Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When I take memory lane back to business school, there is a simple framework that really stood out to me: Porter's "five forces" framework. Early on in my investing career I decided that an economic moat would always be important to me. Turns out this is exactly what Porter's "five forces" framework is all about. It answers the question: What economic forces impact the sustainability of industry profits? After all, without some sort of economic moat (see: 5 Ways to Identify Economic Moats), growth is completely unpredictable.
When I put Apple(NASDAQ: AAPL) to the test of Porter's "five forces" the resulting picture is one of a company with protected sustainable profits.
There are 5 categories or "forces" that impact the sustainability of profits:
Power of Input Suppliers
Substitutes and Complements
Power of Buyers
Let's see how Apple holds up to each of these "forces."
Entry. The lower the barriers to entry in a market, the more margins will be reduced and, hence, the less profitable the industry becomes. Apple's sales volume, customer loyalty, customer satisfaction ratings, and operational effectiveness are mind boggling. This has left entrants struggling to compete with Apple's iPhone and iPad and it has sent competitors' PC market share plummeting. As Apple expert, Philip Elmer-DeWitt noted, Apple only has 8.8% market share, yet they command the lion's share of cell phone profits--73% of all cell phone profits go to Apple. Runner up, Samsung, has 23.5% market share yet only commands 26% of the industry profits (see source). But other than Samsung, profits are nil.
Power of Input Suppliers. Unfortunately for suppliers, in the supplier-marketer relationship, Apple has the obvious win. Its balance sheet carries over $110 billion in cash, cash equivalents, and marketable securities. Suppliers are so small in comparison that, in many cases, Apple makes up over 25% (and up to over 90%) of its suppliers' business. Consider Apple's most important supplier, Foxconn. Foxconn's profit margins hover around 4% while Apple's TTM profit margins are a whopping 27%.
Industry Rivalry. Based on the chart above, there is no doubt rivalry is desperate to do whatever it takes to take even just a sliver of Apple's profits. But it's not easy to compete with Apple. Perhaps you remember Hewlett-Packard's(NYSE: HPQ) announcement to drop its smartphone and tablet businesses last August. It even expressed an interest in spinning off its PC business. Of course it has recently re-entered the tablet business, but not with much success (if any at all). Take a look at gross profit margins of Apple and some of its key competitors in the PC, smartphone, and tablet businesses: HP, Dell(NASDAQ: DELL), Nokia(NYSE: NOK), and Research in Motion(NASDAQ: BBRY).
While Apple's Gross profit soars as it takes advantage of an eager market ready to adopt smartphones and tablets, many competitors stand by losing profit and market share.
Substitutes and Compliments. The value of Apple's interrelated products and services is found in the synergy between its product lines. Apple offers much more than its competitors. When customers buy an iPhone they are getting beautiful hardware seamlessly integrated with an OS that is built specifically for Apple products. Furthermore, iOS is built to seamlessly integrate with Apple's top notch PC and iPod line. Finally, Apple provides iOS and OSX users with the largest App Store, iTunes, and its ever improving iCloud. This synergy locks customers in and prompts them to buy more Apple products to add to their synergy. No competitor has a synergy that can compare.
Power of Buyers. While Apple's ultimate customers are, indeed, very fragmented, so are those of Apple's competitors. Yes, fragmented customers have less buying power than high-volume customers. But there is a much greater story here. Apple's buying power is evident in (1) its intangible switching costs and (2) Apple's enormous sales volume. Most Apple customers are more than a buyer of 1 Apple product, they buy into Apple's synergy and usually own multiple Apple products. This makes their relationship with Apple "sticky" and creates high, intangible switching costs. Plus, Apple offers carriers and retail stores the promise of a huge volume of sales and fanatic customers. Carriers' lack of buying power is evident in their heavy subsidies on iPhones.
The market seems to agree that HP, Dell, Research In Motion, and Nokia all have tough times ahead. Take a look at the depreciation of the market value of these companies:
The point is, Apple's competition hasn't proven itself yet. In fact, Apple's competition is facing some serious headwinds while Apple faces nothing but opportunity.
Apple's moat is defendable. Even if competition makes good decisions in the near term, there is much to overcome.
There are no signs of slowdown at Apple. Apple can realistically achieve earnings growth of over 40% in the next 12 months (for details on my reasoning, see my article, Apple's Post iPhone 5 Launch P/E: 10?).
According to Porter's "five forces," Apple's profits are sustainable.