APPLE HAS PRODUCED STELLAR RETURNS

Two golden rules of investing that Warren Buffett suggests investors should swear by are:

• Don’t lose money.
• Don’t forget rule number one. If one can take the liberty of adding another one to it, it would be.
• Never bet against Apple.

After all, no one has had it as good as Tim Cook has had over the past decade. Truth be told, all the things that could work in an investment have worked in Apple’s case. Itsrevenue grew from $170 billion in 2013 to about $380 billion in 2023 (with stable margins), its multiple exploded from mid-teens to thirties and the company literally turned into a buyback machine (share count down from 25 billion in 2013 to 15 billion in 2023). It’s share price performance has been no different: it has compounded annually at around 28% over the past decade.

This company’s phenomenal success becomes even more evident every time Tim Cook takes centre stage (and does so often) to announce a new set of Apple products. This week was no exception when he announced the latest iteration of its flagship product - the iPhone 15. These annual events do generate enough curiosity and one is almost always eager to know what changes Apple has brought about (both in terms of design and performance). Undoubtedly, the iPhone gets better with each iteration (better camera, longer battery, advanced chips, better connectivity, higher convenience, more buttons), but the flipside to this is a longer replacement cycle. The iPhone has become more durable, thereby reducing the incentive for consumers to constantly upgrade to higher priced handsets.

The launch has also clashed with a broader slowdown in the smartphone market/consumer demand. Apple has now seen three consecutive quarters of negative revenue growth, last of which had happened in 2016. Investors have largely been forgiving (the stock is up 40% year to date) due to Apple’s pedigree and consistent track record of outperformance. That said, the iPhone sales are critical for the company as it still brings in about 50% of the total revenue. Not just that, the rest of the ecosystem (AirPods, Apple Watch, MacBooks, iCloud, App Store) benefits enormously and strengthens the company’s competitive advantage (with a stickier ecosystem, fewer users want to leave). Tim Cook & Co. must now hope that they have done enough to entice many iPhone users to upgrade (although 0% APR financing in the form of monthly payment plans and subsidies from US based wireless networks must help).

Even if one discounts the issue around a longer replacement cycle, there are other risks that investors don’t seem to have pencilled in at the current valuation. Firstly, a key challenge for Apple revolves around its dependence on China for revenue growth/ durability and manufacturing of its products. Patrick McGee in a recent report in Financial Times noted that 95% of Apple’s products are still manufactured in China. This is obviously not a new concern, but it generated some heat this week with the Chinese government banning certain officials from using the iPhone. With deteriorating US-China relations, it’s hard to predict the endgame here, especially if China decides to be actively hostile against Apple. This current ban will probably be a small dent (of around 10 million iPhones) but in the worst-case scenario of severe disruption to its supply chain or an attack on Taiwan, no western company will lose as much as Apple.

Second, a long-pending antitrust suit against Google is finally up for hearing this week. Unfortunately, it indirectly impacts Apple as Google pays the company an annual sum of around $23 billion as traffic acquisition costs. In other words, Google pays this hefty amount to remain the default search engine on Apple’s devices. If the courts do end up labelling this arrangement anti-competitive, Google would obviously be hurt with the loss of this distribution, but this could straight up wipe out a large portion of $23 billion from company’s overall profit of about $95 billion, resulting in a significant dilution to its net margin.

Finally, a more longterm risk to its business comes from the idea of platform shift from phones to AR glasses. Our lives now revolve around our phones but that wasn’t always the case. It’s hard to imagine anything displacing the phone (maybe they’ll co-exist) but these sleek, high-tech AR glasses could one day be as ubiquitous as phones are today. Apple seems to be already aware of this risk and is spending considerable resources in building AR/ MR glasses. In all probability, this is still at least a decade away and Tim Cook’s challenge will be to replicate iPhone’s success and capture a similar kind of market share within AR/ MR glasses. In this context, it is also important to question how motivated Tim Cook will be able to lead this transition (he is already 62) and if Apple will be fortunate enough to find another Tim Cook.

THE VIEWS EXPRESSED BY THE AUTHOR ARE PERSONAL

Arihant Panagariya The writer is a Portfolio Manager at Hundred Ten Capital in London and a graduate of Columbia University