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  • KPB & Co Research

Synopsis

Over the last 10 years, Apple (NASDAQ: AAPL) has been facing margin pressures as competitors in the smartphone, desktop, and tablet markets catch-up to the company's design quality, and technological leadership. The heightened competition has partly created downward pressure on the price of Apple's flagship product - the iPhone. In the midst of this constraint, the company has been focusing on containing costs through a strategic build-up of capabilities in a bid to "cut out the middle man".  In addition, the ownership and control of key supply inputs positions the company to launch more differentiated products to fight back on the pricing power compression. In the 2020 WWDC, the company outlined that all future Macs will use Apple designed Chips, following several other similar initiatives that were in a sense "cut from the same cloth".​

Gross Margins Under Pressure

In the 10-Year period leading up to the 2019 fiscal year, gross margins  declined 2.3 percentage points from a high of 40.1 percent of revenues to 37.8%. In dollar terms, the decline in margins represents approximately US$6.0Bn per year and speaks to the declining efficiency with which shareholder capital is being used within the company. The decline in gross margins reflects both cost pressures and constraints on the revenue side of the business. The price of the company's products is already at the high end of the market, while other competitors in the market are selling comparable devices  at lower prices. The company has released several smaller smartphones at lower prices such as the iPhone SE at US$599. Also, when the company released the first version of the iPhone X, they faced significant push-back from consumers who were alarmed at a phone price in excess of US$1,000.

​​

Optionality Through Vertical Integration

For the better part of 15 years, the company has been using its enormous scale as leverage to undertake the design and production of chips for their various devices.  This move has been a key part of the company's strategy since the time of Steve Jobs, as they sought to enhance their capability to create more differentiated products, gain more control over product margins, and more control over the deployment of technology on their platform. Apple bought Intrinsity for US$121Mn in 2006, a company that was known for creating high-speed chips for mobile devices, including some of Apple's own devices. In 2008, the company purchased a small microprocessor design company named P.A. Semi for US$278Mn. At the time of its sale, P.A. Semi was a 150 person team focused on power-efficient chips. More recently in October 2018, Apple bought  the UK-based chip supplier Dialog for US$600Mn - which includes US$300m to acquire 300 of Dialog’s engineers. Dialog is also one of Apple's former chip suppliers turned division, a supplier that was also focused on making power-efficient chips. Perhaps one of the largest transactions the company has ever done in the chip manufacturing space was the purchase of Intel's smartphone modem business for US$1Bn. With the purchase of the modem business, Apple gains a workforce of 2,200 Intel employees and over 17,000 wireless technology patents.

According to the press release:

Intel will retain the ability to develop modems for non-smartphone applications, such as PCs, internet-of-things devices and autonomous vehicles

In addition, according to Intel CEO Bob Swan:

This agreement enables us to focus on developing technology for the 5G network while retaining critical intellectual property and modem technology that our team has created,

The Key Advantages

As outlined, Apple's expansion further up the supply chain comes with much-needed capabilities that allows the company to be more competitive, not just from a cost position, but also from product position. Cutting out the middle man allow the company to save on the extra margin that using a third party supplier would require. In some instances, using a third party supplier may be cheaper, especially in a context where the third party has a greater scale in the chip design and manufacturing space. On the other hand, Apple is also a huge company that would likely reap recognizable scale economies as their chip design division rivals some of the largest companies in the space.

One of the lessons learnt from the Steve Jobs era where they had to rely on Microsoft to provide some of the Software needed to power applications on the Mac is that having an ecosystem where the hardware is integrated with Software is the best way to maintain a differentiated edge. Going deeper into chip design is important in the sense that it allow greater control over the deployment of technology. In the past, Apple was forced to switch to Intel as IBM could not supply the faster chips needed for Apple to keep up with the competition.  The 2019 purchase of intel's modem business reinforces the need to control the company's destiny as this opens the door for Apple to develop technology for the 5G network, which was a key competitive disadvantage for the company, and a direction Intel did not favour. The recent announcement at WWDC further strengthens the argument around the strategic advantages that going into the chip design industry provides. Apple currently uses its own chips on its iPhones, iPads, Apple Watches and, Apple TVs, which has facilitated seamless integration of applications between each of these platforms. According to the company, building its own chips for the Mac will allow them to build MacBooks that are more power-efficient, more secure, and offer deeper integration between Macs and the other 5 platforms.

Summary

Apple has been pursuing a number of strategies to counteract the effects of competition as the company gets bigger. One of the strategies is the build-out of a high margin service business. The company is now involved in payment services​, health, music streaming, video on the demand, and game on demand. With US$260Bn in sales, there are not many things the company can do to move the needle. One of the best strategies to pursue, that shareholders can appreciate is to protect what is already there. Apple's foray into the chip industry enhances their ability to come up with value-add services and technology that allows them to differentiate their products from the competition while keeping costs under control. This is very important in maintaining margins and protecting shareholder value.


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