January 2012
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Month January 2012

Pricing Paradox

As Apple’s extraordinarily low valuation is being more widely noted, explanatory hypotheses are proliferating. Everyone seems to have an opinion. Some explanations come in and out of fashion. Others are reliable old clichés. We’ve seen liquidity issues with large funds forced to sell, “too much cash”, management transitions, an impending loss of mojo, share price too high to afford, “law of large numbers”, and that old chestnut, competition. None of these satisfy. They don’t explain why reliable growth is not valuable. And reliability is indeed what Apple offers in spades. Consider the following chart:

Note that the scale is logarithmic so that the growth patterns can be seen clearly.

You cannot buy innovation

In a previous series of articles we discussed the capital Apple expends on equipment, real estate, leasehold improvements and data centers. Cost structure analysis reveals subtle shifts in strategy and the CapEx analysis demonstrates Apple’s increasing integration into its supplier network and integration into the distribution and service infrastructure that sustains its ecosystems.

Another form of investing (spending now, reaping benefits later) is the spending on research and development (R&D). Let’s have a look at Apple’s R&D expenses by quarter since Q1/2006.

Apples R&D expenses as percentage of sales have been declining from almost 4% to close to 2% in the last six years as shown in the following chart:

While Apple’s absolute R&D expenses have grown at an annual rate of 33% they have not kept up with the far higher sales growth rate. Apple’s current rate of R&D expenditure is compared to a peer group [1] below.

Apple's Fourth quarter 2011 Growth Scorecard

After the transitional third quarter, Apple’s earnings growth returned to an exceptional level. As the following chart shows, earnings growth has maintained above 50% growth since 2009.

Q3 turned out to be a transitional quarter with

5by5 | The Critical Path #23: Auteur Theory

Horace talks to Prof. Bill Torgerson from St. John’s University about the writing process and how it survives and/or thrives as a commercial enterprise. We touch on writing for movies and compare the collaborative process of “content creation” vs. the “single voice” of an author.

5by5 | The Critical Path #23: Auteur Theory.

If you make software you really should pay attention to how art is made. And vice versa.

Show notes:

The year of the iPad for the second year in a row

The iPad and Mac businesses both grew well in the last quarter. Tim Cook said they are observing some cannibalization of Mac from the iPad but much more switching to iPad is coming from the Windows PC market.

The evidence is still hard to pin down directly but the fact that PC sales (excluding the Mac) are down gives credence to the claim. Mac growth, in contrast, is largely unaffected. The following chart shows the the iPad volumes vis-a-vis Mac volumes and the Mac growth through recent history.

The iPad has out-sold the Mac since inception and is now about three times the volume. However, the growth rate in the Mac has not changed much.

The impact on the PC market has been discussed recently and the data in the following chart is an update given more precision on the units from Apple:

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Price competition

Apple’s products are often seen as being priced “at a premium”. This is mostly a matter of perception, but in certain categories Apple’s products are priced above the industry average (though probably still affordable to sufficiently large populations). As a result, when competitors launch lower-priced products there is a tendency to expect Apple to react and reduce its prices to compete.

This expectation was evident when AT&T had an exclusive on the iPhone. The assumption among many (expressed in comments here as well as elsewhere) was that a switch to multi-carrier distribution would result in a price reduction and consequently a reduction in margins.

It was evident in the iPod and the Mac businesses over the years as prices for competing products collapsed.

It is also evident with respect to the iPad where expectations are that the Kindle will cause a reduction in the iPad price (and presumably in the margin).

However, the data we have from Apple on their pricing shows no concessions to competitive price pressure. The following chart shows the historic prices that Apple was able to obtain for its main product lines:

Apple added $38 billion in cash last year

Last year I suggested that Apple could reach $100 billion for 2011. That was based on the addition of about $20 billion during 2010. Apple added $38 billion to reach $97.6 billion at the end of 2011.

The following chart shows the composition and scale of Apple’s cash holdings.

At the closing price, Apple’s market value is equivalent to 4.3 times the value of their cash.

The story of Fernforest and Petro Dale

Once upon a time there were some innovative farmers that developed a new hybrid crop that could satisfy the hunger of a growing population. This crop grew best in large farms which had to be situated far from where people lived. The food was so tasty and production could scale so quickly that it became necessary and possible to build a novel way to deliver this food to the population. The farmers built their own transportation network, which they called a “railway”.

This network of rail was itself very efficient and soon overtook the ability of restaurants and small shops to absorb the produce. In order to keep the pipeline of food filled, the farmers (now with their own railways) bought most restaurants and grocery stores. They transformed them into more efficient food retailers and the result was even more consumption and demand for the food.

To keep the population happy, the farmers constantly devised new food hybrids and new recipes for the restaurants. The food design process became a profession, even an art form. The farmers employed the best and most creative minds  when it came to food. They created unique recipes that became instant hits and were widely consumed. They invented “star foods” and “blockbuster dishes”. The process of churning out these hits was so highly honed that farms became factories of ideas.

My thoughts on iBook Author

My thoughts were expressed 20 months ago in a private email.

I did not get a response.