Monday, January 9, 2012

Financial analyst believes patent litigation could raise Apple's share price by $35-$260

In an article entitled "Why Apple is in no hurry to settle its iPhone patent suits", Fortune's Apple 2.0 blog (part of the network) reports on a note issued by Deutsche Bank analyst Chris Whitmore to clients today, listing four possible outcomes of the patent wars between Apple and the Android ecosystem, and their impact on Apple's shareholder value.

Philip Elmer-DeWitt, the author of the article, says that the note mentions a neutral outcome (no winner) and one in which Apple comes out on the losing end as possibilities but actually focuses on two more favorable outcomes:

  1. "a settlement where Apple licenses its intellectual property for about $10 per Android device sold"

  2. "where Android's feature set or ability to distribute is diminished"

The analyst apparently believes outcome 1 would raise Apple's share price by approximately $35 (a terribly erroneous belief in my opinion, as I'll explain further below), while outcome 2 (described as "considerably less likely" in the article) would offer an "enormous" payoff since Apple could capture, for example, "25% of the future anticipated Android market", in which case its share price could grow by roughly $260 per share. Apple's (AAPL) closing price on Friday (January 6, 2012) was $422.

I haven't seen the actual research note, just the article. On that basis, here are my thoughts:

I totally agree with the analyst's suspicion that"Apple is unlikely to settle cheaply" and that shareholders could benefit from being patient. I believe a lot of observers overestimate the hard (legal fees) and soft (distraction of management) costs of the patent wars. All of this is perfectly manageable for those large players, and while the costs may be staggering in absolute amounts, they're little by comparison with what's at stake. Quite tellingly, both Apple and Samsung had stellar financials in 2011, and those two companies also fought harder on the patent litigation front than anyone else. Even for HTC it is paying off so far to hold out, though I believe Apple could already have made far more headway against that rival in the (almost) two years that have gone by since it started the dispute if it weren't for some poor choices made back in 2010.

I furthermore agree that the potential reward for Apple in a scenario in which it can (quoting from the Fortune article) "handicap Android's feature set and/or distribution" is huge, and even the aforementioned $260-per-share effect isn't unrealistic in that event.

But the part on which I disagree strongly (again, having seen only the article, not the actual research note) is the suggestion that a $10-per-device royalty income would add "roughly $35 to Apple's share price". That one would be accurate only under an all-other-things-being-equal assumption, and if that is (as it appears) the assumption, it's fundamentally wrong in light of Android's skyrocketing success. Shareholders relying on that assumption would most probably lose a lot of money.

There is no realistic scenario -- not even a remotely realistic one -- in which Apple can simply tax the Android ecosystem, generating additional income but also keeping market prices and its own margins higher by (in the analyst's example) $10 per device, without losing out on the bottom line.

If Apple had to settle for a mere $10-per-device royalty without any further effect on competitiveness that would result from restrictions on features and/or distribution, investors should give serious consideration (after a full analysis of all of the relevant issues and factors) to shortselling Apple's stock. Why? Because this would open the floodgates to Apple going once again through what it experienced in the 1990s: commoditization.

$10 per device is nowhere near the royalty level that offsets the continuing erosion of Apple's market share, which is already huge in connection with smartphones and will sooner or later be substantial in the tablet computer market, too.

Here's a very simple calculation. Admittedly, it's very simple, but it's not meant to be scientifically precise: its sole purpose is to demonstrate the problem. If we assume, for the stated purpose, that someone buying an Android device -- in a scenario in which Google and its hardware partners can commoditize and cannibalize Apple's business to their hearts' content -- would otherwise (if Apple achieved meaningful differentiation) buy, with a probability of only 20%, an Apple product, then $10 is a very bad deal because just the first sale of a device would currently represent a margin in the hundreds of dollars for Apple, and 20% of, for instance, $200, amounts to $40, and even that number is an understatement. Why is the actual loss to Apple far greater than the $40 figure (20% probability times $200 gross margin)? Because of the follow-on business opportunity. The customer in this example will become an Android user. He won't buy any downloadable products from Apple (apps, iTunes songs etc.) and, even more importantly, will be much less likely to buy an Apple device a year or two later when he buys the next one. So the lifetime loss to Apple of letting a customer become an Android user is many hundreds -- if not thousands -- of dollars, and that lifetime loss has to be multiplied with the likelihood in an alternative scenario in which there is differentiation.

In the Australian dispute between Apple and Samsung, Apple told the court the very thing I just explained: that a sale of a Galaxy Tab 10.1 at this stage has longer-term implications because of each Galaxy Tab customer becoming an Android users and then being much less likely to switch to iOS later. If an end user repeatedly buys Android devices and if Apple kept generating $10 per device for many years, it would get several times $10. But in absolute amounts, the loss of a customer would be even greater than in the example I provided.

The fifth scenario (apparently missing from the research note)

There's a fifth scenario that the analyst apparently didn't consider, and it's more likely than at least two of the scenarios he listed. It could very well be that Apple's patent rights aren't ultimately strong enough to hobble Android in terms of a complete removal of a large number of important features. Maybe the Android ecosystem can remove features that are nice-to-have rather than must-have functionalities, and work around the remaining patents in ways that preserve most or all of the functionality but require a different implementation strategy.

At first sight, some people might wonder what the point in this one would be for Apple. Why fight a patent war without doing huge damage to your competitors? But it's not that simple. This scenario would actually also be valuable to Apple for two reasons:

  • While a simple feature-by-feature comparison wouldn't make Apple's products appear hands-down superior over Android-based products, they would at least be unique. The user experience would be unique. Some of this would be subtle or even subjective, but it would mean that using an iPhone or an iPad is different. And Think different is a key part of Apple's corporate history and philosophy. Being different is worth fighting for regardless of whether someone else gets weakened or damaged.

    Yesterday, a Forbes columnist laid out five reasons for which he believes Windows Phone will succeed, and he touts "the originality of the Windows Phone operating system", thanks to which he believes the platform "may dodge a few patent-war bullets". Between Apple and Android, what's at stake could also be described as "originality".
  • Through relentless IP enforcement, Apple can discourage blatant, outright copying, and thereby level the playing field. Over the last year I've seen a number of comments by Apple fans on discussion boards who attributed Android's success in no small part to the fact that Google was, so far, able to free-ride on Apple's innovation. By forcing the Android ecosystem to come up with original ideas (including workarounds and designarounds), Apple can raise its rivals' research and development costs and, more importantly, secure more of a "breathing space" between its own innovation and imitators.

    That, too, is worth fighting for without having to preclude Android in the long term from providing certain kinds of functionality.

A $10 royalty per device is worth far less to Apple than originality.

Apple may not have managed its litigations too well so far. It may not have drafted some of its patent applications too well either (for example, the slide-to-unlock image patent could have much broader scope now if it had been optimized for strategic purposes). But this just delays its efforts, and as long as all those Android companies can't do serious damage to Apple, it can keep enforcing its rights and pursuing its real vision.

Any analyst evaluating Apple's strategic options in the patent wars must understand that Apple can't simply build a patent licensing business in addition to its operating business without some trade-offs and interdependencies. The operational value of a $10-per-device royalty is a bad deal in the greater scheme of things. Like I said, the moment Apple does such a deal (as opposed to a deal involving a combination of a royalty for some patents and restrictions on the use of other patents) might be a good point in time to shortsell AAPL.

Finally, I'd also like to point out that Apple wouldn't even be able to get a $10 deal today. After almost two years of litigation against Android, it has had some impact (not only in terms of court decisions but also in terms of discouraging the Android ecosystem from copying certain features), but in order to get any deal -- whether a flat royalty deal or a more sophisticated deal involving royalties and restrictions -- it needs much more leverage than it has at this stage. The analyst is right that settlements may take time.

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