Using High ROIC’s to Raise Per Share Intrinsic Value

Below are some personal notes on how high ROIC’s can raise a stock’s per share intrinsic value, using Apple as an example:

  • Apple has authorized $100B plus in share repurchases going forward, a result of robust returns on capital — the company is generating more cash than it needs for the business. Repurchases cause share count to go down, causing EPS to grow and market cap to decline, despite flattening/declining operating earnings.
  • High returns on capital — and capital returns via prudent buybacks — should allow Apple to continue growing EPS and reducing market cap at a rate that arguably makes the company undervalued despite slower growth in operating earnings.
  • Apple shouldn’t be making share repurchases if the shares are overvalued — repurchases in this situation are a waste of balance sheet cash. In this situation excess capital should instead be paid out as dividends, leaving shareholders free to invest these monies in other investment opportunities.
  • It’s interesting how a company can grow EPS through share buybacks without growing bottom line earnings. These buybacks should be at fair value or less to avoid wasting balance sheet cash. Buybacks reduce share count, which reduces market cap (the total market price of the company) and increases per share cash flows, both of which make a company more attractive/undervalued from a present value, DCF perspective. This is one of the big benefits of high returns on capital: if a portion of earnings isn’t operationally needed and can’t be invested in incremental capital at attractive return rates, then these earnings can still be used to reduce share count, which reduces total market price and grows per share cash flows, which then leads to a more attractive price to present value ratio (applying DCF analysis).
  • When a company pays more than fair value to repurchase shares, it’s like the company is indirectly making shareholders pay too much for shares relative to earnings — i.e., it’s like forcing shareholders to buy a stock with a low earnings yield, a long payback period, and an unattractive price to present value ratio.
  • An interesting question is whether buybacks at slightly more than fair value could still benefit existing shareholders, and ultimately lead to an attractive earnings yield on the repurchased shares (after repurchases are complete), by increasing the value of each share since each share is now entitled to a greater percentage of earnings.
  • It’s easy to imagine a cash cow type company with high returns on capital liberally repurchasing shares and hypothetically offsetting any unfavorable purchase price (with a low earnings yield on repurchases) with the higher earnings now attributable to each share. The bottom line is that as EPS goes up each share becomes more valuable on a pure DCF basis (ignoring any resulting new debt and/or irresponsible depletion of balance sheet cash by management).

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice. The author owns stock shares of Apple.

Buffett’s Favorite Themes

Low Cost and Size Advantages 

In Buffett’s annual letters certain themes keep popping up. One is that Buffett likes a low cost competitive advantage and another is that he likes it when sheer size confers a competitive advantage. A low cost example is GEICO. A large size example is reinsurance and Berkshire’s ability to insure and reinsure large risks that no one else can — this leads to huge amounts of investable float and often extraordinary underwriting profits.

Capital Intensity 

Buffett also likes capital intensive businesses when large amounts of incremental invested capital can be deployed at attractive rates of return. Berkshire invests huge amounts of incremental capital in utilities and railroads. Businesses like these often face little competition or inferior competition because of regulatory entry barriers and because most companies are reluctant to make these kinds of large investments. Berkshire’s access to abundant capital, and its willingness to freely deploy this capital when return rates are attractive, give it a competitive advantage in capital intensive businesses.

Great, Hard to Copy Products 

Finally, Buffett likes companies with unique, hard to copy, great products. These qualities lead to strong brands, high customer satisfaction rates, and high customer loyalty. This theme seems to drive Buffett’s investments in Coca-Cola, See’s Candies, Apple, and American Express. In his letters Buffett regularly refers to customer satisfaction metrics because these numbers measure loyalty and brand value.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice. 

Capital Allocation

In his annual letters Warren Buffett talks about the importance of capital allocation. Paraphrasing Buffett, when a company can invest its earnings in incremental assets at high rates of return it should do so, or it should use this money to acquire — in whole or in part — fairly priced “wonderful” companies generating attractive returns. When these options are unavailable, the company should return earnings to shareholders through share buybacks if the company is meaningfully undervalued, or though cash dividends if the company is fairly valued or overvalued.

Buffett says one of Berkshire Hathaway’s key advantages is its ability, as a conglomerate, to dispassionately invest capital in closely held and publicly traded companies across a range of industries. This kind of choice makes it easier for Berkshire to find fairly priced companies — to purchase in whole or in part — that are growing sales and earnings at high capital return rates. Additionally, Buffett doesn’t insist on operating control when looking for investing prospects — he’d rather own part of a great company than all of an average company. This gives Berkshire a flexibility advantage over companies that want control. Buffett also notes how easy it is for Berkshire to internally shift capital from a “cash cow” subsidiary that can’t invest retained earnings at attractive returns to a growing subsidiary that can.

Berkshire’s flexibility in deploying capital allows it to continue growing despite large sales and a large market capitalization. Most companies can’t invest capital in such a varied way: they operate in one business and one industry, resulting in fewer acquisition choices and fewer ways to shift money around internally. Limited choice often causes a company’s management to invest capital poorly, either by (1) expanding an existing, low capital return business or (2) making a controlling acquisition at a premium price.

Berkshire benefits not just from the varied ways it deploys capital, but from the large capital amounts it has to deploy. The company invests equity capital in the form of earnings generated by its subsidiaries, in addition to debt capital in the form of insurance float generated by subsidiaries like GEICO. Insurance float is the up-front premium money insurers hold/invest until these monies are paid out in claims. Berkshire invests float in attractively priced equities generating high capital returns. Float is a debt liability on the balance sheet, but Buffett believes this is a mischaracterization: he views Berkshire’s float as a costless, revolving fund — which Berkshire can invest in attractive equities — whereby claim payouts are continually replenished by insurance premiums. Through the years Berkshire’s insurance float has steadily grown, giving the company more and more money to invest. Buffett notes that returns from invested float are then augmented or reduced by underwriting profits or losses. When insurance premiums exceed expenses and eventual losses there’s an underwriting profit. When expenses and eventual losses exceed premiums there’s an underwriting loss. In most years Berkshire’s insurance subsidiaries have generated an underwriting profit. 

Companies shifting from growth to maturity often have trouble adjusting their capital allocation: they retain earnings for low return projects or acquisitions instead of distributing this money to shareholders through dividends or share repurchases. It takes managerial discipline for a company to forgo low return investments, even when these investments generate additional sales, earnings, and earnings per share. Low return investments waste retained earnings because shareholders could invest this money elsewhere at higher returns.

Poor capital allocation, industry competition, technological disruption, and business model disruption all cause declining returns and regression to industry mean returns. A company can delay and sometimes prevent declining capital returns through (1) shareholder-friendly capital allocation and (2) unique activities/strategy a la Michael Porter (e.g., Apple and Southwest Airlines). 

Buffett notes that shareholders of companies that allocate capital poorly actually pay twice: once via the earnings retained and invested by management at low returns, and once via the lower market value assigned to companies that behave this way. Smart capital allocation, whether it’s repurchasing shares at appropriate times or retaining earnings at appropriate times, may be the best quantitative indication of good management.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Marginal Benefits

I just wanted to write a quick post on technology, marginal benefits, and actual harm. 

Speaking personally, I think I’ve reached the point at which further improvements in my day-to-day tech devices, my iPhone, iPad, iMac, and Apple Watch, no longer confer meaningful additional benefits. Everything is truly good enough. Apple can continue improving its products, and at some point I’ll be forced to replace existing stuff, but I don’t suspect I’ll be too happy about it. 

I think Apple is trying to address this situation — and the good enough problem — by segmenting the market through a range of product price points and features. The problem is the iOS updates — if I own an older but good enough version of the iPhone, the latest update may not work too well and Apple will ultimately discontinue support for earlier versions of iOS. So it starts to feel like I’m being forced to replace a product I don’t want to replace. Feelings of delight shift to feelings of exploitation.

None of this is new insight, I know — people have been writing about this issue for a long time.  

There seems to be an assumption among tech writers that all technology and all technological improvement is good. I’m really starting to question this. Is my Apple Watch or my iPhone a good thing? Is social media a good thing? Do these technologies make it harder to focus on in-the-moment conversations, and make it harder to develop deeper relationships with people you care about and want to spend more time with? Do these technologies distract you and cause unnecessary stress? Do social media and smartphones redirect time and attention away from what’s important and toward things that are trivial or superficial?

Flip-phones are sounding better and better to me.

Retail Disruption

Brick-and-mortar retailers that only distribute and don't manufacture are being disrupted by convenient, low price online retailers with low cost structures. This is impacting a big swath of the retail industry.

Traditional retailers are protected -- to some extent -- when the distributed product is something consumers want to try on or touch before buying. Even then, however, sales of "try on" products are impacted by e-commerce: after a buyer makes the first purchase of a try on product at a physical store, he can make repeat purchases online.

Brick-and-mortar retailers trying to bolster sales through an online presence must compete with Amazon. And the difficulty here is that Amazon has the competitive advantages afforded by massive scale, a low cost structure, and a huge selection of products. By selling almost everything, Amazon provides one-stop convenience that other online retailers can't match. This convenience edge has been strengthened by Amazon Prime. So traditional retailers face daunting challenges when trying to compete online.

Retailers manufacturing unique products that they also sell -- like Apple -- are largely protected from Amazon. That's because these retailer-manufacturers can control distribution and/or distribute their products exclusively.

Looking beyond retail, other industries are experiencing widespread dislocation, often due to new technologies rather than Christensen-style low end or new market disruption. The oil industry is becoming less profitable due to EV's, abundant natural gas, and cheaper and cheaper solar/wind alternatives.

If a disruptive force doesn't swallow the entire industry market, then a disrupted company can try and adjust to reduced market share by downsizing. An unleveraged balance sheet makes downsizing easier and survival more likely. In the case of retail, many brick-and-mortar companies will survive -- particularly the companies that manufacture what they sell or sell products that people want to try on first -- but their sales may be lower. 

Getting Hamstrung by Legacy Services and Products

Ben Thompson at stratechery.com just wrote a thought-provoking article titled "Apple's Organizational Crossroads." In the article Ben says Apple should consider organizing its services into divisions with separate P&L's, creating a direct profit incentive to help it create better services and then rapidly iterate/improve these services. This would be a break with Apple's current functional structure, under which the company is organized around functions like design, engineering, marketing, and so on rather than by product division. 

I wrote a pretty lengthy response/rebuttal to Ben's article. Rather than rewrite the response I'm going to quote it in full:

I think Apple does iterate its services independent of hardware releases -- I get regular updates to iTunes and OS and iOS regardless of whether I purchase new hardware.

I like the simplicity of Apple's approach to services: when I buy the hardware I know it's going to come with certain core services I need -- mail, messaging, contacts, calendar, Pages, Numbers, etc. -- and I don't have to worry about getting nickel and dimed for service updates (which is what Apple would presumably have to start doing if each service had a P&L).

Conversely, as an end user I really dislike the way Microsoft is following a nickel and dime approach by trying to funnel me into a yearly subscription for Word, Excel, etc. -- and I'm finding I can get along without state of the art services from Microsoft. Apple's core services are good enough for me. If any core Apple service isn't good enough then I just buy the service/app from a third party -- no big deal.

I think Apple is actually doing a fair job monetizing most of its services through its hardware, iCloud backup, and iCloud storage. And while hardware monetization doesn't provide a direct incentive for Apple to improve its services, it does provide an indirect incentive: Apple wants to make sure its core services are generally liked and used, since that use keeps the buyer purchasing future Apple products.

It's strange but you don't seem to hear as much about Google Docs anymore, despite powerful direct incentives for Google to improve this service (such as collecting user data, generating ad revenue, etc.). I continue to see complaints on Twitter about the limitations of Google Docs. I'm not convinced incentives have to be direct to be effective.

Apple Music may not be as good as Spotify but it's good enough for me, as is the ability to purchase videos through the iTunes Store. Apple Maps is also good enough for me and continues to get better (despite Apple's lack of direct incentives to improve Apple Maps).

I really think Apple's focus on the integrated user experience is appropriate, because this approach puts the focus on the job-to-be-done. Focusing on the job-to-be-done helps keep prevent unused features and non-meaningful improvements to services that are already good enough (again, I'm thinking of Microsoft services here).

And referencing Steve Jobs, Jobs always said you have to start with the user experience and work backward to the technology. You could arguably take this line, change a few words, and say something like: you have to start with the user experience -- which by its very nature is broad and encompasses both a hardware and a services component -- and work backward to a holistic, well-designed solution which isn't tied to whether particular components of this solution are profitable.

This holistic, integrated approach is enabled by a functional organizational structure. I don't think I'd ever want Apple to abandon this approach and go to product divisions/silos and a bunch of separate P&L's where great, integrated solutions/products become almost impossible.

Going forward I believe Apple will try to make a profit on services that don't have to be tightly integrated with Apple hardware. Such services might include: App Store revenues, iTunes music/video revenues, and Apple Music. This list might also include iCloud backup/storage tiers, since this is a backend service that's arguably more standalone. The more standalone nature of certain Apple services may explain why Apple made iTunes and Apple Music available horizontally to users of Microsoft and Android hardware.

Much of this response suffers from anecdotal, first person bias -- my own experiences and opinions regarding the "good enough" nature of many Apple services may not hold true for others. Despite this, I suspect at least some Apple users feel this way.

The Problem with Legacy Products/Services

After mulling around Ben's article and my response, it occurred to me that the Apple services struggling the most -- in terms of quality, complexity, and general cumbersomeness -- are the legacy ones. iTunes and Apple Music are confusing and complex because they still provide users like me with the legacy stuff I bought a few years ago (downloaded music, for example) while also giving me access to newer technologies/approaches like music streaming. iCloud can be confusing and cumbersome because I used to back things up to my computer and iTunes rather than backing up with iCloud. iPhoto can be confusing and cumbersome because Apple is trying to accommodate users who sync with their computers while also encouraging users to start using iCloud to save all their photos and videos.

I don't think the main thing holding up improvement/iteration of these Apple services is the absence of separate service divisions, each with a separate P&L. I think the main problem is the pre-existence of legacy solutions -- e.g., downloading and syncing music in iTunes or syncing photos with iPhoto on your computer -- that were developed before cheap cloud storage and high speed broadband became widely available. These legacy problems would exist regardless of whether Apple used a separate P&L for each service.

The Apple services without significant legacy issues seem to iterate/improve pretty rapidly. Apple Maps has no legacy issues and has rapidly improved. Apple services like contacts, calendar, notes, Pages, and Numbers have few legacy issues and have rapidly improved. iCloud has a few legacy issues related to traditional computer backup and iPhoto, as noted above, but because iCloud operates largely out of sight, it has also improved rapidly. Again speaking anecdotally, I now use iCloud Drive for all my folders/documents on both my Mac and iOS devices. 

The thing I like about Apple is that it's always trying to move users away from legacy approaches toward newer, more efficient ways of doing things. So Apple has abandoned built-in computer disk drives, is encouraging people to backup with iCloud instead of their computers, and is encouraging people to use Apple Music instead of continuing to download music through iTunes. Apple is trying to take care of legacy users who don't want to change while also "getting its foot in the door" by adopting new technologies that improve legacy services like iTunes and iPhoto (with services like Apple Music streaming and iCloud).

Companies that let legacy products and services rule their portfolio -- and don't get their foot in the door by adopting technologies that can improve products and services -- can pay a heavy price. Intel's adherence to legacy x86 chips, and its reluctance to shift to ARM chip designs, is a good example of this.

The author owns stock shares of Apple.

Functional Needs and Irrational Wants

The iPhone is like a pocket Porsche -- it comes in iconic, arguably artistic designs like a Porsche. The difference is that it's affordable to a lot more people. Artistic, iconic design leads to strong brand value and purchase decisions driven not just driven by rational, functional needs but also by irrational wants (desire, lust, envy, communicating status, etc.). Some consumer products have an inherent artistic element that goes beyond purely functional needs: cars, smartphones, fashion, furniture, and so on. Conversely, some consumer products are almost entirely functional in nature -- people buy or use them because of functional needs, not because of irrational wants. Some examples of purely functional products/services might be: hard drives (Christensen's famous example from The Innovator's Dilemma), backhoes, commodities like steel or glass, Internet search engines, and artificial intelligence. 

If you're selling a purely functional product, Christensen's "good enough" concept is particularly important. That's because irrational wants don't come into play, and the buyer can easily determine what's good enough by comparing the product's functional, measurable performance attributes with the particular job the buyer needs to get done. So a buyer can look at a hard drive, for example, examine its data retrieval rate and storage capacity, and compare that to his functional needs -- how he'll be using the computer and how many photos, videos, and documents he needs to store -- to determine whether the hard drive is good enough or whether it overserves.

As noted in other posts, the best way to keep functional product elements from overserving is to make sure improvements are meaningful and actually used by buyers.

Another great way to prevent functional overserving is through technological leaps that change consumer expectations of what's good enough. This happens when a company comes up with a breakthrough product that makes consumers think that existing alternatives -- that consumers previously felt were good enough -- aren't good enough anymore. The consumer's perception of what's good enough isn't static: it's relative and changing depending on the latest breakthroughs and what's available in the marketplace.

If a sustaining technological leap or breakthrough creates a large enough performance gap between the breakthrough product and existing incumbent alternatives, it may allow the entrant to establish the beachhead needed to effectively enter an existing market. An entrant with a sustaining improvement/innovation normally doesn't do well because incumbents respond vigorously. The exception may be an entrant with a surprise breakthrough product that catches incumbents off-guard -- you could argue the original iPhone succeeded this way.

Two challenges for an entrant with a breakthrough product may be: (1) the lack of a recognized, trusted brand; and (2) ramping up manufacturing, distribution, and marketing fast enough to take full advantage of the sales opportunity. Incumbents are highly motivated to "fast follow" the entrant's breakthrough product with similar products. The key question here is whether incumbents can quickly acquire the capabilities needed to compete with the breakthrough. In the original iPhone's case, Blackberry and Nokia were unable to fast follow the iPhone with similar products because they lacked Apple's integrated hardware and software capabilities. As a result Apple had the time needed to ramp up iPhone production and distribution. Apple's strong brand also helped.

Returning to this post's original subject, a person buying a Porsche or an iPhone -- or any other product with an inherent artistic element -- considers (1) functional needs but is also influenced by (2) irrational wants like the desire/lust for something beautiful. The good enough standard is highly relevant to the functional needs part, but may not be very relevant to the irrational wants part. And irrational wants become even more of a factor when the product is distinguished by iconic, artistic design. So a product with an artistic element may overserve a buyer's functional needs but still be something the buyer wants to purchase because of irrational wants -- a Porsche or a Ferrari is a good example of this.  

You could almost look at a product on a sliding scale: as a product's artistic/iconic elements go up, the relevance of what's good enough -- and the danger of overserving -- go down. The ideal situation may be a product with improving artistic elements and improving functional elements: the key here is that functional elements must improve in a meaningful way that's valued by consumers (to prevent unused, overserving features that actually end up degrading functional performance and ease of use).

Applying another Christensen concept, when the buyer's "job-to-be-done" encompasses purely functional needs, overserving is a greater risk. When the buyer's job-to-be-done is broad, encompassing both functional needs and irrational wants, there's less danger of overserving. 

Art vs. Algorithms

Industrial design sometimes rises to the level of art, and art doesn't commoditize. Artistic design creates tremendous brand value and is very hard to copy, and close copies are never valued as highly as the original. Examples of companies producing iconic products and industrial art include Braun, Ferrari, Porsche, Apple, and Tesla. Industrial art has driven the brand value of each of these companies. 

Conversely, algorithms and machine learning methods can be copied, and the copy is valued just as highly as the original because the product's appeal is based purely on functional needs. Much of the theory behind algorithms comes from educational institutions and is in the public domain. As noted above, Christensen's good enough concept -- and the danger of overserving -- is much more relevant with purely functional products.

So if you're an investor, it seems to make sense to invest in companies that make products that aren't purely functional. The ideal situation may be a company that makes a product with artistic elements, and that is committed to iconic design. This kind of business model is (1) hard for competitors to copy and (2) reduces the danger of creating an overserving product (since buyers in this kind of market are driven by both functional needs and irrational wants).

This post has been amended since it was first written. 

The author owns stock shares of Apple.

Moving Downmarket Without Damaging Your Brand

With the iPhone SE Apple is differentiating its products through size while still offering a best-in-class product at every price level. By differentiating through size, Apple can move downmarket with a less expensive iPhone without damaging its brand, and without detracting from an important motivator for people purchasing an iPhone: the status that comes from owning a best-in-class product (best four inch phone, best large phone, etc.). This was one problem with the iPhone 5c -- it was a downmarket move but it wasn't a best-in-class product. As a result the iPhone 5c degraded Apple's brand and failed to accomplish the job-to-be-done of communicating status.

The author owns stock shares of Apple. 

Country by Country

All Apple can do is make the best product possible within the legal constraints of each country it sells in. If it wants to sell iPhones in the United States, it has to comply with United States law. It it wants to sell in China or India or France, it has to comply with the laws in those countries. 

The courts or legislators in a particular country may make bad decisions about what the laws should be. At that point Apple will have to: (1) modify products sold in that country or (2) stop selling in that country. The first choice is an option as long as country-specific product changes don't jeopardize the quality and security of products sold in other countries. Apple may be forced to stop selling products in countries with laws that jeopardize the security of Apple products sold in other markets.

Apple's competitors will have to deal with these same issues. Some will mount vigorous defenses to bad laws, some will not, but the competitive playing field should be the same on a country by country basis. I think the main thing is for Apple to take firm, ethical stands against legal and governmental overreaching, protecting the user's security and privacy as much as possible. Companies that don't do everything they can to protect user security/privacy will suffer big hits to their reputation and their ability to attract and retain customers.

The author owns stock shares of Apple. 

The Benefits of Technological Improvement

Technological improvements to device security have made it harder for law enforcement to gather evidence. But technological improvements -- over the larger scope of human history -- have generally improved the human condition.

In How to Fly a Horse by Kevin Ashton, Ashton comments on how weaver-Luddites destroyed automated weaving looms because they feared losing their jobs. These looms eventually led, however, to greater manufacturing efficiencies and even more advanced technologies, which led to more jobs and more educated workers. More people learned to read and obtained higher levels of education, with huge improvements in living standards. Id. This trend has continued -- in multiple industries -- through the present day.

Ashton notes that no one could have predicted or anticipated the positive long term impacts of automated looms -- it is impossible to predict all the consequences flowing from a technological improvement. Id. Ashton says that new technologies always bring new problems, but that the answer is not to restrain the new, beneficial technology but to welcome unanticipated consequences, both good and bad, inventing and problem solving along the way. Id.

Apple and other device makers have been improving their products by making them more secure. These technological improvements will produce unpredictable long term consequences. As with past technological improvements -- like the automated loom -- many of these consequences will be beneficial and improve the human condition. Unforeseeable but largely positive long term consequences shouldn't be addressed through a wide-ranging, premature, regressive legal/government mandate that retards improvement and forces device makers to damage their own software/security (destroying their own "loom").

And law enforcement has the resources/expertise needed to address the evidence problem internally -- through their own decryption efforts -- instead of trying to roll back improvements to device security through the careful selection of "bad fact" cases that create bad law and destructive legal precedent. The FBI's internal decryption efforts might not be as easy or convenient, but a trade-off in convenience seems reasonable given the unanticipated, long term societal benefits of improvements in device security.

The author owns stock shares of Apple.

Growing Users Without Growing Profits

A number of popular companies with great products or services don't seem to make much money or are losing money; some of these are closely held, making it hard to determine the extent of losses. These companies include: Uber, Tesla, Amazon, Twitter, and Evernote.

I use Uber, Twitter, and Evernote regularly -- they're invaluable to me. Yet these companies apparently lack the pricing power needed to acquire users, grow sales, and generate/grow profits.

Investors satisfied with profitless sales growth seem to be banking on speculative, undemonstrated pricing power. Many investors believe these companies can turn a profit -- and generate healthy sales and sales growth -- once they stop focusing on the "land grab" effort of acquiring new users. When this kind of speculation doesn't pan out -- either user growth slows and/or profits never materialize -- the stock can really take a beating (a la Twitter). 

Absent aggressive, successful equity fundraising, a company that grows users without growing profits is going to have a hard time investing in its business and improving its product. Uber and Tesla have been very successful fundraisers, allowing them to continue releasing new, improved products/services. At some point though, investors want profits -- they want a return on their investment. Aggressive fundraising won't work forever. If the fundraising music stops and the profits aren't there, an unprofitable company faces major problems like paying its bills and improving its product/service at a rate sufficient to compete. Companies with profitable business models can invest in product/service improvements that unprofitable companies cannot.

If a stand-alone service can't increase its user base without losing money, what alternative business model could work? How could the service still drive profits? Possibly through tight integration with a product that does make money, like an iPhone or iPad or Apple Watch. Tight hardware/service integration creates a more unique, "magical" user experience by making things faster, simpler, and more convenient. As Michael Porter notes, companies should compete to be unique rather than competing to be the best.

It's worth noting that Apple doesn't try to compete within traditional, well-defined hardware or service categories -- they compete by trying to provide the best integrated hardware/software/service experience. This point was recently emphasized in John Gruber's podcast interview of Craig Federighi and Eddy Cue (on Gruber's "The Talk Show" podcast). When questioned about whether the quality of Apple's services was slipping, Federighi and Cue both emphasized that Apple focuses on the integrated, holistic user experience, not on the specific hardware or service component (consistent with Apple's functional organizational structure, its single P&L, and Steve Jobs's advice to focus on the user experience and work backward to the technology).

Apple's in a great position to cherry pick useful services and integrate them into their products, making their products more unique and "sticky." Apple can see how Evernote has become more and more valuable and can use this knowledge to make a more attractive, useful version of Notes. Apple can look at Uber's unprofitable transportation service and find ways to provide a more unique, magical user experience through an integrated hardware/service offering driven by profitable device sales (i.e., iPhone, Apple Watch, and Apple car). Apple can use the unprofitable stand-alone service to complement/strengthen its ecosystem and its profitable hardware.

This article has been amended since it was first posted. 

The author owns stock shares of Apple.

Thinking in Reverse

Google recently removed an ad blocker called Adblock Fast from the Google Play store. This product was designed to work with Samsung's mobile Internet browser, which operates on Samsung Android phones.

Apple permits ad blocking on iOS. Apple has also publicly announced its commitment to user privacy, stressing its efforts to keep user data on the iPhone rather than gathering this data in an Apple cloud database. Some worry that Apple's machine learning and AI efforts could suffer, since data can be better analyzed in the cloud than on the device itself. 

Google's recent ad blocking decision reveals the benefits of "thinking in reverse." Rather than looking at how Apple could be hurt by forgoing user data and permitting ad blocking, think about how Google could be hurt by an advertising business model that forces it to: (1) gather and deeply analyze user data; and (2) serve up ads that users can't block. Google's model may facilitate machine learning and AI while creating a permanent competitive disadvantage when it comes to ads.

The author owns stock shares of Apple.

Landlines vs. Cellphones, Traditional Watches vs. Smartwatches

For many years the general population thought telephone landlines were "good enough." When cellphones first came along, I remember thinking they were too expensive and unnecessary. Cellphones then got smaller and cheaper, while reception and functionality also improved. Now cellphones and more specifically smartphones are much better than landlines -- almost no solicitation, the ability to block calls, reliable coverage, and a computer that fits in your pocket. 

So the landline telephone, which people thought was good enough and didn't think much about, has slowly become not good enough, at least relative to current cellphone/smartphone options. That's because what's considered good enough doesn't exist in a vacuum -- buyers decide what's good enough based on available options. A product that's widely considered good enough today may not be considered good enough five to 10 years from now.

You can imagine the same scenario unfolding with traditional watches versus smartwatches. Today many people believe the traditional watch is good enough, and they consider smartwatches expensive and unnecessary. In five to 10 years though, smartwatch functionality will be far ahead of where it is now. At that point the traditional watch may not be good enough based on other available options like smartwatches. It's not hard to imagine a slow and immense market shift from traditional watches to smartwatches.

I think this analysis may also apply to traditional cable, advertising, and privacy/security. Maybe today traditional cable is good enough. But what happens as a la carte, on demand streaming options continue to proliferate? On demand streaming is going to change the consumer's perception of good enough choice/price. Customers may start walking away from cable providers that won't unbundle their content and price the unbundled components attractively. 

With advertising and intrusions to privacy/security, most people accept some of both so they can receive free services -- for them, privacy and security is currently good enough. But this could change as interconnected devices proliferate and privacy/security becomes more important -- people could start paying more for products designed to protect their privacy/security.

The author owns stock shares of Apple. 

Control Groups and Meaningful Improvements

I just finished reading Superforecasters by Philip E. Tetlock and Dan Gardner (Crown Publishers, 2015). In the book the authors talk about how the accuracy of most forecasts is never measured. Forecasters make predictions (often too vague to be verified or refuted), and no one later gathers data to determine who's right and what forecasting methods work best. So there's no feedback loop to improve forecasting accuracy. Id.

Tetlock and Gardner make an analogy to medicine. For many years doctors relied mostly on personal experience and intuitive judgment to decide what treatments to use. Over this time treatment outcomes either didn't improve or improved slowly. Then control groups were introduced, with one set of patients receiving a placebo and one set of patients receiving the new treatment. This allowed researchers to carefully measure treatment outcomes to determine what worked, what didn't, and how treatments could be improved. This feedback loop led to rapid improvement in medical treatments and outcomes. Id.

A company making smartphones could apply these same concepts to make more meaningful product improvements. So Apple could look at iPhone usage, and the value of its latest improvements, by providing 1000 of its employees with an iPhone 6s (the control group) and 1000 of its employees with a prototype of Apple's upcoming smartphone release (the test group). It could then measure usage of both phones, including various phone features, to determine whether the latest improvements are meaningful/used or whether they're overserving/unused. Feedback from these in-house controlled studies could help keep Apple from releasing overserving products.

Because Apple is so vertically integrated, it already is well-positioned to collect usage feedback from customers. This feedback makes it easier for Apple to identify meaningful product improvements while paring back features that aren't used or are overserving. This may be one of Apple's biggest competitive advantages in designing/creating new products and improving existing products: the customer feedback loop that comes from making the "whole widget."

OEM's that rely on the Android OS, or Android software engineers who must rely on OEM's, don't make the whole widget and therefore don't get end user feedback about the entire product. And when Google and Android OEM's do get meaningful end user feedback, their ability to act on it is limited by the fact that Google must design/improve Android not just for end users, but for advertisers that pay Google to collect user data and target these users with ads. Android is designed/improved based on end user feedback and advertiser feedback.

The author owns stock shares of Apple.

Integration and Iteration

When you look at how Apple is taking smartphone customers from Android vendors, it's striking how much product/service integration has helped. Apple's integration allows it to make a continuing series of cutting edge, meaningful product improvements, while its scale allows it to offer a competitively priced -- if still high end -- product.

Android vendors relying on undifferentiated, modular/standardized product elements -- like the Android OS or Qualcomm chips -- cannot seem to match the iterative improvement of Apple's products. These vendors are at the mercy of their modular suppliers, and these suppliers aren't keeping up with Apple: Qualcomm is having difficulty matching Apple's in-house chip design, while Google is having difficulty keeping Android updated and malware free. As a result Android vendors are forced to sell an inferior, commoditized product at an unprofitable price. Companies that do this long enough go out of business -- they run out of time and money to improve margins by moving up the product improvement trajectory. See Concepts page and discussion of Clayton Christensen.

You might expect a large group of modular suppliers to eventually catch up with Apple's in-house efforts, but it doesn't seem to be happening. If anything, Apple's profitability is making its in-house efforts even harder for modular suppliers to match, since Apple has the deep pockets needed to hire the very best talent.

The author owns stock shares of Apple.