Apple's Big Strength: Operational Excellence

Source: apple.com.

Apple (AAPL -0.28%) is very well-known, well-covered by analysts, and owned by a broad swath of retail and institutional investors. It couldn't have become such a massive success without the visionary leadership of Steve Jobs and the continued work of product designers and engineers in Cupertino, but the operational efficiency brought to the table by CEO Tim Cook is often overlooked. In fact, it might be Apple's greatest strength. 

One could argue that Apple's outrageous success over the past 10 years, as its stock value rose from about $5.50 to over $127, is based almost exclusively on the massive global proliferation of the iPhone. This single product has clearly been the driving force behind one of the greatest wealth-creation stories in the history of American business. In the last quarter, Apple reported just over $50 billion in total revenue, with slightly over $40 billion of that coming from iPhone sales. Furthermore, year-over-year iPhone revenue was up 55% compared to just 27% for the company as a whole, meaning other segments' revenue declined.  

As a company grows, managing suppliers, distributors, stores, and employees becomes more difficult. Imagine a great local pizzeria unsuccessfully expanding to new locations. This could be for myriad reasons, but likely boils down to not being able to source good materials at scale, find capable management and employees for its new locations, and manage the flow of money from multiple new revenue centers. Cook has been able to do all of the above on an utterly massive scale, and it shows in Apple's financials.

Cook's background and career path help explain why he's been so successful. Cook joined Apple in 1998 after 12 years at IBM and 6 months at Compaq. At IBM he eventually rose to the position of director of North American fulfillment.  After nine years as senior vice president for worldwide operations at Apple, Cook was promoted to COO where he "was responsible for all of the company's worldwide sales and operations, including end-to-end management of Apple's supply chain, sales activities, and service and support in all markets and countries."  Cook had managed inventories, negotiated favorable terms with suppliers, and run Apple's massive global operations so well that he was tapped to run the company when Steve Jobs became sick in 2009 and was later the founder's choice to succeed him as CEO.

Apple is spending less on SG&A while holding R&D steady
Selling, general, and administrative expenses are what a company spends on rent, salary and other fixed, continuing costs necessary to run the business. It is easy to think of these costs as overhead. Apple's SG&A expenses accounted for 12.34% of revenue in 2007. This generally approximated Nokia's (10.89%) and was far lower than Microsoft's (28.92%). Research and development expenses in the same year for the three companies came in at 3.26%, 11.06%, and 13.93%, respectively. The chart below illustrates the changes to 2011, when Cook was promoted from Apple COO to CEO, as well as trailing-12-month numbers.

From these numbers we can see that Nokia has been forced to spend more in these two categories since 2007 to try to stay relevant in a space it once dominated. In 2007, Nokia was the No. 1 seller of mobile phones, with 436 million to Apple's 2.3 million. Now Nokia doesn't even fall in the top five manufacturers for the much more lucrative and higher-margin smartphones that have become nearly ubiquitous in the past eight years. These numbers also show that while Microsoft has done an admirable job of cutting costs, what Apple has done is extremely impressive. From 2007 to today, its SG&A spending percentage has been cut in half while R&D has held relatively flat. These savings go toward increasing net profit margin and are a factor in Apple growing its earnings from $3.5 billion in 2007 to $39.5 billion in 2014.

"If it weren't for Tim Cook, the iPad would cost $5,000," a computer industry veteran quoted anonymously by Business Insider  said in 2012. While this might be a bit hyperbolic, it helps to underscore the importance of the less flashy operations side of the business. Massive margins and soaring net income are generated when a product is able to be sold for premium prices while keeping costs lower than those of competitors. Cutting the cost of a product through negotiating with suppliers and optimizing the supply chain directly affects the bottom line. Apple's cost of good sold (COGS) has declined from 71.02% of revenue in 2006, the year before Tim Cook took over as COO, to 61.41% in 2014. These savings have had an immense positive impact on Apple's operating margin, which has grown from 12.70% to 28.72% over the same period. 

What does this mean for the future?
Cook is only 54 years old and hopefully has many more years at the helm of this great company. As Apple continues to grow, develops more lines of business, and further strengthens its ecosystem, it is critically important that it has an operational genius as its head. Steve Jobs was the perfect CEO to pull the company from the abyss and get Apple to the mountaintop of industry in the 21st century. Staying there is more about being able to see and manage all of the moving pieces on the global chessboard. Tim Cook has displayed this skill set since his time at COO, and I believe he is the perfect CEO to push Apple even higher in the years to come.