Rethinking Apple

Between 2003 and 2010, Blackberry saw its profits climb from $0.10 per share to $8.28 per share. The stock, which traded around $10 in 2003, hit a high of $148 in the summer of 2008. In a five-year time period, Blackberry was able to turn every dollar into $14.80. It only required a bit over $67,000 in 2003 to become a Blackberry (then, known as Research in Motion) millionaire five years later.

Today, Blackberry trades around $10 per share. It is as if the past twelve years never happened. The company paid no dividend. And, worst of all, you saw a mini-fortune come and go before your very eyes. This year, Blackberry is expected to lose about five cents per share for a company-wide loss of $26 million this year. That’s actually a significant improvement from the $700 million loss Blackberry experienced in 2013. Both figures are far cries from the $3.4 billion in profit that Blackberry made over the course of 2010.

That is the story that I keep at the back of my mind whenever I study businesses that rely on you purchasing their electronical device that is presently at the forefront of technology and fashionability. It is a ruthless market because the profit streams are not guaranteed to be replicated. You know Hershey will be selling chocolate bars in 2030. You know Procter & Gamble will be selling Gillette razors in 2030. You know Pepsi’s Frito-Lay division will be selling Doritos in fifteen years. You don’t need excellent leadership in place for that to be true.

The technology sector is much less forgiving. You cannot get away with laurel-resting. You must be selling a new product, or a more sophisticated version of an existing product, five years from now. Kraft went into auto-pilot with macaroni and cheese for the past fifty years, and shareholders get enriched throughout the time period. You can’t pull that off when you are selling cell phones.

That is why I am frequently hesitant to discuss Apple stock. Over half of its revenues come from the iPhone. If that ever gets displayed, the business will be in deep trouble. If you sell maple syrup, your product could be overpriced or technologically inferior and you could carve out a nice profitable niche for yourself indefinitely. That doesn’t work in tech. If a company produces a superior product, your market share tends to evaporate. American streets aren’t filled with men texting their lovers from Nokia phones.

Apple went from making a penny per share in 2003 to an estimated $9 per share this year. It went from $0.50 per share to $125 per share over that time frame, and has been making dividend payments since 2012.

There is a reason why Apple has been able to experience such a triple ascent. It has a triple-dip business model in which it is able to collect money from customers directly, and in some cases, repeatedly. First of all, you are likely to buy your Apple product either through or through an Apple store.

This permits Apple to keep a layer of profits that most electronics companies don’t. If you want a Dell, HP, or Microsoft computer, you can just go to Wal-Mart or something. That eats into the profits at Dell, HP, and Microsoft because they have to share a bit of the profits with Wal-Mart and other sellers. The ability to successfully execute the “We don’t come to you; you come to us” business model is something that distinguishes Apple from its peers.

The stores itself do have tremendous brand equity. If you are at a mall, take a moment and watch the reactions of people as they pass an Apple store. They will either say something to their friends or family about it, or they’ll go in. Very few people simply walk past the Apple store without giving it some kind of mental attention. That is what it looks like to see a strong brand in action.

Now yes, sometimes Apple does go through a distributor in some instances (most notably, universities). But that is an example of knowing when it is okay to tolerate some loss in the pursuit of a greater long-term gain. People are creatures of habit, and Apple wants to get you using their gear during the teenaged years in order to build brand loyalty for the long term.

The second bit of dipping occurs when you purchase the product itself. Apple is one of the few companies in the world to make profit both on margin and volume. Usually, it’s one or the other. Wal-Mart only makes 3.5% profit margins on each item when it is all said and done, but that’s fine because the foot traffic is so immense that it does half a trillion in sales per year. Tiffany only gets customers sporadically, and has a small market niche, but that’s fine because the company generates 48% profit margins.

Apple is unique in that it generates both volume and revenues. It sells tens of millions of products per quarter, and earns 33% profit margins on each item. It went from generating $13 billion to $231 billion in annual revenue in the past ten years alone. That is a product of high margins and high customer demand (2008 and 2011 were the big years in Apple’s profit story because those years mark when Apple consistently raised margins from 10% to 20%, and then 20% to 30%, respectively.)

The triple dip occurs at Apple once you own the product and load something like iTunes onto your iPhone or iMac so Apple can collect more profit from you when it receives $1.29 per song. This is the automatic, self-reinforcement part of the cycle. All Apple does is create the platform and then collects a toll-road share of the profit from musicians that go through the labor of releasing new material. It’s similar to the business model at Seeking Alpha or Reddit where user-generated content is the driver of business growth. You let other people go through the trouble of creating stuff, and then you collect a fee (through advertising or specific charges) because you are the host.

The dynamics of Apple are a great casebook study in the power of virtuous cycles. You buy from Apple directly, bypassing the distribution costs that affect most other firms. The product itself has great brand loyalty, so you are able to charge premium pricing. And then once someone owns your product, you continue to profit from them over and over again as people buy songs.

Of course, the risk is that this virtuous cycle could implode on itself because of the better mousetrap risk inherent in the business model. If someone created a better phone, Apple may have to lower prices, thus reducing margins. To make up for the loss, you might have to sell through Wal-Mart, which reduces the distributorship advantage. And then, if people are using a different physical phone, through Google or something, the question becomes whether the virtuous cycle collapses on itself or not.

Apple invests billions into research and development. It has prompt customer service. It induces customers to create gradual, escalating investments into it by hosting libraries. If you purchased 5,000 songs through iTunes and have a perfected music library, you are going to be unlikely to switch. Apple is doing the right things to protect its turf.

But I am thankful that everyone is permitted to have a “too hard” pile. We don’t have to have an opinion on everything. To be a successful investor, the only bare minimum requirement is that you are right about just one thing in your life and act on it. I’d much prefer the long-term certainty that comes Hershey stock at $90. But I am still impressed at how Apple has created a distinguished business model that leads to devotion and enormous profits, even though I remain cautious about the creative destruction that is the backdrop of the industry.