Two recent events related to Apple Inc. caught my attention over the previous weekend.
Berkshire Hathaway Inc.’s large investment in Apple of $1 billion last month made headlines the world over. It was indeed an iconic moment as Warren Buffet has religiously avoided technology stocks throughout his illustrious career. What could this be attributed to and, more importantly, does this portend a shift in favour of technology investments at a time when the Nasdaq is near its all-time highs?
Tim Cook, chief executive officer of the most valuable company on earth, lands up in India soon thereafter, for the first time—so late in the game when India is no longer an emerging story. Compare this with Bill Gates, John Chambers, Michael Dell and Scott McNealy—heads of technology leaders—all of whom visited India in the early part of 2000s. I still remember the energy and enthusiasm at their closed-door meetings with business leaders in Bengaluru and the huge interest demonstrated on both sides in learning from each other. These visits resulted in significant investments into India a couple of years down the line from these companies.
Is the timing of these two seemingly unrelated events merely a coincidence? Or is there a larger picture?
To understand this, I first attempted to analyse Buffet’s surprising change in approach towards investing in technology stocks.
Firstly, by his own admission, he does not understand technology and does not own stocks even in his best friend’s iconic company: Microsoft Corp. It is highly unlikely that at this stage in his career, he would have developed an in-depth understanding of technology to make such a large investment.
Secondly, he had also once said that though creative destruction is great for capitalism, it is not so for the certainty of investment outcomes. Thus, industries prone to disruptive technologies did not figure in his investment philosophy. Apple is clearly in this category of companies prone to high risk of disruption. iPhone contributes about 65% of Apple’s profits and is in its eighth year.
Compare this with the current state of irrelevance of the erstwhile companies dominant in this space over the last decade: Nokia Corp, BlackBerry Limited, Motorola Inc., Sony Ericsson etc., and the drift should be clear.
Thirdly, the underlying theme of Berkshire’s investments has been one of consistency and predictability of cash flows—businesses related to public utilities, energy, foods and drinks, retail, etc. After all, utility companies are natural monopolies (as demand for electricity will always be around with no alternative to cables running into our homes) as will the need for food products, with changing food habits being a huge entry barrier for competitors of his investee companies like Kraft Heinz Co, Coca-Cola Co, or Sees Candy Shops, Inc.
Apple just does not fit into this hypothesis, unless Buffet is giving a message that Apple is not the high-growth stock it used to be, and is now to be deemed in the same category as a boring utility/FMCG stock with stable cash flows, which is his investment forte. That’s something he did with IBM Corp.—his only technology investment—in 2011 after its metamorphosis into a services organization. By the way, returns from that investment are still negative after five years.
This leads me to Tim Cook’s visit to India—significant, given that Apple has consistently ignored India. Apple’s difficulties in China are well known and are now reflected in its poor results just announced in April, after which the stock tanked by 30% from its peak of $133 to below $90. No CEO can ignore such a catastrophic fall in its market cap in the global markets.
It is quite obvious that India is perhaps the only market with the potential to alleviate Apple’s growth concerns in this situation. And, being a neglected market, the benefits of low-hanging fruits are too tempting as a quick-fix. The humility of Cook’s visits of visits to Siddhivinayak Temple and Shah Rukh Khan are a far cry from his public statement in 2012 that India had less potential than other markets.
The challenges Apple will have to overcome as a result of not being meaningfully present in this market are huge. The ecosystem for iPhones is under-developed and the sales of the product so far are largely because it is seen as a status symbol by upmarket Indians.
Spotify, for example, does not exist in India; neither does a customer-centric service offering where a faulty product is simply replaced across the counter in Apple stores. Accessories are overpriced, leading to a flourishing grey market. Indians by nature are cost-conscious though there is a segment which would try to outdo neighbours with expensive purchases, but that is not a large number. Though “Apple’s U Turn from arrogance to servility" was reported in www.qz.com post his visit, I did not quite hear anything substantive from Cook which reflected a climbdown to break into the Indian market, notwithstanding some breathless television reportage.
For example, the fact that iPhones are more expensive in India than in the US due to higher taxes here, but with far less functionality due to lack of ecosystems, is a serious challenge surmountable only, in part, by pricing initiatives specific for India till these issues are resolved.
However, Cook insisted that the quality and value being superior, pricing will remain at international levels and Apple will not participate in the market of ₹ 12,000 smartphones. Yet, Apple aspires to increase its share of India business from less than 1% of its total revenue.
Secondly, Cook proposed to sell refurbished phones in India to reduce price points, a request India has rejected. Granting it without any commitment to set up a local manufacturing capacity in India would have resulted in dumping of used iPhones in India. Remember PL 480 case of the mid-sixties when US dumped contaminated wheat in the name of aid into India.
His latest request for waiver from policy conditionalities of 30% local sourcing for single brand retail on the grounds that it is a “high technology" company, was again refused by the Foreign Investment Promotion Board (FIPB) while clearing its proposal to participate in the Indian market on a level-playing field.
The approach of what’s right for US is right for the world, and premium pricing based on perceived value rather than what the market can bear, is the same mistake many multi-national companies made in the 1990s and early 2000s including leaders like Digital Equipment Corporation (DEC), Lucent Technologies and General Electric Co. GE learnt from it and survived, DEC and Lucent did not.
Back in early 1990s when I said Digital’s cost-plus pricing model cannot survive in India’s post-liberalization environment and that the company needed to migrate to a revenue-minus pricing model to match low-cost PCs from IBM and Compaq, Dick Poulsen, a member of the core team of Digital Equipment founder Ken Olsen responded that “these are playthings and not ‘real’, high technology products" and that “a petty finance manager" should not attempt to understand them.
In a few years, Intel and AMD, responded with sharply cheaper x86 chips and DEC’s days were over. Lucent too ignored pleas from the local management not to exit the high potential GSM business in India in 2002 due to competitive pricing pressures from rivals like Ericsson and Huwaei. They opted for CDMA instead, purely due to its ability to price it higher. Lucent does not exist today.
Even decades later, in a vastly interconnected world, Apple’s Cook echoes this same philosophy of intransigence many American managers are infamous for. Both DEC and Lucent (legendary Bell Laboratories was part of Lucent after the trifurcation of AT&T) had awesome research and innovation capability, believed in proprietary operating systems to extract exorbitant prices from its cult following and had huge cash flows.
Apple is strikingly similar at this moment in all these respects. It is also perhaps making the same mistake by ignoring large markets like India and trying to play the game without learning from either the past experiences of other MNCs or seeking inputs from its local management team.
Perhaps Buffet has seen through this and believes Apple will not risk a disruptive change in its business model and, given its high innovation capability and strong franchise, will still continue to grow safely at FMCG rates in the secured confines of its existing markets. He perhaps believes that Apple would be akin to a solid income generating utility, given that growth is not likely at the company any time soon.
However, Cook is perhaps looking to introduce all forms of services to capitalize on its cult following among its loyal consumer base who are unlikely to migrate to an Android platform. These services will potentially cater to the ongoing need among its 400-million plus customer base for apps and connected services like Apple Music, Apple TV, Apple Watch, leasing options and shopping platforms like Apple Store, iTunes, physical Apple Stores, etc.
This is, therefore, essentially a play on the retention of its cult stature among its followers and their customers’ ability, and indeed willingness, to continue supporting the high-value pricing proposition for Apple’s largely undifferentiated current product range.
Of course, Apple’s massive cash balances allow it the flexibility and time to experiment for a few years. However, how this will prevent an erosion of value due to the risk of disruptive competitive technologies is not clear.
Maybe this will be Buffet’s second technology investment after IBM which will test the patience of his investors.
At a price-to-earnings multiple of 10 times there is not much downside, or upside, to the stock—A vintage Buffet investment after all!
Prabal Basu Roy is a Sloan Fellow from the London Business School and a Chartered Accountant. The writer presently manages a PE fund and has formerly been a director and group CFO in various companies.