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Danger Zone 5/13/2013: Apple Inc. (AAPL)

Tuesday, May 14th, 2013

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.

Apple Inc. (AAPL) is in the Danger Zone. Too many investors see AAPL through the rear view mirror and assume that its sky-high profits and return on invested capital (ROIC) are sustainable. As detailed in my Jan 25, 2013 CNBC interview, Apple is not cheap and investors should not underestimate the impact of losing Steve Jobs. Without another ground-breaking innovation like the iPhone, Apple is destined to be just another consumer electronics company. And the stock is very expensive relative to other technology and consumer electronics stocks.

Just Another Computer Company

Almost a year ago, I wrote a bullish article on Apple, arguing that its sky-high ROIC made it a great value for investors even at such a high price. Since then, the company’s ROIC fell from 340% to 271%. Add the lack of innovation and issues with new products, and I see the recent drop in ROIC as a new trend. Without significant product differentiation, Apple cannot maintain the ultra high profit margins and ROICs.

Comparing Apple’s ROIC to its competitors and industry averages provides fair benchmarks for what might be a more reasonable future level of ROIC for AAPL.

Figure 1 compares Apple’s ROIC to competitors Microsoft (MSFT), Google (GOOG), Blackberry (BBRY) and Dell (DELL) as well as the market-weighted average ROICs of different industry segments. This figure shows just how far Apple’s ROIC could fall if it returns to more normal levels, which I think is inevitable after the departure of Steve Jobs. The problem is that AAPL is priced to maintain a sky-high ROIC of 124%. Here is more detail on why a 124% ROIC is unsustainable.

Figure 1: Apple Versus its Competitors

Fig1_DangerZon_AAPLSources: New Constructs, LLC and company filings

No Longer a “Value” Stock

People think AAPL is a value stock, but that’s only the case if one assumes its current ROIC is sustainable. AAPL’s current valuation of ~$452.97/share implies a long-term ROIC of 124%. I think that level of profitability is still too high to maintain.

If we assume Apple can maintain an ROIC close to Microsoft’s, around 75%, then the stock is only worth ~$295. If Google’s 34% ROIC is the benchmark, the stock is worth only ~$191. If we assume Apple can maintain a long-term ROIC of 20%, which is still high in the consumer electronics sector, the stock is worth ~$162.

The “value” in Apple is an illusion. Astute investors need to look at Apple through the lens of what is a reasonable ROIC in the future.

The Law of Competition Reverts ROICs To The Mean

Super high ROICs are a blessing and a curse. On the one hand, a 340% ROIC is an unprecedented achievement for a company Apple’s size. On the other hand, it invites lots of competition from businesses seeking to get in on those high margins.

For years, Apple’s superior products could demand premium pricing. Today, other phone and tablet makers are quickly narrowing the gap between their products and Apple’s. The differences between an iPhone and a Samsung Galaxy or a Motorola Droid are no longer enough to justify a major difference in price.

The loss of Steve Jobs hits Apple extremely hard when it comes to innovation and product quality. His energy, creativity, and attention to detail played a critical role in enabling Apple to stay ahead of the pack for as long as it did. Without him, Apple has not come up with any significant new innovations and appears to be falling a bit behind the competition. The Apple Maps fiasco last year revealed how much the company missed his attention to detail.

Taking the competition to court does not stop them. It only slows them down – at best. Apple’s $1 billion verdict in its patent infringement lawsuit against Samsung last year was encouraging, but that amount was reduced 50% on appeal. Patent suits are very expensive (time and money) and difficult to prosecute. As hard as it tries, Apple will not be able to sue its competitors out of business. Google, Samsung, Blackberry, Microsoft and many other firms will continue to put out phones, computers, and tablets that will be increasingly competitive with or better than Apple products. Apple needs another ground-breaking new product to maintain margins and profit growth.

Do not get me wrong. Apple is still a great company and an American icon that gave us amazing new devices. My point is that a great company does not make a great stock. And AAPL is not a good stock.

Figure 2: ROIC Has Peaked

Fig2_DangerZon_AAPLSources: New Constructs, LLC and company filings

Beware of Groupthink

Normally I end these articles by warning investors to avoid the ETFs and mutual funds that allocate significantly to the stock in the Danger Zone. With AAPL, there are too many funds to include in this report.

An astounding 664 of the 7,000 ETFs and mutual funds I cover allocate at least 5% of their value to AAPL. Mutual fund managers have caught a serious case of groupthink when it comes to AAPL. No fund manager or ETF provider wants to have to explain to investors why they did not own AAPL if the stock takes off again. So, they keep the allocation rather than do more independent research.

Mutual fund managers and ETF providers are too often focused on performing in line with their peers. That strategy helps protect them from losing market share. In the event of a market downturn or a big drop in a widely-held stock, they are protected from losing assets as long as all or a majority of other funds underperform along with them. The goal is to avoid being singled out and risk losing more assets than peers.

Sam McBride contributed to this article

Disclosure: David Trainer owns MSFT. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

 

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75 Comments

  1. th3uglytruth says:

    David…

    What value does your model give GOOG, NLFX, DELL, CRM and AMZN?

    please provide the same spreadsheet for the assumptions. I think this should provide some clarity to help people who question the approach,

    Patiently waiting…

  2. Jon Tseng:
    Thank you very much for your very reasoned comment. Quite refreshing.

  3. Bill says:

    Jonathan–

    http://www.blogger.com/profile/01916149961326205602

    Helpful? No, not helpful at all. His “model” makes unproven assumptions, and tortures/misrepresents/”adjusts” data, to arrive at a claimed present value–which no one in his right mind believes. He doesn’t just “make some assumptions which could be considered bearish”, he makes some assumptions which could be considered nuts. And, without those unrealistic assumptions–his skyhook–he couldn’t come up with his headline grabbing/CNBS pushing $240 valuation. And that’s being kind.

  4. Jon Tseng says:

    You’re welcome. Interesting approach; if you were involved in CS/HOLT I guess you don’t need reminding about CAP! But I do reckon even a couple more years of super-normal returns might have an impact on the valuation (although the high cash balance will dampen down the impact on the overall equity value).

    Then again I guess the whole point of the last six months is that the market has dramatically reassessed its view of AAPL’s competitive advantage period!!

    Def a worthwhile prism tho. Need to revisit my valuation over the next few weeks anyway will be interesting to see if the EVA and the PE are telling me different things. That might be a solution to the perennial “oh its cheap on an ex-cash PE” dilemma.

    All the best

    Jonathan

    PS Was having a look a NVDA the other day – the opposite a stock that’s dead cheap on an ex-CASH PE but also has a good record of producing excess returns!

  5. Jon Tseng says:

    Bill

    I wouldn’t consider a 70% or 52% ROIC assumption to be particularly nuts or unrealistic.

    Let me walk you through it. The ROIC is the annual payment you get for investing your capital. So the 2% interest on your checking account – thats the ROIC on the cash you have stashed in there. Similarly the long run return on US equities is – what? 10%? Something in that ballpark or used to be (obviously slightly depends on your time period). So in that context making even a 50% or 70% ROIC assumption is pretty heroic. Tell me another asset you can invest your capital in that will produce those returns…

    You also need to think about the sustainability of those returns. With the bull case not only are you arguing that you get very high returns but they are sustainable for a number of years (Competitive Advantage Period). That is definitely tricky.

    For context a good asset-light business model (say a software company) could probably do you 20%+ ROICs sustainably. But that’s pretty damn good. Again link it back to your bank account – how easy is it to find places to put your capital that increase it by a fifth every year.

    Now as I pointed out there as a couple of issues with DTs model. In particular its massively sensitive to the initial NOPAT number you are capitalising – perhaps enough to make it useless. I’d like to see it rebuild as a standard HOLT-type EVA with a longer fade and an adjustable CAP to sense-check.

    But I don’t think his basic approach is unsound, or he’s particularly misrepresenting anything (woulnd’t mind checking IC calc to be sure on that).

    All the best

    Jonathan

  6. Contradan:
    The unadjusted model based on the current 270% ROIC shows the Economic Book Value at $796.
    The purpose of my article is to show the implications on valuation of lower ROICs.

  7. David Gekiere,
    MY model answers your question. And all other like it.
    That’s why I gave you the model

  8. th3uglytruth says:

    David…

    I continue to patiently wait for the value your model would peg GOOG, DELL, AMZN, NLFX and CRM.

    You’ve answered other questions; my simple question shouldn’t really be that hard to answer.

  9. Bill says:

    Jonathan–

    “In particular its massively sensitive to the initial NOPAT number you are capitalising – perhaps enough to make it useless.”

    Bingo!

  10. Bill says:

    Article–

    “The problem is that AAPL is priced to maintain a sky-high ROIC of 124%.”

    The problem with your problem is that your graph shows that AAPL has been above that “sky-high ROIC of 124%” since 2004/2005. Your entire adjusted model simply boils down to your assumption that Apple can’t keep going, and you make up (“adjust”) numbers to bootstrap your assumptions.

  11. Dave says:

    I think based on Mr. Trainor’s model that I can roughly answer my own question from above – suppose that Apple invests another $20 billion of excess cash in the business and ends up with a 70% ROIC? That implies:

    - Additional $14 billion of NOPAT;
    - Capitalized at his WACC of 6.5% (which I actually think seems low, BTW) is $215 billion of additional value
    - Removing that $20 billion of excess cash means a net value increase of $195 billion

    I believe that equates to a value of roughly $490 per share.

    Yes, this includes a lot of assumptions, but I fail to see how they are any less plausible than Mr. Trainor’s assumptions. His implicit assumptions are (i) that ROIC plummets and (ii) that Apple stops investing in its business – basically that it cannot find any way to put capital to use productively. In other words, not only is average ROIC 70%, but Apple’s incremental ROIC is dramatically south of that. He is making the first assumption explicit but not the 2nd assumption.

    The point is that playing around with this type of model is illustrative of certain scenarios, but it is also extremely sensitive to changes in assumptions around ROIC, WACC, and amount of invested capital.

    I ask Mr. Trainor to say where my analysis is wrong.

  12. th3uglytruth says:

    David…

    I continue to patiently wait for the value your model would peg GOOG, DELL, AMZN, NLFX and CRM.

    You’ve answered other questions; my simple question shouldn’t really be that hard to answer.

  13. th3uglytruth,
    Thank you for your patience.
    You are welcome to buy my report on any stock.

  14. Jon Tseng,
    Thank you for your comment.
    Here is the invested capital model for AAPL.

    http://ncblog.cloudapp.net/wp-content/uploads/2013/05/NewConstructs_AAPL_Model_InvestedCapitalPage.pdf

    I am happy to share any other pages from the model that you wish.

  15. th3uglytruth says:

    Buy? What no public service ala AAPL? Why is that?

  16. Bill says:

    No one paid him to squeeze out an attention grabbing link-bait story as a “public service” on those others.

  17. mike millman says:

    Apple reported net income of $13.1 billion in the December 2012 quarter, $9.5 billion in the March 2013 quarter and I am projecting $37 billion for the year. However, in Trainer’s analysis he has NOPAT (which is close to net income) of only $8 billion for the year. Unless he is expecting Apple to lose money for the rest of this year, I don’t think the analysis makes sense.

  18. Richard says:

    In studying David Trainer’s valuation, I’ve come to the conclusion that his assumptions and model are quite nonsensical.

    Let me start out with a question. What’s something that is really unusual about Apple compared to all other companies? Answer: They have MASSIVE amounts of cash. This large cash position will not continue to exist into the future. They will distribute it to shareholders or make acquisitions, but for now, they have it sitting on their balance sheet. Now David’s main rationale for why AAPL is overvalued is that their ROIC is unrealistically high. But he’s looking at the wrong financial ratio. That’s because;

    ROIC is calculated as (Net Operating Profit – Adjusted Taxes)/(Invested Capital)

    And Invested Capital is calculated as: Total Debt and Leases + Total Equity – Nonoperating Cash and Investments

    As you can see, Invested Capital is greatly influenced by the amount of Nonoperating Cash and Investments which the company possesses. In the case of Apple, they have a TON of Nonoperating Cash. David uses an ROIC of 271% that was calculated by a data provider which may include the debt Apple just added to the Capital Structure. But just to show you how much non-operating cash skews the ROIC calculation, let’s just see what the ROIC looked like before they added $17B of debt to the capital structure.

    ROIC prior to debt comes out to:

    (Net Operating Profit – Adjusted Taxes) = $38.685B

    Invested Capital = ($135.5B in Book Value of Equity + no Debt + $3.87B in Leases – $144.7B in Cash) = -$5.33B

    ROIC = (38.685)/(-5.33)= -726%

    So considering Apple’s massive cash position, it’s not possible to calculate anything BUT a nonsensical number for ROIC. Additionally, it’s a terrible financial ratio to use if you want to conduct a relative analysis. David compares Apple with Microsoft and other competitors, yet each of them has their own cash issues, therefore making them impossible to compare using ROIC.

    Perhaps most disturbingly, instead of doing a DCF valuation, which is the appropriate thing to do for Apple, David does a perpetuity cash flow valuation. In addition, he uses NOPAT, which is only an estimation for FCFF. But you can’t use NOPAT if there’s going to be any growth. That’s because, among other things, investments in CAPEX and depreciation don’t match up. So instead of dealing growth and future investments in CAPEX, working capital, etc., he decides that starting TOMORROW, Apple does not grow and its margins will plummet. That way he can use NOPAT and a perpetuity formula that models zero growth. Additionally, Under the perpetuity assumption, Apple is going to suddenly start paying out all available cash to shareholders. Meaning all cash that’s left over after they cover all debt obligations and maintenance CAPEX (where CAPEX = Depreciation). Apple doesn’t have a history of doing any of these things, nor have they shown any desire to start doing it now. So why would he model that in his valuation?

    Next, David’s rationale for slashing Apple’s margins is that profitability levels should naturally revert towards the mean in a free market economy, to which I agree. HOWEVER, this doesn’t happen overnight. He’s completely ignoring market forces, economics, and general common sense.

    I estimated his valuation breakdown looks something like this:

    Perpetuity Value = NOPAT/Cost of Capital

    ($7.69B NOPAT)/(7.15%) ≈ $108.6B

    $108.6 Perpetuity Value
    + $150 cash per share
    - $17 debt (The debt they just took on)
    - $1.6 option value per share
    =$240/share

    Now hold on as I explain just how extreme David’s assumptions are:

    The perpetuity value based on NOPAT is calculated assuming that Apple’s NOPAT will fall from $41.7 Billion last year to $7.69 starting TOMORROW. That means that the NOPAT Margin falls from 26.6% to 4.9% IMMEDIATELY. Then, to discount this cash flow estimate, it appears that he used an average of the WACC from the last two years that he obtained from a data provider and came up with a 7.15% cost of capital. Which seems aggressively low considering Prof. Damodaran’s WACC (before the addition of debt) is 11.29%. Had he used the same WACC as Prof Damodaran, he would have found a price per share of $176.50. Well below the $428 it is trading at today and close to the $150 it has in cash. At the end of the year, Apple will probably have $176.50/share in cash alone!

    Summary of his assumptions
    - Zero growth starting tomorrow.
    - Maximum dividend payouts starting tomorrow.
    - Massive reduction in operating margins starting tomorrow.

    Now, If David wanted to do a better comparison, how about ROE which is not skewed by cash holdings. Microsoft’s ROE is 22.58% and Apple’s is 33.34% according to yahoo finance. Now you could suggest that Apple’s will skew down below MSFT overtime because AAPL is a hardware and software manufacturer and they tend to make lower ROE. If he went with ROE instead of ROIC, his report would have more credibility.

    So I decided to determine what a “worst” case might look like. Using Prof. Damodaran’s DCF valuation spreadsheet for Apple. I Changed two of his normal case assumptions; First I changed growth to the following pattern: -5% growth for years 1-5 and for years 6-10, growth slowly recovers from -5% growth to 1.73% growth at the Terminal Date (Year 10). Using this assumption, Apple’s sales fall from the most recent year, $169B, to $126B in the terminal year (year 10). Also, their Operating Margin lowers in a straight-line manner from 31% in their current year to 12% in year 10. Under this scenario, the stock is worth $334.72/share. According to these assumptions, the stock would be 28% overvalued. But keep in mind, they are “worst” case assumptions. Under Prof. Damodaran’s valuation, the stock is 37.3% undervalued based on his intrinsic value of $588/share.

    So,
    David’s “valuation” = $240/share, or 44% overvalued.
    My worst case scenario = $334.72/share, or 28% overvalued.
    Damodaran’s normal case scenario = $588/share, or 37.3% undervalued.

    I still feel quite comfortable with Apple’s current risk/return profile, especially considering the fact that David’s valuation holds no water. So I’m content to keep Apple in my portfolio moving forward.

  19. Jon Tseng says:

    Richard

    > What’s something that is really unusual
    > about Apple compared to all other
    > companies? Answer: They have MASSIVE
    > amounts of cash.

    The point of a ROIC/EVA is to only analyse the returns the company is generating on the capital that’s deployed in its operations. That is why the cash is stripped out of the numerator (note that NOPAT is calculated on a pre-interest basis) and the denominator (IC) strips out cash and debt.

    Imagine if the Bill & Melinda Gate Foundation ran a souvenir shop which make $1000 of NOPAT a month. To calculate the ROIC you’d divide that by the assets it had (the shop, the stock etc). You wouldn’t divide it by the total cash and assets of the foundation.

    > David compares Apple with Microsoft and
    > other competitors, yet each of them has
    > their own cash issues, therefore making
    > them impossible to compare using ROIC.

    That’s precisely why you strip non-op cash out of IC. To ensure comparability with other companies.

    re: Your point about debt see the IC calc posted above – note this is calculated from the 2012 balance sheet so there is no debt issuance to cloud the issue.

    > Perhaps most disturbingly, instead of
    > doing a DCF valuation, which is the
    > appropriate thing to do for Apple, David
    > does a perpetuity cash flow valuation.

    Errr, why is a DCF not a perpetuity cashflow calculation? When you have your terminal value +10 years out and you capitalise it at (WACC-terminal growth) that looks to me a lot like a perpetuity cashflow calculation. Or am I missing something?

    The answer is that DT is doing a DCF valuation – he is just assuming zero growth. That’s what you call a perpetuity.

    > Next, David’s rationale for slashing
    > Apple’s margins is that profitability
    > levels should naturally revert towards the
    > mean in a free market economy, to which I
    > agree. HOWEVER, this doesn’t happen
    > overnight.

    Yes, this is the Competitive Advantage Period issue I flagged above.

    However we can do some back of fag packet sensitivities around this.

    DT’s run-rate of NOPAT is $10bn. Consensus net income (ignore interest for sake of simplicity) is roughly $30bn. Therefore each year of ongoing competitive advantage assuming current return levels is worth about $30bn or $32 /share.

    Assume this fades linearly over a five year period (believe me that’s more than enough to see a CAP eroded – viz Nokia / Blackberry) that implies an additional $90 /share of cash generation on top of the $240 base case. That gets you to $330, or 24% below the current share price.

    This roughly correlates with your worst case DCF. That’s not surprising as effectively when you cut margins to 10% you are doing the same this as DT cutting ROIC to 70%, you are just inputting it into the model from different cells. Remember the DCF and EVA are mathematically identical, just the cells have been reordered.

    So reconciling the two: If you believe AAPL will lose its competitive advantage over the next five years, then AAPL’s shares are worth roughly $330 on either DT + Fade or lower-margin DCF analysis.

    A thought experiment: What competitive advantage does the iPhone + Siri + iCloud have over the Galaxy SIV + Google Now + Google? If you are saying Apple’s current ROICs are sustainable you are implicitly saying the Apple package has an overwhelming competitive advantage over the Android package.

    Ahem.

  20. Ajay Nagpal says:

    David,

    I someway agree with your opinion of apple loosing its charisma of coming up with innovation or new magnetic functionalities in existing products. Competitors like Google, Samsung and Amzon are catching up fast on phone, ipod kind of products. Apple is facing too much market share issue from Samsung in developed and emerging markets, as Samsung is fast in producing good phone stuff, thanks to Android software.
    Let’s wait and watch in next 2-3 months when apple hold its marketing gimmick show to show what it is holding under wrap. If it is something that no one has expected then IT IS ALL APPLE.
    Having billion of cash in pocket has not much worth if company cannot use it to improve future earnings and at the end of day, they have to distribute it to shareholders.

  21. See posts 48 and 55.

  22. Nice article on diminishing competitive advantage of AAPL: http://www.forbes.com/sites/nigamarora/2013/06/03/next-big-thing-in-smartphones-could-be-coming-from-google/

    The barbarians are at the gate and they are only getting stronger and louder.

  23. Samsung Electronics notched a high-profile legal victory against Apple, when the U.S. International Trade Commission said it found some of the iPhone maker’s products violated a Samsung patent and issued a limited ban.

    The commission issued an exclusion order barring the import of a set of Apple mobile devices. Among them is the iPhone 4, the iPhone 3GS, the iPad 3G, the iPad 2 3G and the iPad 3. The latest Apple products, the iPhone 5 and the fourth-generation of the iPad, were unaffected.
    http://online.wsj.com/article/SB10001424127887323469804578525723885896616.html?mod=djemalertNEWS

  24. Henro says:

    Mr David Trainer, Greetings from Argentina. What are your comments about your statement on May 14 2013 almost 2 months later ?. Thanks a million and all the best.

  25. Henro:

    Thanks for reading. I continue to believe everything I wrote here and think a long term decline in Apple’s ROIC is going to happen. In fact, I went on CNBC just last week to reiterate my argument, which you can see here:

    http://video.cnbc.com/gallery/?play=1&video=3000180395

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