Tuesday, April 30, 2013

Apple: News, Noise and Value

As has been the case for much of the last two years, the Apple earnings report on April 24, 2013 was a media event, previewed endlessly on investment sites, covered heavily by the media and tweeted about by both Apple fans and foes. While I try to stay away from the hype around earnings reports, this is a good occasion to revisit my earlier posts on Apple, and especially the one I made at the start of this year on its valuation.

The Signal amidst the Noise

One of the most difficult parts of being an investor in Apple has become dealing with the cacophony of rumors, stories and news releases that seem to permeate the day-to-day coverage of the stock. Not only do we, as investors, have to determine whether there is truth to a story but we also have to evaluate its impact on value (and indirectly on whether to continue holding the stock). To keep my perspective, as I read these stories, I go back to basics and draw on my “financial balance sheet” view of a company. While it resembles an accounting balance sheet in broad terms, it is different on two dimensions. First, it is a forward looking and value based assessment of a company, rather than being backward looking and historical cost based. Second, it is flexible enough to allow me to record the potential for future growth as an asset, thus giving businesses credit for value that they may create in the future from growth. In very broad terms, here is what Apple’s financial balance sheet  looked like just before the most recent earnings report:

There is nothing surprising about this balance sheet but it brings together much of what has happened to the company between April 2012 and April 2013. During the year, the company has become increasingly dependent upon its smartphone business, accounting for 60% of revenues and even more of operating income, generating immense amounts of cash for the company (with the cash balance climbing $50 billion over the course of the year to hit $145 billion). During the course of the year, we have seen a slowing of revenue growth and pressure on margins, both of which have contributed to declining stock prices. The other big change over the course of the year is that the value of growth potential (from unspecified future products) has faded, at least in the market’s eyes, and this is reflected in the decline of $200 billion in market value over the last nine months.

The Last Earnings Report (April 23, 2013)
The most recent earnings report contained a mix of good news on the financial front (cash and financing mix) and bad or neutral news on the operating asset front. Using the same framework that I used in the last section, here is how I parsed the news in the report:

First, in the no news category, revenue growth is no longer in the double digits and smartphones continue to increase their share of overall revenues & operating income. Well, we knew that already and the revenue growth was well within the expected bounds. Second, the bad news is that margins are shrinking faster than we expected them to, though I get the sense that Apple is understating its margins (by moving some expenses forward) and its guidance for the future with the intent of getting ahead of the expectations game. Third, in near term bad news, the fact there is no mention of any new products or breakthroughs suggests that there will be no revolutionary product announcement (iWatch, iTV, iWhatever) in the next quarter. However, if you are a long term investor, it is mildly disappointing that it looks like that there will be no blockbuster announcements in the next three months but it is clearly not the end of the world.

On the financial side, there was substantial news, much of which I think is positive. 
  1. Cash return to stockholders: The decision to decision to return about $100 billion more in  cash to stockholders in buybacks and dividends by 2015  has to be viewed as vindication for those (like David Einhorn) who have arguing that Apple should be explicit about its future plans for cash and that it should distribute a large chunk cash with stockholders. 
  2. Buybacks versus Dividends: In a bit of a surprise, the cash return will be more in the form of buybacks than dividends. I, for one, am on board with that decision because hiking the dividends further will essentially make this stock a "dividend" play, with an investor base that will put dividend growth in the future ahead of all other considerations.  If Apple wants to retain the option of entering a new and perhaps more capital intensive business in the future, it is better positioned as a consequence of this decision. 
  3. Debt coming? In an even bigger surprise, Apple has opened the door to taking on conventional debt. While the details are still fuzzy and the initial bond issue may be for only about $10 billion, it seems likely that the debt issued will grow beyond that amount. To those who would take issue with this decision, arguing that Apple does not need to borrow with all of its cash reserves, you may be missing the reason why this debt will add to value. If the trade off on debt is that you weigh the tax benefits of debt against the bankruptcy cost, there can be no arguing against the fact that borrowing money will add value for stockholders. To those who feel that it is in some way immoral or unethical, based upon the argument that Apple is sheltering its foreign income from additional US taxes while claiming a tax deduction for interest expenses, I would be more inclined to listen to you if you showed me convincing proof that you make mortgage interest payments every year but did not claim the mortgage tax deduction in your tax returns, because you think that it deprives the treasury of much needed revenue. The US tax code is an abomination, with its treatment of foreign income as exhibit 1, but to ask Apple (and its stockholders) to pay the price for the tax code's failures makes little sense to me. 

In summary, the net effect of the earnings report is negative on operating cash flows (with the declining margins) but positive on the financial side (with any discount on cash dissipating, as a result of the cash return announcement, and the tax benefits from debt augmenting value). 


Intrinsic value impact
In my post from the end of last year, I had reported on an intrinsic valuation of Apple of $609/share, using data as of December 2012, with a distribution of values in a later post. Given that there have been two earnings reports since, I decided to revisit that valuation. In addition to updating the company's numbers (all of the numbers except leases) to reflect the trailing 12 months (through March 31, 2013), I also incorporated the information from the most recent earnings reports to update my forecasts on three variables in particular:

  1. Revenue growth: As the competition in the smartphone business continues to increase, I am inclined to lower my expected revenue growth rate for the next 5 years to 5% from my original estimate of 6%. While this is well below the revenue growth of 11.28% over the last year (even using the last 'bad" quarter comparison to the same quarter the previous year), it is the prudent call to make, especially in the absence of news about new products in the near term.
  2. Operating margin: I had projected a target  pre-tax operating margin of 30% in my December 31, 2012, valuation, about 5% below the prevailing margin of 35.30% from the last annual report (the 10K in September). The pre-tax operating margin has dropped to 30.92% in the trailing 12 months ending March 31, 2012, and was about 29%, just in the last quarter. Since margins are coming down faster than expected, I lowered my target margin to 25%. 
  3. Cost of capital: The cost of capital that I had used in my December 2012 valuation was 12.49% reflecting my expectation that Apple would stay an all equity funded firm in the foreseeable future. The decision to use debt upends that process and adding $50 billion in debt to the capital structure, while buying back $50 billion in stock raises the debt ratio in the cost of capital calculation to about 13%, while lowering the cost of capital to about 11.29%. 

The net effect of these changes is that the value per share that I obtain for Apple is about $588, about 3.5% lower than the value of $609 that I estimated in early January. You can download the spreadsheet with my valuation of Apple. Again, make your own judgments and come to your own conclusions. If you are so inclined, go to the Google shared spreadsheet  and enter your estimates of value.

If you are concerned about whether borrowing $50 billion will put Apple in danger of being over levered, I did make an assessment of how much debt Apple could borrow, by looking at the effects of the added debt on the costs of equity, debt and capital, with the objective being a lower cost of capital. I try to be realistic in my estimates of cost of equity (adjusting it upwards as a company borrows more) and the cost of debt (by coming up with a prospective rating at each dollar debt level and cost of debt at each debt ratio). If Apple can maintain its existing operating income, its debt capacity is huge ($200 billion plus) but even allowing for a halving of their operating income, it has debt capacity in excess of $100 billion. As with the valuation spreadsheet, you are welcome to download my capital structure spreadsheet for Apple and play with they numbers.

Clear and present dangers
Given the price collapse over the last few months, it would be foolhardy not to stress test the numbers in this valuation. In the first set of tests, I went back to the discounted cash flow valuation and computed my break even numbers for growth, operating margins and cost of capital, changing each of these variables, holding all else constant. The table below lists the current numbers for Apple for these variables, my estimates and the break even that yields today's stock price ($420 on April 28, 2013).






Holding all else constant, Apple's revenues would have to decline 5% a year for the next 5 years to justify a value per share of $420. Similarly, the pre-tax operating margin would have to drop to 12% from 30% today, holding the other variables at base case levels, to get to the same price. As an investor in Apple, there seems to be plenty of buffer built in, at least at current stock prices.

Will Apple go the way of Dell and Microsoft?
As a technology firm, though, your concerns may be about the company hitting a cliff and essentially either losing value or becoming a value trap. In particular, you may be worried that Apple may follow in the footsteps of two technology giants that have had trouble delivering value to stockholders in the last decade. One is Dell Computers, where Michael Dell's attempts to rediscover growth have failed and the company is now facing a more levered, low growth future. The other is Microsoft, a less dire case, but a stock that hit its peak about a decade ago and has plateaued since. Can Apple be "Delled" or "Microsofted"?

To be Delled: What awaits a company when it's product/service becomes a commodity and it operates at a cost disadvantage. 
Dell was an success story in the growing PC business through much of the late 1990s and the early part of the last decade. As the market for PCs grew, Dell used its cost advantages over Compaq, IBM and HP to make itself the most profitable player in the market. What's changed? First, the market for PCs hit a growth wall, as consumers turned to tablets and other connected devices. Second, PCs became a commodity, just as Dell lost its cost advantage to Lenovo and other lower cost manufacturers. With Apple, the peril is that their biggest and most profitable business, smartphones, may be heading in that direction. Unlike Dell, though, Apple is more than a hardware manufacturer and it's success at premium pricing in the PC business is indicative of the pricing power that comes from creating the operating system that runs the hardware. I believe that the risk of Apple being Delled is small.

To be Microsofted: The destiny of a business that has a profitable, cash-cow product(s) but runs low on imagination/creativity.
 Riding the success of Windows and Office, Microsoft became the largest market cap company about a decade ago. Like Apple, it seemed unstoppable. So, what happened? From the market's perspective, the company seemed to run out of imagination and creativity and investors got tired of waiting for the next big hit and moved on. Note, though, that while the stock price and market capitalization have not moved much over the last ten years, the company has returned billions in cash to its stockholders. Could this value stagnation happen to Apple? Yes, but to me (and I have never been shy about my Apple bias), there are is a big difference between the companies. One is that I don't think that Microsoft lost its imagination and creative impulses a decade ago. I don't think it ever had any. While Windows nor Office were workmanlike and professional products, neither can ever be called elegant or creative (and I speak as a heavy user of Office products). Apple, on the other hand, has created iconic products through the decades, some less successful than others (remember the Newton), and I find it hard to believe that those creative juices just dried up last September.

Buy or Sell? Hold or Fold?

If Apple was being priced as a high growth stock, with sustained margins and on the expectations of "big" new hits in the future, I would be worried about the last earnings report. It is not. As you can see from the break even table in the last section, it is being priced as a low growth, declining margin company, with no great hits to come. I find it striking that the same investors who have priced the stock on this basis react to incremental news on these items (growth, margins, new products), as if they had not already priced it in.

As I see it, if I have Apple in my portfolio at $420 and the company continues to disappoint on every dimension (growth, margins, new products), I will have a boring stock that delivers billions in earnings and pays a solid dividend. However, if the company surprises by stopping margin leakage and increasing revenue growth in the smartphone market or by introducing the iWatch or the iTV, it will be icing on my investment cake. In a market, where my alternative investments are richly priced, Apple looks like a winner, to me. It stays in my portfolio, the price disappointments of the last few months notwithstanding.

My earlier posts on Apple

  1. Apple: Thoughts on Bias, Value, Excess Cash & Dividends (March 1, 2012)
  2. Apple: Know when to hold 'em, know when to fold 'em (April 3, 2012)
  3. Emotions, Intrinsic value and Dividend Clienteles: The Apple postscript (April 6, 2012)
  4. Apple's Crown Jewel: Valuing the iPhone Franchise (August 29, 2012)
  5. Winning by Losing: The power of expectations (October 9, 2012)
  6. The Year in Review: Apple's Universe (December 27, 2012)
  7. Are you a value investor? Take the Apple test (January 27, 2013)
  8. Market Mayhem: Lessons for Apple (January 31, 2013)
  9. Back to Apple: Thoughts on value, price and the confidence gap (February 7, 2013)
  10. Financial Alchemy: David Einhorn's value play for Apple (February 8, 2013)

55 comments:

Anonymous said...

Great Article as usual.

Jason DaCruz said...
This comment has been removed by the author.
Anonymous said...

I think the fact that you have had to take your margin target down by 500 bps in just five months speaks to how vulnerable that number is. Apple never put up 25% operating margins in its history before 2009, yet you're willing to capitalize those margins, which rest on the back of one product, the iPhone. That product is currently enjoying hyperprofitability in a segment that is notorious for lack of stability. Maybe Apple can be the one that brings consistant profitability and stability to the segment, but is that the high-odds assumption? You say it's being priced for declining margins; I agree. So why is that wrong, in the face of margins that are declining in a category that has had many players with high margins over the past decade, and they have all fallen so far?

Mohammed Albalwi said...

Why not divide by the new number of shares outstanding? (After buyback)

Frode Storesund said...

I am myself an Apple shareholder, but I am not an Apple product user since I find their user interface a bit dull. This means my bias is somewhat opposite to yours and also my valuation is mtherefore more pessimistic to yours. Do you have any comments on what margin of safety to aim for to minimise the psychological biasing error?

Mihai Radu said...

Excellent (but VERY complicated) work. I arrive at pretty similar results using my own proprietary methods. My Fair value $592.43 vs. your $588. So it looks like is around there.

dualityoferror said...

From the perspective of an aspiring shareholder, there is one particular side effect of the excessive cash pile on the balance sheet that bothers me the most:

Being forced to commit more funds to buy an interest in the company compared to if it had no excess cash on its balance sheet. In essence we are transferring the discretionary power over an amount equal to the excess cash from ourselves to the company’s management (via the route of buying out an existing shareholder).

Full comment here: http://dualityoferror.wordpress.com/2013/04/29/excess-cash/

Aswath Damodaran said...

Anonymous,
You may be right about margins. That is why I emphasized that this was my estimate of Apple's value, not the estimate. Question, though, is how low do you think margins will get? Below 12%?

Mohammed,
Since everyone in the world knows that Apple is doing a buyback with borrowed money, they will build in the expected change in value into the price they demand on the buyback. That is why I would allocate the increase in firm value across all shares outstanding.

Aswath Damodaran said...

dualityoferror,
You are right about the fact that you are giving management discretion over the cash and you should worry about that. Of course, you worry more with some managements (say HP) than others (say Google) but that is the basis for my argument that cash can sometimes get discounted in the market place.

Anonymous said...

I do believe that "if the company surprises by stopping margin leakage and increasing revenue growth in the smartphone market or by introducing the iWatch or the iTV, it will be icing on my investment". But the investment it self without this surprise wouldn't be better than alternative investments. I rather hold fairly priced quality and growth companies where revenue growth and margins are somehow more predictable. I love the company products, "current" balance sheet, not the industry nor the hype. I would be happy to achieve lower consistent returns and employ my capital else where. Good look Apple / Apple inc. fans.

Jordan said...

Great post! I've worked off your excel spreadsheets in the past and like the way you value companies. Thanks for posting those resources online!

Is it possible to get a list of other companies you are an investor in?

Thanks again!
Jordan

dualityoferror said...

@Aswath:

A new entering investor giving management discretion over the excess cash on the balance sheet is one thing (via the route of buying out an existing shareholder).

Giving the same discretion when the company has no use for this cash and actually intends to return it to shareholders is quite another.

Paying today $440 for one Apple share means I am committing $314 for its operations and $126 for its cash (i.e. $144 less $18 tax on trapped cash per your spreadsheet).

Key question: what returns can the company generate on the $314 and $126 parts of my investment?

From a capital allocation point of view, I would be way better of if I could invest the whole $440 directly into the operations instead of getting a 70%-30% mix of operations vs cash.

In essence, by investing in an overcapitalized company I am under-utilizing a part of my fund's capital.

This inefficiency is a side effect of the company not having a clear strategy about how to deal with cash before it gets to excessive levels.

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Aswath Damodaran said...

Dualityofreturns,
The answer to your question is easy. On the cash, it is always a fair rate of return, since it is primarily invested in marketable securities (usually low risk or riskless & liquid). Cash, by itself, is not the problem. It is what managers choose to do with the cash that should be worrying you.

Varadha said...

Being a value investor and a student of behavioural finance, I am quite bemused by the bipolar and rather emotive reaction to apple's products getting reflected in the stock price. People underestimate the strength that mounds of cash brings as competitive advantage - It is like a chess game where you have the full set of coins still to lose - unless you do something stupid, probability of you winning is fairly high. Check this out - Apple grew 400% in India last year on what is still a "skimming " strategy

http://articles.economictimes.indiatimes.com/2013-04-15/news/38556020_1_apple-india-iphone-sales-apple-spokesperson

Assuming that apple runs out of ideas, I think they still have another 3-4 years to milk their "cool factor". Of course margins might drop, but return on equity might not drop that much as incremental invested capital might not be that much.

Apple to me represents a classic case of a bi-polar, yo-yo stock because much of the weightage to the fundamentals tends to be swayed by emotions surrounding the "coolness" of the product. Sort of saying that U2 is going to go bankrupt because their latest album is poor ! Remove the veil of emotions and I do not think it is doomsday - if this was a "cigar butt", this is only half way down - enough for a dozen more puffs, not just 1-2 IMHO.

dualityoferror said...

Let me disagree on this: it's a double-trouble situation (both the excess cash and what management does with it). Let's focus on the mere existence of the excess cash and think about its implications for a potential investor:

If there was no excess cash, one could buy the operations for $314. However, given the excess cash on the balance sheet we have to commit additional $126 ($440 in total).

The expected return compared to a pure investment in operations shrinks substantially. This is because one can only invest 70% of the capital into the high return operations and must commit the remaining 30% into what is practically a low yielding cash account.

It is not a matter of valuation, it is a matter of efficient capital allocation from the perspective of a potential investor.

Jim said...

Professor, I tried editing your spreadsheet with the variables you say are implicit with the current stock price. However I seem to get a fair value of $275. Can you explain why it's not the current price?

Anonymous said...

Your break-even analysis is based on everything else held constant.

What if everything else also changes for worse? For example, what happens if revenue falls, margin falls and cost of capital increases? All of these could take place in a phased manner in the coming years.

Microsoft may have no imagination left; similarly, Apple may not continue to bring out innovative products. If fact they are proving this already.

If we change - Growth rate to 4% instead of 5% (and why not); Margin at Year 10 to 20% instead of 25% - the value comes down. If we increase cost of capital it will come down again. If we start with a lower Year 1 margin the value is lower too.

The problem with these kind of businesses is that it is very difficult to lay down projected revenues (growth), margins and cash flows. This means we have to keep referring to each quarter's earnings statement and keep changing our input estimates. So the value changes every quarter.

Unfortunately our investment decisions are made for much longer than that.

Businesses like Apple look good for investment only with hindsight. Who believed this company would go so far?

Still there is no harm in making a prediction: Apple now has a shelf life of less than 5 years. In these years Apple would still be able to keep some growth (don't know how much) but margins would take a slide (don't know how much), the cash will be made albeit with lower doses.

The amount of smartphones, tablets, and similar or new stuff coming out in the next decade would be a nightmare for the sellers but music for the consumers. While the firms fight for market share, the prices would have to go down. We can confirm this comparing the Iphone5 price at day 1 and 6 months later (especially outside of US).

Innovation from Apple? May be not this time. It may be from some other company that we don't know today but would be talking about 5 years from now.

Aswath Damodaran said...

Anonymous,
If you expect revenue growth to be -5%, margins to converge on 12% and the cost of capital to go to 12% at the same time, you should not be buying the stock. As you point out, there is a non-trivial probability that this will happen. But investing is about probabilities, not possibilities.
Jim,
I think that you are getting $275 because you are setting all three variables at their break even levels. So, you are answering the question posed by Anonymous. What if everything turns bad at the same time?

Scott said...

The recent debt announcement raises an interesting question in my mind about your valuation of Apple.

Valuation is based on the net present value of Free Cash Flow. The important word is Free.

Apple has accumulated cash flows that are not "free" to be distributed to shareholders unless significant additional tax is paid to repatriate these funds.

Your valuation reflects this by assuming an incremental 15% tax on the current cash holdings.

I agree with this approach, but my question is why don't you extend this same method to the future cash flows, which presumably: 1) benefit from offshore low tax rates (26% in your model), 2) will continue to accumulate as cash on the balance sheet that isn't "free" , and 3) if they are made "free" must be adjusted for US taxes at that time.

It seems to me that you should be adjusting your forecasted FCF to reflect the impact of taxes that should be paid to make them "free".

If you tax effect the cash balance you should tax effect the future cash flows as well. Tax rates shouldn't be 26% they should be 35% in your model

For a business that had significant go forward reinvestment opportunities in non-USA jurisdictions I could see keeping the lower tax rates as the actual cash flows earned would be spent in those jurisdictions to create future value, but for a "cash cow" type of business with limited reinvestment opportunities the cash earned should be paid to shareholders and as such the cash flows should be adjusted accordingly.

I'm interested in your thoughts.

Regards,

Mcmaaaaath said...

Beta does not determine risk of permanent loss, and should not be used to calculate the appropriate discount rate.

Discounting Apple's cash flows to the equity at 11% or 12% when they are paying 2-3% on their bonds and are a AA+ credit is sheer nonsense.

And anyways, beta has been thoroughly debunked as a method for predicting returns. In fact, lower betas are correlated with HIGHER returns, the exact opposite of what you would expect if people were using beta to discount cash flows in the manner that you are here.



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Anonymous said...

Hi Prof.

Pls could you think about tweeting out your appearances on TV/Radio/Podcasts?

like CNBC :)

Friar said...

Should amortization of capitalized software dev costs really be counted in the cost of sales or can it be backed out ?

I mean it's not a "real" cash expense as in cash flowing out right ? So to get a truer picture of the eps, legal/ethical/moral to back it out ?

Parker Bohn said...

Interesting post.

AAPL is outside my circle of competence, but I find it educational to play with valuation assumptions nevertheless.

You've given a fair value estimate. What expected return are you requiring in this estimate?
By which I mean, if an investor bought AAPL at your fair value price, then what return would you expect them to get (assuming your projections turn out to be 100% accurate).

Thanks!

Aswath Damodaran said...

Parker,
It is easy to do. If you solve for the IRR, using the current price in the DCF valuation, you get an IRR of 17.15% (approximately).

Shaiku said...

very nice article, Great analysis...

Arvindh said...

Hi Prof,

Spot on article. As an android user (biased against Apple), and a believer of the ubiquity of mobile technology, I simply cannot imagine a future where ubiquitous tech like cell phones run at $600 a phone. This is not an argument against only Apple, but as the darling of the industry I'd have to wonder if it has the longest to fall.

My one concern is that in some ways Apple feels like Nokia on an accelerated time-table. Nokia's gross margins (not operating margins as you discuss in your article) rose from the high twenties in the late 80s to a little over 40 by the late 90s. This margin then proceeded to decline over 10 long years, reaching 30% before the first iPhone was released. The first generation of smartphones i.e. iPhone 1, wasn't just cool, it added real, tangible improvements in quality of living. For the life of me I cannot see how the next iPhone will justify a marginal $600 expenditure, just as how I cannot see how the Galaxy S4 is that different from the S3.

While the odds of Apple being shredded by a collapse in the cost of mobile computing seems low (my failure to imagine a plausible catalyst), the damage that collapse in cost will cause has to be incredible.

Maya said...

good morning Sir, I am a accounting student, I wanted to research on mergers and acquisitions. whether you have a reference regarding mergers and acquisitions? please recommend some references that you have. thanks Sir, God bless you.

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Radar The Kat said...

I think it's a little misleading to suggest that MIcrosoft stagnated over the last decade. The stock price didn't go up but the P/E came down, meaning the company grew into its valuation. MSFT should never have been valued at 100x earnings. And there lies another difference between the Microsoft of 2000 and Apple of 2013; Apple is trading at one tenth the valuation today that Microsoft carried back then, so Apple doesn't need to spend long years growing into its valuation as Microsoft did over the past 13 years.

Mark said...

I bought Apple stockes few months ago thinking that the price is too low and it will rise. Only now I see some movement up. Hope that the price will go up very soon.

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Gill Bates said...

Seems like you're anchoring the downside to Microsoft.
MSFT was entrenched infrastructurally. Apple isn't.

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Anonymous said...

Hi
is the base of the holders is changing as u "wish" ( as we here about sales in the first quarter)?

sam

Anonymous said...

"as we hear"

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QUALITY STOCKS UNDER 5 DOLLARS said...

Theirs many other technology stocks that have great prospects other than apple.

Gaurav Mehta said...

my only question to your analysis is about -5%decrease in revenues over 5years.....apple is a product company and if tomorrow innovative products are not good enough ...not sure how long and how much will iPhone 10 or iPad 10 sell.... I am not saying Apple has lost innovation but Microsoft had strong competitive advantages on products that it sells even after being in the business for ages....does Apple have them I am not sure as not a single product it has which has not been replicated in a year....no one has been able to replicate a successful operating system on PC and neither a office.... I think google has strong competitive advantages with Google ....but not Apple.... A product company is a product company....u can stay on top for years but the downfall is inevitable as newer technology takes you out...Sony, blackberry, Nokia, ...are recent examples...all seemed the best at their peak...

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