those apps, you need an iPhone. And because of the higher revenue, apps are always developed first for iOS over Android.

Globally, Apple has enjoyed the highest ever switch rate from Android. Asking yourself how long this might last yields an interesting answer. You see, only 27% of iPhone owners have switched to iPhone 6 and in China 4G penetration is only 12 per cent.

More stunning is just how quickly the growth might come. To date phone switching or upgrading to iPhone has been predicated on an industry standard of two and three-year phone plans but phone companies are moving to 1 year plans and anytime upgrades.

Most importantly Apple has recently launched a buyback program. For $32 per month users can experience the latest handset at all times. Just hand your old phone in, keep paying and you get the latest phone. This program will speed up the replacement cycle and give Apple control of the superseded iphones.

Meanwhile, the global PC market is contracting at 12 per cent p.a. but Mac sales are growing at 9 per cent.

Apple’s iPhone market share is hovering around 20 per cent of the total installed base of smart phones and was about 15 per cent of smart phone sales last quarter. No other vendor offering a premium priced phone sells anywhere near the volume of the iPhone. Apple’s global share of premium sales had always been in the 60 per cent range but our estimates have that number now much closer to 70 per cent last quarter.

Here’s the great twist in the story, all this success is bringing with it apathy and even despondency. Believe it or not analysts aren’t recommending the stock as a buy because, they say, the growth will eventually end. Each time the company grows its earnings and revenues, its sets a new higher bar, making it difficult to beat next time.

But what the analysts who are focusing on the next earnings number are missing is this: As more people buy iPhones, the network effect strengthens, and as a result the company is in the strongest shape it has been in. It’s a point of fact that most iPhone users upgrade to iPhones and Android users are switching at record rates. Combine that with the fact the 4G network currently only covers about 12 per cent of China and you have a very long run growth profile ahead of you.

Stock market investors can be a funny bunch. On any given day, the very thing that was once seen as positive and supportive for equity valuations, can become the investors nemesis and share prices collapse. Apple is a demonstration of the reverse; when growing profits is seen as a negative.

And that’s true, but the growth will also end one day for Dominos Pizza and that company is trading at 50 times earnings, not the ten times earnings multiple on which Apple is trading.

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.