Buffett's Moat: Is Apple's Competitive Advantage Sustainable? (AAPL)

Apple Inc. (NASDAQ: AAPL) is one of the largest companies in the world, with a June 2016 market cap of $540 billion. The company has achieved this scale despite offering a relatively small number of products. Apple has built one of the world's strongest brands through innovation and superior aesthetics, with transformative products such as the iPod, iPhone and iTunes. This strong brand and first-mover status on several disruptive technologies has allowed Apple to charge a premium for its products, supporting high profit margins. The company maintained a wide economic moat in early 2016, but declining margins and returns on invested capital could indicate some contraction of competitive advantage in coming years. Apple must lead its peers in innovation to maintain its moat going forward.

An economic moat is established by competitive advantages that protect a company's place in its industry. These factors create barriers for new entrants and limit other competitors' ability to accumulate market share. Economies of scale, network effects, regulation, intellectual property and brand strength are the five most important determinants of moat width and sustainability. Companies that are not protected by at least one of these elements will be subject to intense competition, especially in mature industries.

Apple established very strong brand loyalty through years of clever innovation, design and marketing. The brand was ranked as the world's most valuable by Forbes in 2015, and was worth an estimated $145 billion, which was more than double the next highest-ranking brand. Apple's products gained a reputation as high-quality personal electronics for savvy consumers with disposable income. This made them aspirational items for conspicuous consumption, even though their market penetration was exceptionally high. When lower-priced competitors followed Apple into the portable digital music and smartphone markets, the perceived quality and brand recognition protected Apple's sales volume and margins.

The App Store and iTunes also helped create a network effect, with the marketplace becoming a more attractive medium for exchange. Content creators benefited from gaining access to a larger number of users on a single platform, whereas users benefited from a central location to consume and rate music or applications. Apple also maintained a so-called walled garden, with its own operating systems, customer support and marketplaces, all of which were restrictive enough to maintain a more captive user base and facilitated the sale of value-added services.

Apple is a large company that benefits from economies of scale, but it does not have a distinct advantage in this regard over its largest competitors. The existing competition includes massive firms that can match or surpass Apple's manufacturing, administrative or marketing efficiency. While Apple possesses intellectual property and patent protection, the array of comparable products across several major categories indicates just how narrow the moat is in this regard. Apple exists in a highly competitive environment in which aesthetics can eventually be copied, and other firms will constantly innovate. To maintain this edge in a rapidly evolving environment, Apple has to periodically create a radically disruptive new product. This is not an easy task to accomplish, and an inability to revolutionize new markets will eventually lead to margin compression and moat erosion.

Economic moats can be quantitatively identified by the extent and stability of profit margins. If returns on invested capital (ROIC) exceed the weighted average cost of capital (WACC) for a business, then it most likely has a moat. Apple's ROIC was 25.5% over the twelve months ended March 2016, which was well below its recent high of 42%. The company's WACC was 7.85%, assuming weighted effective interest of 2.54%, an equity risk premium of 6.16%, beta of 1.5 and a debt-to-capital ratio of 0.38. ROIC is well in excess of WACC indicates a wide moat.

Apple's gross margin was 39.8% over the twelve months that ended in March 2016, which was above the five-year low of 37.6% and below the five-year high of 43.9%. Operating margin of 29.4% similarly fell in the middle of recent distribution. The quantitative threats to Apple's economic moat are evident, but there was little to indicate its systematic erosion as of March 2016.