Instead of further examining where Apple’s current (and future) products fit in on the “innovation scale,” in Part II I want to talk about Apple as an investment, and where its products fit in in terms of investment value.

Apple has been a fantastic investment over the past decade. In fact, since April 2003 when they launched the iTunes store (and iPod sales took off), a dollar invested in Apple would be worth over $40 today – an annualized return of almost 70%. That’s a return that would make most venture capitalists blush. Not bad for a company founded 27 years prior.

One more statistic: even if Apple stock had gone nowhere from its IPO in 1980 up to 2003, its annual return over the three decades since going public would be 13%, which still beats the S&P 500 by over 3%. In other words, almost all of Apple’s current value (~$230 billion) was created over the last seven years.

Where did that value come from? For the seven years ending 2009, sales grew from $5.7bb to $42.9bb. Over 70% of that growth came from new products: the iPod, the iPhone, media sales, and other related peripherals. On a net profit basis, even more than 70% of Apple’s growth came from new products (segment margins aren’t disclosed, but overall margins have hugely increased and most of that likely came from new products). Aside from the storied brand name, Apple is basically a startup that was funded with the cash and income from their struggling Macintosh business.

Apple and the Red Queen Run the Hedonic Treadmill

“…it takes all the running you can do, to keep in the same place.” – The Red Queen, Lewis Carroll’s “Through the Looking-Glass”

So, clearly, the law of large numbers comes into effect when looking at Apple’s future growth prospects. To double revenues, Apple would have to sell an extra $43 billion a year in products – that’s over 68 million iPhones or 32 million Macs every year.

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Apple is an incredibly creative, innovative company, and is usually at the top of people’s minds when it comes to new consumer technologies. So for the rest of this post, I’ll examine if and why Apple’s products are disruptive.

Disruptive Portable Music?

Before MP3 players, the only real option for portable music was a CD player. The first MP3 players were introduced in 1998, and had very low capacities. They could hold at most one or two CDs worth of music. In 2000, Creative released its NOMAD Jukebox, which had a capacity of around 1,200 songs. However, it was expensive and had limited usability.

The first generation iPod (5GB) was released in 2001 and could hold an average of 1,000 songs, or about 79 CDs at an equivalent quality. The cost of music (content) was low at first: consumers who already had a CD collection could transfer their songs to the iPod, or download them from the (usually illegal) filesharing programs on the internet.

The total cost per portable song for an iPod 1G was $1.48 or $0.39 if users converted old songs. This compares favorably to a CD player’s $1.95 cost per song (assuming someone can carry around a maximum of 10 CDs without it becoming too much of a burden – see notes for details). Despite this ability to carry more music for an incrementally cheaper cost, like earlier players the high total cost of the device—and the lack of convenience to use its capacity—confined sales to “fist adopters” and high-end users who were willing to convert their old music collection.

So at first, the iPod was a sustaining innovation relative to other portable music devices. Although it wasn’t made by a current industry leader, it was a breakthrough improvement upon other portable music devices and the performance metrics that customers valued (quality, capacity, cost per portable song, etc.).

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Although the phrase disruptive innovation is used often, it is best described by Clayton Christensen in his books “The Innovator’s Dilemma” and “The Innovator’s Solution.” Most new technologies are sustaining—they improve the performance of current products along dimensions that the market already values. Rarer disruptive innovations result in products that are worse than current offerings in the near-term, but offer a different value proposition and are directed toward a different set of customers.

There are two types of disruptive innovations: new-market and low-end. New-market disruptions create a new value network (the context in which customers and firms within an industry define what attributes are most important), with different performance attributes. They usually serve customers who would normally not be using the product at all (i.e. personal computers, Bloomberg terminals). Low-end disruptions attack the least-profitable and most overserved customers along attributes that the market currently values (i.e. discount retailing, steel minimills). Both types of disruption eventually end up overtaking or completely replacing current offerings as their performance improves.

There are also two types of sustaining innovations: incremental and breakthrough. Most sustaining innovations are simple, incremental year-to-year improvements. Others are dramatic, breakthrough advances that surpass all current offerings (i.e. contact lenses replacing glasses, airliners replacing other long-distance travel). Many people confuse the terms disruptive and breakthrough. Christensen further distinguishes them by pointing out that disruptive innovations usually do not entail technological breakthroughs. Instead, they package current technologies into a disruptive business model.

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Just going through the book “The Innovator’s Dilemma” by Clayton Christensen. I have a few posts I’ll likely write that relate to the book — this is one of them.

The Innovators Dilemma talks a lot about a company’s culture, and why incumbent leaders of a certain technology are restrained from participating in a disruptive technology’s upside. Christensen names these attributes as the incumbent’s downfall: (1) Current customers aren’t served by new market; (2) New market is too small for large companies; (3) Use of new technology isn’t fully known yet; (4) Processes that help them with current business hurt them with new business; and (5) New technology isn’t good enough yet to meet higher-end market demand.

One solution to the above issues is to acquire another company that can take advantage of the disruptive technology. If done correctly, this can solve numbers 1, 2, 4, and 5 above.

Christensen breaks down the factors that affect what a company can and cannot do into Resources, Processes, and Values. Resources are people, equipment, brands, technology, customers, etc. Processes are how companies transform those resources into products or services of greater value. Values are standards by which employees make and prioritize decisions (think of a company’s “Core Values” of the Jim Collins variety).

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I wrote the following article for partners of Braewick Holdings LP and readers of this blog. The article is on the story of Steak n Shake, Sardar Biglari, and what it takes for a restaurant to succeed. I’ve included the introduction here, but the entire article is in PDF format through the link below:

“The Restaurant Investor” by Max Olson

In March, 2008, Sardar Biglari won the most important victory of his life. In an activist campaign to gain control of the board of directors of The Steak n Shake Company, Biglari and his partner received nearly triple the number of votes of the directors they were replacing.

It hadn’t been easy—their proxy fight with incumbent management had been going on for more than six months. Biglari and the entities he controlled first purchased seven percent of Steak n Shake during the summer of 2007. In August, the initial filing was made with the S.E.C. stating that Biglari had been in discussions with management. At this point, as with many activist investors, Biglari hoped that management would be open to his suggestions and criticisms of the company. He was the third largest owner of Steak n Shake at the time, holding more shares than all executive officers and directors combined. Only days earlier, C.E.O. Peter Dunn had unexpectedly resigned, stating his intent to “pursue other interests.” It seemed like the perfect time to reform the faltering restaurant chain.

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The New York Times, 11/4/1907

In October of 1907, financial markets in the United States came to a complete halt. Credit markets froze, major banks collapsed, and the stock market plunged. Heads of industry, like J. P. Morgan, were forced to inject massive amounts of capital to prevent a complete collapse.

The circumstances of the Panic of 1907 are very similar to our current crisis. In both, the economy had experienced huge growth over the preceding decade. Banks lowered lending standards, which led people to take on more and more debt. When bank assets began to decline, depositors panicked, and there was a run on the financial system.

But for the rest of this post, I’d like to focus on the period that follows a financial crisis—not on the crisis itself. (Keep in mind that although I speak in terms of American progress, my point applies to any country around the world.)

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The period following 1907 was monumental in American history.

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