Mark LaMonica: Alright, so Shani, we're back recording because you are back from your trip.

Shani Jayamanne: I am back yes.

LaMonica: So you went to Sri Lanka.

Jayamanne: I did and the first thing you said to me is I look quite tanned.

LaMonica: Yes, I did say that. So you spent some time in the sun.

Jayamanne: I did.

LaMonica: And how was the trip?

Jayamanne: It was really good. I just lazed around, drank coconuts and gin, and ate lots of curry and fruit. And that's it.

LaMonica: Okay, it sounds a little bit like what you do here. But it was nice that you got to do that in a different country. And you told me that you had – you moved around a couple of places. And you had somebody driving you in between those places. And you said that your mother contacted this person and told him to drive slow.

Jayamanne: She did.

LaMonica: And so it took you a really long time to get anywhere.

Jayamanne: Yeah. So we were travelling from Colombo down south and this trip probably should have taken an hour and a half and ended up taking three. So it was quite frustrating. But precious cargo apparently.

LaMonica: Exactly. Exactly. So did you use your iPhone when you were there?

Jayamanne: I did use my iPhone. I took lots of pictures.

LaMonica: Okay, and the reason I mentioned an iPhone is because we're going to talk about iPhones today.

Jayamanne: Are we?

LaMonica: We are. And we're going to talk about Apple, who makes iPhones.

Jayamanne: Okay.

LaMonica: And did you know that you are one of 1.36 billion people who own an iPhone? And that's globally of course, not in Australia. And that's saying something that's 19% of all mobile phones that are used worldwide.

Jayamanne: And although that doesn't seem that impressive, that is competing against every other phone model.

LaMonica: And we're going to do – as is probably obvious right now, we're going to do a deep dive on Apple. And Apple share price is close to an all-time high as we record this. And I will say, just as disclosure, Shani owns an iPhone. I do own some Apple stock. I bought it back in 2016, which has worked out pretty well, it's up around 600% since then and the dividends gone up from 56 cents a share to 96 cents a share.

Jayamanne: And even if you don't own it directly, if you own a broad international index fund or an S&P 500, you will have an outsized position in Apple. And it was a secondary traded U.S. stock for Aussie users of Sharesight in the month of May behind Tesla.

LaMonica: And if we look at the S&P 500, Apple makes up around 7.5% of that index. And that's just 1 stock out of 500, and the stock has grown a lot. So obviously I mentioned since 2016, but if you invested in Apple on the 30th of June 2008, on the 21st of June 2023, it would have grown 2976%, so clearly, I should have bought it earlier.

Jayamanne: That's how you feel about SJ, right? And in a bigger position.

LaMonica: That that's true. I know exactly, exactly.

Jayamanne: Yeah, it is huge. And so, for a stock that has had such a meteoric rise, and a company that has made products that a lot of us use throughout the day, and a strong likelihood that you have exposure to the stock if you have international stock exposure, how is it as an investment opportunity?

LaMonica: And that's what we're going to discuss today, of course. And I think Apple, the company, probably doesn't need much of an introduction, but we do need to set a bit of a foundation to understand how our analyst thinks about Apple.

Jayamanne: Apple has been around since the mid-1970s and so for such a fresh company it has existed for longer than both of us.

LaMonica: Yes, some. Some more than others.

Jayamanne: It is the world's biggest company by market cap, and it is an absolute Goliath. It recently hit a $3 trillion USD market cap which is bigger than every company that trades in Australia. Its dominance stems from its ability to package hardware, software, services, semiconductors, and 3rd party applications into sleek, intuitive, and appealing devices,

LaMonica: That sounds like a commercial for Apple.

Jayamanne: I know I was just about to say that.

LaMonica: Exactly. Well, today we're going to talk about something called a walled garden, and we're going to talk about this in terms of the approach for apples iOS ecosystem.

Jayamanne: And a walled garden is basically a closed ecosystem where all the operations are controlled by the operator – in this case Apple. And what this allows Apple to do is it allows them to capture a premium on its devices, unlike most of its peers that rely on open operating systems like Windows and Android.

LaMonica: And when we talk about a premium, it is pretty mind blowing.

Jayamanne: The base markup on the latest iPhone model is 119%. That is insane.

LaMonica: It is, it is, so it costs them about 500. well, not about, I guess this is an exact number. $501 US to make each iPhone 14 and Apple sells the base model for $1099 US.

Jayamanne: I went on the Apple website, and they recommended iPhone 14 Pro Max, and it is $1899.

LaMonica: For, for a phone?

Jayamanne: Yes, for a phone, so it's definitely selling at a premium.

LaMonica: And we don't see any other technology titan with comparable expertise across consumer hardware, software, and services.

Jayamanne: Because of this, Apple are able to build premium devices that have industry-leading average selling prices and margins and at the apex of this is the iPhone.

LaMonica: And our analyst refers to this as their crown jewel.

Jayamanne: No one has ever said anything that nice about me.

LaMonica: And an interesting fact about Shani. Shani is obsessed with the crown jewels.

Jayamanne: Is that an interesting fact?

LaMonica: It's not interesting, but it's an interesting fact about you. But you're obsessed about them because you always tell me about how they were stolen from places like Sri Lanka.

Jayamanne: This is very controversial for investing podcasts, let's maybe change the topic. So, this ward garden approach lends itself naturally to a mode, and that's high customer switching costs. First think about the risk of customers moving away from smartphones, and it is just an unimaginable scenario. They are essential computing devices for users, even though there have been innovations such as smart speakers, AR/VR headsets and the Internet of Things.

LaMonica: Okay, why don't you describe what the Internet of Things is Shani?

Jayamanne: Basically, it is a term to discuss the billions of physical devices that connect and exchange data.

LaMonica: Yes, we're very tech savvy here.

Jayamanne: Yeah. No, not quite, mark.

LaMonica: Okay. Well as people probably realise, the smartphone has replaced a bunch of products already. So stand-alone cameras, MP3 players, gaming consoles, and it's also the primary portal that many people use to access digital services like emails, ebooks, web browsing, social media, shopping, podcasts and Instagram accounts – where I post all of my food pictures.

Jayamanne: You know you've got 62 followers, Mark. I did have a look at that.

LaMonica: Yeah. No, it's pathetic.

Jayamanne: No, I think it's quite a good audience, as long as they're engaged.

LaMonica: Yeah, I don't know how engaged they are, but anyway, besides my pathetic followers, we can look past the iPhone and talk about some other things that Apple makes as well. So they've got a suite of hardware products, they've got the iPad, the Mac, the Apple Watch, AirPods, and all of these enhance the experience of the user, and we just don't see these products becoming irrelevant. These multiple devices are, in our analyst opinion, the stickiest aspect of the iPhone. If you're an iPhone user and you've got an iPad, a Mac, an Apple Watch, or AirPods, you understand that a lot of the value that you get from these products is how seamlessly they integrate together, and they lose significant functionality if they're paired with non-apple products.

Jayamanne: And an example is if you've received a message.

LaMonica: Hasn't happened yet, but hopefully someday Shani.

Jayamanne: Maybe that's not an iPhone problem. But if you do receive a message, an iMessage will show up on an iPhone, iPad, Mac and watch if they're all owned by a customer. Apple's active installed base - so that's iPhone, Mac and iPad, reached 1.8 billion at the end of 2021, up 9% from the year prior and that highlights the growing adoption of multiple iOS products by individuals.

LaMonica: And our analyst doesn't believe that iOS will lose ground to new or existing operating systems like Android. Just thinks that Apple's market share is pretty secure.

Jayamanne: So that's a little bit about switching costs. There's also intangible assets that contribute to apples wide moat. Apple's got a very distinct and differentiated user experience through iOS and its design is industry-leading. This means that they can vertically integrate products more seamlessly.

LaMonica: And there's also a little sprinkle of network effects.

Jayamanne: A sprinkle.

LaMonica: A sprinkle. It's got a billion users as an installed base with a new app development favouring iOS. So basically, when app developers develop an app, they can develop for iOS or Android or Windows. Developers are favouring iOS because of this established base.

Jayamanne: All in all, our analysts considered the iPhone a revolutionary product that created the smartphone ecosystem and transitioned people away from the computer and to the smartphone.

LaMonica: And the App Store is robust, and it strengthens every day, and this fosters iPhone adoption and grows Apple's user base.

Jayamanne: Going forward, what we see Apple doing is better monetising its captive user base – so all the users that are stuck in its walled garden.

LaMonica: So it's basically a walled present.

Jayamanne: Yeah, in a lot of ways it is, but that would be through supplemental products and services. So their Apple Watch, Apple music, Apple TV, iCloud, the list goes on. And that will develop into a more robust recurring revenue stream for Apple.

LaMonica: And services now make up around 22% of their total revenue and this is really attractive revenue as is generally recurring, which of course investors like.

Jayamanne: The other really attractive thing about services is that they have gross margins of 70%. That compares to product margins basically selling hardware, of mid 30%. And gross margin is a money that companies get after you account for the cost of delivering the service. So the more the services make-up of the revenue, the better it is for shareholders.

LaMonica: Okay so let’s spend a second on competitors. We mentioned that we think Apple’s expertise in hardware, software, semiconductors, and services are an intangible asset. Even the strongest tech firms are struggling to replicate this advantage. 

Jayamanne: And although the Android cohort has replicated a similar field of apps, app stores, and integrated experiences, the third parties within the Android ecosystem just don't work well enough together like the Apple products do.

LaMonica: And competitors such as Samsung, that have produced the Galaxy smartphone and Google, which is Android OS, they specialise in hardware and software respectively. And this means that there's no true integration like the iPhone.

Jayamanne: So Mark, I am a Formula 1 tragic - here's something vanilla I can talk about.

LaMonica: Yes, I I'm aware that you are big Formula 1 fan.

Jayamanne: And so I started following Formula 1 from a young age and back then my team was McLaren Mercedes.

LaMonica: Okay, so this. Is like your tangent like I do my history tangents. And finally you're doing one on F1.

Jayamanne: On Formula 1 yes. So in F1 you have a chassis – McLaren and you have an engine supplier which is Mercedes and a lot of this has to do with expertise, but it also has to do with money. It's much cheaper to buy an engine from another supplier than it is to research and build your own. And so, most of the grid was filled with this chassis engine provider combinations. What you also have is teams that have a lot of money. Teams like Ferrari. Teams now like Mercedes AMG. And it is so difficult for these hybrid teams to win, and consistently win when they are trying to build a car around a pre-built engine that has been handed to them. But anyway, that's how I justified my team never winning any championships while I supported them so.

LaMonica: Okay, Okay. Well, I'm going take a stab in the dark that what you said is actually relevant.

Jayamanne: It is. Yes.

LaMonica: Okay. So what you're saying basically is that this is similar to the smartphone market. That it's hard to compete with a smartphone that has an operating system built by the same manufacturer.

Jayamanne: You got it.

LaMonica: And that the integration just isn't the same, and the performance just isn't there.

Jayamanne: Yes. Well done.

LaMonica: Alright, well good for me.

Jayamanne: Okay, so Apple has three remote sources. We don't think that Apple's captive user base is going to be scaling the walls of its walled garden anytime soon.

LaMonica: Switching costs are stronger than ever because of all the products that users are adopting. Switching away from iOS is just becoming more and more difficult for users.

Jayamanne: Intangible assets look safe and network effects around iOS and its 1 billion plus installed base is rock solid.

LaMonica: So a strong wide moat.

Jayamanne: Exactly. And we mentioned price before, but let's speak quickly about this because it's one of Apple's strengths.

LaMonica: When we look at tech, one of the underlying patterns that we see is that as time moves on, technology becomes cheaper and more efficient to produce. This leads to lower prices, and this was a large concern for investors in the smartphone market. It was just the fact that people thought smartphones were going to be commoditised.

Jayamanne: And what have we seen from Apple? We've seen Apple lift its iPhone average selling price much higher than Android.

LaMonica: And so all of this sounds pretty spectacular. So we've got good pricing, a strong moat from three different sources. There must be some risks involved, Shani. So what are those?

Jayamanne: Well, that's a good question because we actually assign Apple a high Morningstar uncertainty rating.

LaMonica: Apple is the largest firm in the world, and this means that they are prone to material competition in a cutthroat industry that is short product cycled, and customers hungry for ever superior features.

Jayamanne: And this environment means that market leadership is difficult, but not impossible to maintain. The walled garden has helped Apple a lot, but they still compete across all tiers with competitors.

LaMonica: And customers are also holding on to their phones for much longer. They're more than good enough for what most of us use them for – web browsing, streaming and social media. So this means that even if customers are walled in, revenue from customers is not recurring as often as before.

Jayamanne: The risk that Apple faces is the possibility of smartphone unit stagnation or even declines when emerging markets saturate or consumers gravitate to mid-tier devices. If they don't innovate, Apple may lose the ability to charge the premium prices that it does.

LaMonica: And we've obviously seen this before. We concede Apple's competitive advantages are not insurmountable. And we've seen this by the rise and fall former mobile device Titans such as Nokia, Motorola and BlackBerry –all of which failed to keep up with smartphone innovation. Our analysts do argue that iPhone has become materially more vital to users than the preceding mobile devices.

Jayamanne: Some peers are also selling their hardware at cost to try and drive and maintain market share. A good example of this is Amazon, with its Echo smart speaker, Fire TV, Prime Music and Prime Video. If these devices supersede their iOS counterparts, Apple might be at risk.

LaMonica: And one place where Apple is not market leading, is AI assistants such as Google Assistant, Amazon's Alexa and Apple Siri. Siri has lost a lot of its efficacy and other brands have a superior product.

Jayamanne: Alright so as a company, what about capital allocation?

LaMonica: And obviously, as investors, we really care about capital allocation because it's a huge driver of the future growth of the business, or the income we receive in the form of dividends.

Jayamanne: And for Apple, they are assigned an exemplary capital allocation rating. The rating reflects that Apple has a sound balance sheet, exceptional investments associated with the firm strategy and execution, and appropriate shareholder distribution policies.

LaMonica: And we can take a quick look at their balance sheet. They have $166 billion in gross cash and cash equivalents, compared to $109 billion in debt, as of March 2023. So they have sufficient cash flow and ample resources to meet debt obligations, capital expenditure requirements, shareholder returns, and any potential acquisitions that they want to make.

Jayamanne: Let's speak a little bit about shareholder distribution policies. Tim Cook, the CEO, decided to initiate dividend and stock buyback programs, as well as take on debt, in order to fund programs when most of the cash was trapped overseas. Apple is striving to achieve a net cash neutral position over time.

LaMonica: And everyone likes cash so why don't we dig into their cash position a little bit, Shani?

Jayamanne: Alright. So operating cash flow totaled 28.6 billion in the latest fiscal second quarter, compared with 24.4 billion at Microsoft, 23.5 billion at Alphabet and 13.9 billion at Meta – it's pumping out more cash than any of its peers. So the problem for Apple and a problem we would all like to have is, what should they do with all that cash?

LaMonica: And they have made acquisitions, but ultimately it's not going to be a large focus as the company moves forward. Apple is focused on tuck-in acquisitions that have aided its R&D efforts over the years Although the company has the balance sheet strength to conduct significant M&A activity in the years ahead, we suspect that Apple stick with its strategy of mostly building rather than buying technological expertise.

Jayamanne: And so on one hand, it's good to be cash rich –this means that the company has the flexibility to manage its businesses in good times by investing in innovation and maintaining their competitive advantage.

LaMonica: And when the future is not so certain, this fortress balance sheet really helps. It allows the company to have the stability to keep running their business smoothly. It's been a large part of why investors find the stock appealing.

Jayamanne: And investors have been the winners in the cash issue facing Apple. The company has returned nearly $732 billion to its investors through share buybacks and dividends since the start of 2013. In that timeframe, its stock price has soared 952.5%, compared with 180.4% for the Morningstar U.S. market index.

LaMonica: And the main goal now, as we mentioned, is that Apple wants to be net cash neutral. And this has been a goal for them since 2018. What this means is that they want any excess cash to be balanced by total debt. Since 2018, the net cash position has shrunk by more than half, so they're on their way.

Jayamanne: But Morningstar equity analyst, Abhinav Davuluri, says that it might take years. Apple don't like making large acquisitions and they want to build things themselves. So investors should expect share buybacks from them to reach their goal of net cash neutral. They're also supercharging this by spending more, so they're increasing R&D significantly to almost double from their 2015 investment.

LaMonica: And if we take a look at Apple’s dividend it's safe to say Shani, it's not exciting. So the yield is 0.56%.

Jayamanne: Okay, so that naturally comes to fair value. Our fair value estimate for Apple is $150.00 per share. We're expecting revenue to drop and we think that's pretty reasonable given the strong demand for products for the working from home trends during COVID.

LaMonica: But regardless of this revenue drop, we still believe that iPhone revenue growth will be 3% CAGR – so that's Compound Annual Growth Rate, over the next five years and we think that the strategy for services to locking users will succeed. We think that users will buy more and more of the firm services like Apple TV and Apple Music. There will be strong growth across Apple's wearables and home accessories.

Jayamanne: And the latest from Apple that everyone is talking about, the VR headset, Apple Vision Pro. Our analyst doesn't believe that enough of these units will be sold to move the needle on its massive valuation.

LaMonica: And currently a $150.00 fair value puts Apple in the overvalued category, and it's a 2-star stock.

Jayamanne: In terms of the type of investor that the stock may suit, Apple doesn't pay a decent dividend. It has experienced enormous growth and is a stock with attractive margins on its products and loyal customers. It's got three sources of protecting its competitive advantage.

LaMonica: So it may suit long term investors with a long time horizon that are confident in the company's trajectory. The only problem of course, is the share price.

Jayamanne: And we've advocated for a watchlist for investors before. It is choosing investments that align with your Investment Policy Statement or IPS. The key to successful investing is buying quality companies at good prices. These quality investments aren't always priced cheaply – and Apple will probably never be cheap, but investors who believe in Apple's future and growth could add it to their watch list and hope for a better price.

LaMonica: But important to this is understanding whether you believe in our analyst’s hypothesis. As we mentioned, there were tech Goliaths like Nokia and Motorola that were seen as unbreakable. And yet here we are.

Jayamanne: So think critically about the prospects of a company and whether you are confident that they will be able to maintain the growth trajectory that they've experienced. And this critical thinking is also done for you in our analyst reports, in our bulls say bears say section.

LaMonica: All right Shani, I'm going to do bulls. You do bears.

Jayamanne: Sounds good.

LaMonica: Okay, so the bull case. The bull case says that between greater smartphone penetration in emerging markets, and repeat sales to current customers, Apple has plenty of opportunity to reap the rewards of its iPhone business.

Jayamanne: But the bears say that Apple's decisions to maintain a premium pricing strategy may help fend off gross margin compression, but could limit unit sales growth as devices might become unaffordable for many customers.

LaMonica: Okay, seems like a strong point, but the bulls say that Apple’s iPhone and iOS operating system have consistently been rated at the head of the pack in terms of customer loyalty, engagement and security. And that bodes well for customer retention regardless of these price increases.

Jayamanne: But bears say that their loyalty is fickle. If Apple were to ever launch a buggy software update or sub-par services, it could diminish the firm's reputation for building products that just work.

LaMonica: And bulls of course counter, by saying that Apple still innovating. They've introduced Apple Pay, Apple Watch, Apple TV, AirPods, and although the revenues incremental and isn't like their crown jewel, the iPhone, what it does do is it helps retain iPhone users overtime.

Jayamanne: But bears say that Apple is behind Google and Amazon when it comes to innovation and integrating AI. If AI is a future, this could be problematic for Apple, as they would be behind their competitors on the AI front and will struggle to deliver premium servers to their user base.

LaMonica: It's not like anyone thinks AI is going to be big, right?

Jayamanne: I don't think anyone thinks that.

LaMonica: Yeah, well, you hear it here first. AI, just a myth, right? Anyway, that's our bulls and bears segment and you should do this yourself. You don't have to do this whole bulls and bears thing. You can go pluses and minuses, but we do think it's a good exercise to conduct when you're deciding on the merits of an investment. Although our analysts take the hard work out of it, this is something that all of us can do when evaluating anything you're considering buying.

All right, so that is our episode for today – we heard about Shani's trip, we heard about Apple and that seems like enough for an episode. So we would appreciate any comments in your podcast apps, of course, maybe on an iPhone. And of course, you can send an email to my email address which is in the show notes.