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Why This Apple "Fanboy" Hasn't Panicked

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Despite the drubbing Apple's share price took following its recent earnings release, I remain optimistic for Apple's prospects in 2013.  Apple continues to have the strongest ecosystem in the war of mobile device ecosystems currently underway between Apple (NASDAQ: AAPL), Google (NASDAQ: GOOG), and Microsoft (NASDAQ: MSFT).  Tim Cook's statements at the conference call have convinced me that Apple will rise to the challenge of defending its market share.

Confessions of an atypical “fanboy”

Recently I had the moniker hurled at me as an epithet in comments on my posts.  In truth, I doubt that ardent Apple fans would accept me as one of their own.  Outside of iOS development work, most of my professional and recreational computing is done on Windows 7 PCs, which I assembled myself.  I also don't fit the stereotype of an Apple fanboy who is a technical know-nothing, since I have a relevant technical degree as well as decades of experience. 

My investment and computing platform decisions are based purely on self-interest, not “brain washing” by Apple or anyone else.  Remaining an Apple investor is based on a cold, calculated assessment of Apple's competitive position relative to its principal rivals in the most important computing market today, that of mobile, Internet connected devices, consisting of smart phones, tablets, and tablet “convertibles.”  In this arena, Apple only has two rivals that count at the moment, Google and Microsoft.

The war of ecosystems

As Stephen Elop put it so succinctly in describing the smart phone market, “The game has changed, from a battle of devices, to a war of ecosystems.”  On the supply side of the ecosystems, Apple, Google, and Microsoft have organized keiretsu of affiliated companies and partners supplying components, accessories, software, and even entire devices.  It is indicative of the paramount importance of the mobile operating system that the keiretsu are led by the suppliers of the OS. 

The health and well being of the respective keiretsu depend mainly on the health and well being of the OS supplier.  Thus, an assessment of the competitive strengths of the three main ecosystems should begin with a comparison of the basic finances of Apple, Google and Microsoft.  In the table below, I show basic financial metrics for the big three, on a GAAP basis.

<img src="/media/images/user_14227/incomecompare_1_large.png" />
 

Much has been made of Apple's shrinking gross margin, which did decline from 44.7 percent a year ago to 38.6 percent in Q4 2012.  However, different companies book expenses at different levels, so I prefer to compare operating margin for the Big Three.  Operating margin is just the pre-tax operating income divided by total revenue, and all three companies report operating income on a GAAP basis.  All three companies saw operating margins decline in Q4 as new products were introduced and margins were squeezed by intense competition.  But Apple was in the middle of the pack for operating margin and margin decline. 

The consumption side of the ecosystems is composed of new customers and existing users, and generates considerable income from app and content sales, and for Google, advertising.  As the user base grows, revenue increases lead to a virtuous cycle in which the gravitational pull of the ecosystem becomes greater.  The table below summarizes some metrics related to ecosystem consumption side growth and size:

<img src="/media/images/user_14227/consumptioncompare_large.png" />
 

Numbers I regard as particularly soft because of a lack of transparency are highlighted with a (~). Microsoft has never published sales numbers for Windows Phone, so it's difficult to estimate the number of existing users.  Likewise, Google and Microsoft don't break out specific sales numbers for their online stores.   The Google number is based on an annual “run rate” Google announced at their Q3 conference call.  Microsoft recently announced that Windows phone content sales had doubled from the year ago quarter, but didn't give exact numbers.  Obviously, the iTunes number includes some amount of sales that are derived from non-mobile devices, but I have no way to break down the number further. 

Is there a “critical mass” of users for the ecosystem, below which it cannot flourish?  I believe there is, although the exact number is debatable.  The idea here is that without a certain installed user base, the ecosystem is not self-supporting and the cost to maintain the platform exceeds revenue from the platform. 

What the critical mass is also depends on the business model.  Since Apple makes money directly on each device it sells, its critical mass requirement is actually lower than for either Google or Microsoft, which make no revenue currently from device sales.  Based on the cost to maintain a mobile OS and associated cloud infrastructure, I estimate that the critical mass is about 100 million users.  Google and Apple have certainly achieved critical mass.  Microsoft has not, after two years of trying. 

Reasons for optimism

In contrast to much of the market, I came away from the earnings call feeling more optimistic about Apple than I have in a long while.  In Apple's Impending Break with the Past I pointed out that Apple's best option to defend its iOS market share is to further diversify the iPhone and iPad product lines.  I pointed out that the “iPod is available in three distinct designs and price ranges, all of them current. . . “ as opposed to merely offering older obsolete iPods as the only alternatives to the current model. I also pointed out that as a consequence, iPod has been very successful at defending Apple's market share for MP3 players. 

Tim Cook's statements at the earnings call echoed these sentiments very closely: 

“The most important thing to Apple is to make the best products in the world that enrich customers' lives. . .”  “So what does that mean for market share.  We've been able to do that and have had a great track record on iPod of doing different products at different price points, and getting a reasonable share for doing that.  I wouldn't view the things as mutually exclusive.”

With the success of the iPad Mini, Cook and Co. seem to have finally “got religion” regarding the importance of real product diversification.  I fully expect this lesson to be applied to the iPhone and further applied to the iPad.


MarkHibben has a position in Apple. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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