In my last post ‘The Apple Growth Story – Lessons for Tech Companies’, I talked about Apple’s phenomenal growth over the last several years and the 5 lessons that Technology companies should take from Apple. Yesterday, Apple crossed yet another milestone. It became the World’s most valuable company, with its Market cap overtaking that of Exxon Mobile. Apple and Exxon Mobile are the only 2 companies in this world with Market Cap of more than $300 Billion. On 10 August 2011, Apple had Market cap of $337 Billion and Exxon Mobile had Market cap of $331 Billion. Exxon had held the Number 1 spot since 2005.
For a while now, even before Apple gained the Number 1 spot on Market valuation, people had been talking whether Apple can achieve $1 Trillion Market cap. A recent story on Bloomberg Businessweek ‘Apple’s Earnings Power Befuddles Wall Street’ mentioned Microsoft Market cap of $607 Billion in 1999, a record for any company so far. The story concludes by saying that if Apple keeps it up, the company will soon have a shot at breaking Microsoft’s record tech company valuation. Then, $1 Trillion isn’t so absurd because “Apple is an industry, not a company.”
$1 Trillion is an interesting number. Only 15 countries in the World have GDP more than $1 Trillion. Can Apple achieve $1 Trillion Market cap? The answer may lie in its business model. Bill Gurley (VC in Silicon Valley) wrote an interesting article ‘All Revenue is not create equal – The keys to the 10x Revenue Club’ few months back. In this article, Bill talked about 10 distinguishing traits that warrant high price/revenue multiples and thus higher valuations. Let us look at Apple’s Business Model from Bill’s lens.
1. Sustainable Competitive Advantage – Here you basically need to answer “How easy is it for someone else to provide the same product or service that you provide?” Does your company have “high barriers to entry”? Apple has created a sustainable competitive advantage for itself with iTunes platform. Earlier iTunes allowed users to download songs for iPod. Now, iPhone and iPad are also integrated with iTunes for apps download. The iTunes platform and its tight integration with Apple products is so powerful that Walmart has decided to exit the digital music selling business by 29 August 2011, as per a news that came yesterday. iPhone and iPad, which didn’t even existed 5 years ago, now contribute nearly 70% of Apple’s revenues. How many companies you know who have 70% revenues coming from the products that didn’t existed 5 years before?
2. The presence of Network Effects – In economics and business, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it. Network effects are present in two-sided markets. Example markets include credit cards, composed of cardholders and merchants; operating systems (end-users and developers), newspaper and magazines (advertisers and readers); video game consoles (gamers and game developers).
As per Tom Eisenmann (Professor at Harvard Business School who studies lean startups, entrepreneurship, platforms, and network effects), there are two types of network effects: A same-side effect, in which increasing the number of users on one side of the network makes it either more or less valuable to users on the same side; and a cross-side effect, in which increasing the number of users on one side of the network makes it either more or less valuable to the users on the other side.
With its products, Apple is able to build both the same-side and the cross-side Network effects. On one side, Apple has iPhone and iPad users. On the other side, Apple has app developers. As per Apple financial disclosures, Apple has sold nearly 29 Million iPads during last 5 quarters. The cumulative number of iPhones sold so far is 129 Million. These numbers are big enough to attract the developer community to develop apps for the users. More the users buy Apple products, more the developers will develop apps. More the apps are there in Apple App store, more the users will buy.
3. Visibility/Predictability are highly valued – Investors favor pricing models that provide a high level of predictability & consistency in the future. The business models should be less vulnerable to the “hit” risk. Apple doesn’t have a huge breadth in its product range unlike IBM or HP. This allows the analysts to easily model Apple future revenues.
4. Customer lock-in/High Switching Costs – Investor favor companies with low churn rates of customers and High switching costs. The switching costs can take many forms like Hardware lock-in, Data lock-in etc. Apple has a highly loyal customer base. Apple initially achieved Customer lock-in with Hardware, then apps, and now with upcoming iCloud offering.
5. Gross Margin Levels – As per Bill, lower gross margin companies will trade at highly discounted price/revenue multiples. Apple Gross Margins have continued to improve over last 5 years. Apple Gross Margin currently stand at 42%, up from nearly 30% 5 years ago. Apple competes primarily with HP and Dell in Desktops and Portables business and with Nokia in Phone business. HP and Dell had Gross Margins of 31% and 19% respectively in their last quarter reporting. Apple Gross Margins are higher than Nokia as well who has Gross Margins of nearly 31%.
6. Marginal Profitability Calculation – Investors love companies with scale. Investors will value a company more if higher revenues create higher profit margins, all other things being equal. 5 years back, during Q3’06 (April-May-June 2006), Apple had revenues of $4.3 Billion and Operating Income of $566 Million. This translates to operating profit margin of 13%. Now, during Q3’11, Apple reported revenues of $28.5 Billion and Operating Income of $9.3 Billion. This translates to operating profit margin of 33%. Clearly, higher revenues resulted in higher profit margins for Apple.
7. Customer concentration – Investor prefer a highly fragmented customer base versus a highly concentrated one. This is because concentrated customers have “market power” that can result in pricing, feature, service demands over time. The ideal situation is tons of very small customers who are essentially “price takers” in the market. Since Apple is focused on Consumer Market than the Enterprise Market, the customer base of Apple is highly fragmented. This allowed Apple to grow much faster than enterprise-focused companies, even during a “consumer-driven” recession. Apple was least affected by the freeze in IT budgets or discretionary spends of Global 2000 companies.
8. Major Partner Dependencies – Investors will discount price/revenue valuations of any company that is highly dependent on another partner in some way or another. One of the key reasons for Apple success is that they own both Hardware and Software. Apple controls the complete user experience. They are not dependent on their partners for any technical breakthroughs. They innovate at their own pace. Apple does outsource mass-scale manufacturing to vendors like Foxconn, but it is not dependent upon them for value proposition development or customer reach-out.
9. Organic vs Heavy Marketing Spend – Investors love companies where the products/service sales are achieved through “word of mouth” process and the cost of acquiring a new customer is low. Lower the marketing spend, the better it is. In case of Apple, Gross Margins improved by 12% during last 5 years, whereas Operating Margins improved by 20% during the same time. Sales and Marketing Expenses are usually captured as Operating expenses. Clearly, higher operating margin growth implies low spend on Marketing to acquire new customers.
10. Growth – The faster you are growing, the larger and larger future revenues and cash flows will be. As per Bill, High growth also implies a company has tapped into a powerful new market opportunity, where customer demand is seemingly insatiable. Apple announced its Q3’11 (April-May-June 2011) results on 19 July 2011. Apple crossed the $100 Billion TTM revenues (Trailing-Twelve months) milestone in Q2. This translates to nearly 4x revenue growth in 4 years. Apple had less than $25 Billion TTM revenues 4 years back. During last 12 months, Apple had nearly twice the incremental revenues than HP, IBM, Microsoft, Dell combined.
* FY ending June.
** HP and Dell AMJ’11 quarter revenues are as per Analyst estimates.
Now let us summarize the aforementioned parameters.
Clearly, Apple Business model scores 10 of 10. I am aware of very few companies who would score 10 of 10. Which companies are you aware of? Do their numbers speak for themselves? Are you aware of other methodologies to analyze the business model robustness of different companies? Please let me know. You can connect with me on Twitter at http://twitter.com/#!/jitendermiglani (@jitendermiglani).