Saturday, July 31, 2010

Apple and The Law of Large Numbers

Apple and The Law of Large Numbers
There's been much talk about the perceived limits to Apple's continuing growth due to what's called the Law of Large Numbers. This axiom or financial rule suggests as Apple's revenue grows the chance of sustaining current rates of growth diminishes as more growth is required to maintain the same percentage of growth.
In my view applying the Law of Large Numbers to Apple at this time is a fallacious argument. It might appear valid to casual observers of the company or to those fixed on applying commonly accepted axioms in their investment strategies without regard to the  unique circumstances of a particular enterprise, but for now this axiom or financial rule does not apply to Apple. 
Here's why:
In the June quarter close to 50% of Apple's revenue was derived from products that did not exist in the market just over three years ago. In the September and December quarters, well over 50% of Apple's reported revenue will be derived from iPhone and iPad sales. At the moment there's no practical limit to the size of the market for these two products. 
The Macintosh
Apple's oldest hardware product line, the Macintosh, has sustained a roughly 33% unit sales growth rate over the past three fiscal quarters. In the June quarter operating segments exclusive of the Americas and Apple's international chain of retail stores accounted for just over 41% of unit sales. In Europe alone unit sales increased 46% over the prior year period. While Mac sales continue to grow at a pace greater than industry averages, the Mac still accounts for less than 10% of domestic PC sales and garner a much lower percentage of global market share. Although Apple's offerings in the sub-$1,000 PC market are limited to the Mac mini and nominally the MacBook, the company recorded in the June quarter the largest shipment into the educational channel  in the company's history. This occurred during a period in which public education spending remains severely constricted. 
Apple Retail Stores
At the end of the June quarter Apple had 293 retail stores open for business. During the September quarter Apple will open 24 new stores and store sales and foot traffic continue to accelerate. In the June quarter store revenue increased 73% to $2.578 billion and produced average store sales of $9 million. Foot traffic into the stores reached a record 60.5 million visitors, an increase of 57% over the prior-year period. With an increase of over 8% in the number of stores in the September quarter alone, store sales and foot traffic will continue to rise at record levels for the foreseeable future.
Management reports roughly 50% of the 677,000 Macs sold at Apple retail stores in the quarter were to customer who had never owned a Mac before.
The Apple iPad
In the June quarter and in limited release, The Apple iPad and constituent products accounted for $2.166 billion of reported revenue, representing almost 14% of Apple's reported revenue activity. The Apple iPad remains in constrained supply and even Apple's management does not have a reliable metric to gauge global demand for this currently unique device. 
In the September and December quarters the Apple iPad and constituent products should deliver between 15% and 20% of Apple's reported revenue. This is revenue from a product that was not present in the market as recently as five months ago and will deliver significant year-over-year revenue gains for the next several quarters. 

The Apple iPhone
According to Apple's management, iPhone unit sales in the June quarter were running 90% above the year-ago period prior to the company aggressively draining the global channel ahead of the iPhone 4's release. In the December and March quarters, unit sales were 100% or more above prior-year results. Supplies of the iPhone 4 remain constrained and each successive iPhone model has surpassed the sales records set by its predecessor. With at least an annual model update, the iPhone franchise will continue to grow unit sales as the global market for smart phones continues to expand.
The Apple iPod
No matter the 8% decline in unit sales in the June quarter, the iPod line delivered a 4% gain in revenue due to the popularity of the iOS-based iPod touch and its 48% unit sales  gain. Although the iPod's percentage contribution to Apple's revenue and earnings have diminished following the successful Intel transition of the Mac and the release of the Apple iPhone and now the Apple iPad, the company will continue to innovate its line of ubiquitous digital content players with additional iOS-based devices.
Mac OS X's Versatility
Apple's UNIX-based operating system is at the core of the company's iOS for mobile devices. With more than 100 million iOS-based devices sold, Mac OS X's versatility has been brought into global view. At the center of Apple's hardware devices is a highly scalable operating system that was designed to serve as the foundation and springboard for new generations of digital devices. Apple has yet to reach the limits of Mac OS X's versatility and the operating system can be scaled up or down to meet the particular needs of each hardware device. 
With a common operating system running a multitude of digital devices, interoperability and complementary features and functions are elements of new product development that Apple can exploit for the next several years.
Overview
To a casual observer unfamiliar with Apple's products and product markets and for investors who dare not tread far from conventional ways of looking at investments, the law of large numbers as it applies to Apple would on the surface appear to be a reasonable concern considering the company's recent pace of revenue and earnings growth.
With more than 50% of revenue and resulting earnings for the next several quarters sourced from products that did not exist in the marketplace as recently as three years and three months ago, the law of large numbers does not apply to Apple at this point in time. 
To suggest that Apple's current or near-term growth is limited due to its recent historical rates of growth is a fallacious argument. It suggests Apple's pace of new product development will cease or slow and Apple in the future will be unable to find new markets or products for new markets in the way the company, for example, discovered revenue and earnings opportunities in smartphones and now digital tablet devices. 
Apple's robust earnings potential is evidenced by 27% of revenue flowing to the operating income line and no less than 20% of revenue flowing to the net earnings line. With nearly $46 billion in cash and marketable securities on the books at the end of the June quarter, there's no shortage of resources to develop new products, expand the company's global retail store presence or acquire technologies desired for product innovation.
Foe Apple, for now, the law of large numbers should not be applied. I reiterate my early fourth fiscal quarter estimate of revenue of $20 billion and earnings per share of $4.30 or more. I also reiterate my price forecast of over $400 per share by early May 2011. 

Robert Paul Leitao

9 comments:

  1. The trouble with the law of large numbers is that "large" is undefined.

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  2. don't forget to add in the huge number of credit card accounts Apple retains. iTunes once existed to sell iPods now it contributes to the bottom line in a meaningful way.

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  3. It should also be noted that Apple is a major cost hawk. The A4 processor and the new antenna design is just two areas of cost improvement. Note that the smaller sized A4 provides adequate power management at higher speeds with increased glueless interface to subsystems, resulting in reduce PCB space inwhich apple atributes the increase in battery size to. The edge designed antennas also contributed to a thinner device reducing mechanical cost and assembly time and materials. Additionally, Apple took over providing a protection band around the device. This band was attributed to solving the death grip problem but I suspect it to become a $1Billion revenue stream for Apple (50 million units at $30 each is $1.5B). At present they are giving them away but I suspect they'll solve the antenna problem within the next month at which time the giveaway will end. The beauty behind the protective casing is that it's estimated to cost apple $5 and retails for $30 (83% gross margin).

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  4. There are two unbelievable iPad strengths (1) the iPad is being adopted at an astonishing rate and (2) there is no competitor to the iPad at this time. After over six months since the iPad was announced, in great detail, there are only vague announcements of various tablet platforms due to hit around November of this year. Within months, Apple will probably introduce iPad #2 which has to potential to finish off any potential competitor. Only Lotus 123's rapid adoption and complete domination within a short period of time would compare to what is happening here.

    In addition, with an estimated 100 million iDevices to ship in 2011, who has the economy of scale to compete (and make Apple's profit margins) with Apple. These iDevices all share many of the same components and manufacturing facilities.

    Last, look at the meltdown at Microsoft in the mobile space. At some point this will be the only space for personal computing. Google is the only competitor, at this time, and it remains to be seen if this one trick pony can sustain subsidizing their various experiments (look at the Wave announcement today).

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  5. For the next year or so, I think your assertion is correct and I'm confident Apple is going to be starting new services and opening new markets. That said,

    Re: "At the moment there's no practical limit to the size of the market for these [iPhone, iPad] two products."

    Perhaps no limit to market size but as current supply constraints indicate, there IS a limit to production limits. Given the need to innovate rapidly, I doubt 40%+ growth of iPhone and iPad sales will be sustainable for long. When a new model is released it takes time for production to ramp.

    I'm extremely bullish on Apple stock – it's by FAR my largest position – but I'd say $400 by May 2011 is simply dreaming. May 2012, yes – if a positive overall market.

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  6. The only thing I would note with the law of large numbers is that though there's likely a huge ways to go before Apple actually runs into this issue as it can get up to $500 billion per year in revenue before slowing down, there is the issue of market perception. When you look at analyst estimates for Apple for the next 5 years, they are modeling for only 18% growth per year. A few years ago, that number was 25%. That could become a problem.

    See even if Apple shows that it can post growth well above that projected 18% rate, there will always be this concern presented by market participants that "next time" Apple will only grow at 18%. You can see how this argument can be carried on into perpetuity.

    They're doing the same thing with Research in Motion today. Though it still continues to post strong growth rates with the Blackberry, its going to lose to Apple and Google in market share is the perception. Maybe not this year, maybe not next year, but eventually. While this may or may not be the current state of events taking place in reality, this is the current market perception on RIMM and its valuation. Hence the laughable 8 forward p/e.

    i think we can see this happen with Apple very soon. That even though it proves the market wrong and repetitively so, market participants might be skeptical on its ability to grow next year or the following or the following year so on and so forth. And i think this perception derives itself from the law of large numbers. Your article does a lot to try and temper that perception.

    But I fear that Apple is probably bound to an 18 to 22 P/E for some time. This isn't necessarily a bad thing because its EPS will lead to a much higher stock price. Instead of valuation driving the stock, earnings will drive it.

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  7. Also don't forget that number of PCs usually also means cash registers, and any appliance that isn't really considered a PC by anyone, but is counted in anyway because it runs Windows.

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  8. Apple has created a well integrated easy to use Consumer Content Delivery Ecosystem. What Microsoft did was to create an Operating System based Ecosystem, which Google is trying to imitate with Android. But an OS ecosystem is just a piece of the pipeline from the content creator to the enduser. That is the main reason both Microsoft and Google will not succeed in the long run!!!

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  9. Robert:

    You predicted $400 by early May. Not a bad estimate—it's mid July, and it went over $400 in after-hours trading yesterday. It's since pulled back a bit, and as I write this it's about $389.

    Allow me to suggest that if the analyst keep underestimating AAPL, then options offer a great way to leverage a small investment into a big gain.

    Last month, on June 10 I bought AAPL Call, January 2012, $315 strike. As of yesterday's close, the stock has risen about 16% since then, but my option contract is up 96%!

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