Apple: Gravity Is Catching Up With This Juggernaut

Seeking Alpha2021-09-17

Summary This article analyzes Apple (AAPL) from the perspective of its profit sustainability and scalability. This analysis examines the most two important aspects of profit sustainability: return on...

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SFern
·2021-09-17
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FALCON
·2021-09-17
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e13v3n
·2021-09-17
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This analysis examines the most two important aspects of profit sustainability: return on capital employed (“ROCE”) and marginal return on capital employed (“MROCE”). To me, ROCE and MROCE are the two most important metrics for analyzing a business. They reveal the two most fundamental aspects of the same central issue of profit sustainability. ROCE tells us how profitable the business has been or is so far. And MROCE sheds insights into which direction the profitability is likely to go.\nThe results show that even though AAPL earns an astronomical ROCE in the past and currently, it is entering the inevitable stage of diminishing return on capital.\nWarren Buffett likes to say that interest rates act like gravity on all economic activities. Well, diminishing returns act like gravity on all economic activities too, if not more so. And the gravity of diminishing returns is beginning to catch up with the AAPL juggernaut in recent years, although investors do not have to be too alarmed. Given its remarkably high ROCE to start with and its reasonable valuation, AAPL still represents an attractive investment even with such diminishing returns considered. And as such, my final verdict on this stock is a hold rating under its current conditions.\nThe moat and the network effects\nAAPL’s moat is in its scale and the loyalty of its users. As an example, the following chart shows the annual unit sales of the Apple iPhone worldwide from 2007 to 2018 (in millions). As can be seen, in their 2018 fiscal year, Apple sold more than 217 million iPhones. The iPhone sales have obviously stabilized over recent years and the days of exponential growth are over. However, investors do not have to be too concerned about the stabilization of the iPhone sales per se (which is currently still AAPL’s most profitable product). What investors need to examine is if the network effects brought about by the iPhones (or other AAPL devices) have reached their limit of scalability, as to be discussed next.\nSource: Unit sales of the Apple iPhone worldwide from 2007 to 2018 (in millions) from Statista.\nThe network effects refer to the fact that the value of certain products or services increases as more people use them. In other words, certain networks become increasingly more valuable as they become bigger – at least to a certain point. There is nothing new about the network concept. It was true of railways, telephones, and fax machines. All these examples share these common traits: A) the larger the network becomes, the more valuable it becomes (one segment of a railway linking city A and B is far more valuable when this segment also links to other railways linking other cities); and B) the larger the network becomes, the higher the switching cost (if everyone uses a fax machine and you do not want to use one, good luck to you).\nAgain, up to a certain point. At some point, gravity always catches up, and return begins to diminish. In the railway example, if enough railways have already been built to link all cities with high population density, building the next segment would suffer a diminished return now. In the fax machine example, if every office already has one, adding a second one to each office would also suffer a diminished return.\nTherefore, as investors, we do not only need to examine the ROCE, but also equally importantly, to examine the marginal return. Because the marginal return tells us if the network effects are still in a scalable stage, or if the business has already passed the tipping point of scalability and begins to see a diminishing return. In other words, MROCE lets us see if the gravity of diminishing return has caught up yet or not.\nIn theory, one would intuitively expect the services AAPL provides to enjoy the benefit of perfect scalability. Because AAPL’s business model benefits from a self-sustaining positive feedback loop. Once the business captured enough users with iPhones as shown above and an ecosystem initiated, the network effect would kick in and amplify itself. More users in this network will lead to more convenient sharing and communication among users and devices, more added values, more accurate recommendations, search results, et al. Such benefits will make the network even better and more valuable for its users and clients; which will, in turn, attract more new users to join and purchase its new devices; which again will lead back to more users and an even larger network.\nIf you share the same intuition, then you are in for a surprise by the results in this article. The MROCE results in recent years actually show that the gravity of diminishing return is catching up on AAPL.\nReturn on capital employed (“ROCE”)\nROCE stands for the return on capital employed. Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how effectively the business uses its capital to earn a profit. For businesses like AAPL, I consider the following items capital actually employed:\n1. Working capital, including payables, receivables, inventory. These are the capitals required for the daily operation of their businesses.\n2. Gross Property, Plant, and Equipment. These are the capitals required to actually conduct business and manufacture their products.\n3. Research and development expenses (an essential expense for a business like AAPL).\nBased on the above considerations, the ROCE of AAPL over the past decade is shown below. As seen, it was able to maintain an astronomical level of ROCE over the past decade. It used to be 450% early in the decade and still hovers around an average of 152% in recent years since 2016. To put things in perspective, the next chart compares AAPL’s ROCE against the other FAAMG stocks – a group of exemplary stocks that best exploit the network effects. As can be seen, AAPL still earns the highest competitive ROCE among this group of overachievers.\nSource: author and Seeking Alpha.\nSource: author and Seeking Alpha.\nIntroduction to marginal return on capital employed (“MROCE”)\nIn addition to ROCE, an equally important concept is the marginal return on capital employed (“MROCE”). To me, ROCE and MROCE are the most two important metrics for analyzing a business. They reveal the most fundamental two aspects of the same central issue of profitability. ROCE tells us how profitable the business has been or is SO FAR. And MROCE sheds insights into which direction the profitability is likely to go.\nA bit of background and introduction for readers who are new to the concept. For readers familiar with the concept already, definitely skip this section. From what I’ve learned, the legendary economist John Maynard Keynes first explicitly expressed this concept, although people before him have observed and thought about it for some time already. What the concept tries to capture is a basic law in economic activities: the law of diminishing returns. Warren Buffett likes to say that interest rate acts like gravity on all economic activities. Well, diminishing returns act like gravity on all economic activities too, if not more so, as long as human nature does not change in any fundamental way.\nThe next chart illustrates the concept. As long as shareholders are seeking profit, a public business will first invest its money at projects with the highest possible rate of return (i.e., picking the lowest hanging apples first or getting the most bang for the buck first). Therefore, the first batch of available resources is invested at a high rate of return – the highest the business can possibly identify. The second batch of money will have to be invested at a somewhat lower rate of return since the best ideas have been taken by the first batch of resources already, and so on. The last batch of money invested may earn a rate of return that is only above the cost of capital. And finally, the end result is a declining MROCE curve as shown.\nSource: author\nThe ROCE we normally talk about and companies report refers to the average of this curve – averaging the return on all batches of money invested. Obviously, the average is very useful information by itself. It tells us how efficiently the business has been converting resources into profit so far – but its limitation is that it only tells us the efficiency of the resources that have already been invested so far. What is of equal importance to investors is the MROCE, which tells us how much incremental profit the business will generate when the next batch of resources is invested.\nFor investors, a dream business to invest in would be a business that enjoys a flat MROCE curve as shown by the solid blue line. This would be a business that is perfectly scalable. A business that earns a consistent and stable profit for every batch of resources invested. However, such a business is really only a dream business. I mentioned earlier that diminishing returns act like gravity on all economic activities - because they really do. There has been no business (at least not so far in human history) that can keep growing while at the same time maintaining a constant return on capital. At some point, gravity always catches up and the return begins to decline (as shown by the dashed blue line).\nAAPL’s MROCE\nSo for investors, the next best deal is to invest in a business that A) has a high and stable ROCE, and B) that is still in the scalable stage (the gravity of diminishing return has not caught up yet). Unfortunately, as shown in the next chart, AAPL seems to have passed the tipping point of scalability and begin to see a diminishing return in recent years.\nThis chart shows the MROCE and ROCE for AAPL over recent years. The ROCE data are the same as those shown in the previous section. The MROCE data are estimated by the following steps. First, the capital employed was calculated for each year. Second, the earnings were calculated each year. Third, then the incremental of capital employed year over year was calculated. Similarly, the incremental earnings year over year were also calculated. And finally, the ratio between the incremental earnings and incremental capital employed was calculated to approximate the MROCE. During years when there were large fluctuations in either the incremental earnings or the capital employed, a multi-year running average was taken to smooth the fluctuations.\nThe results shown in the following chart show that at this stage, APPL has been maintaining an MROCE that is noticeably below the average ROCE. As seen, the ROCE has been on average 152% in recent years as aforementioned, and the MROCE has been on average 45%. And the difference is too large to be caused by the uncertainties in the financial data and rounding off errors. So this result shows that AAPL has started entering a stage of diminishing return - gravity is beginning to catch up. And if the current MROCE continues, AAPL’s ROCE will gradually decline from its current level and converge to 45%.\nSource: author and Seeking Alpha data.\nBut no need to panic yet\nHowever, AAPL investors do not have to panic yet - for two reasons at least. Firstly, AAPL has a very high ROCE to start with. And even when its high ROCE deaccelerates and eventually converges to 45%, it is still a very competitive level of profitability compared to the other FAAMG stocks as seen from the following chart.\nSource: author and Seeking Alpha data.\nSecondly, AAPL currently features a very reasonable valuation, both in absolute terms and especially in relative terms. As can be seen from the following chart, at its current price levels, AAPL’s FW PE is about 28.6x, the lowest among the FAAMG pack.\nThe next chart also compares AAPL valuation adjusted for its ROCE with its peers. It is not that meaningful to discuss valuation in isolation and without adjusting for the quality of the business. Therefore, this chart shows the valuation adjusted for ROCE by simply dividing the PE by the ROCE. As seen, its adjusted valuation is even more attractive among the FAAMG pack.\nAnd finally, the orange bar shows the adjusted valuation when AAPL’s ROCE eventually deaccelerates to 45%. As can be seen, even when this happens, AAPL’s ROCE-adjusted valuated is still quite reasonable compared to the rest of the FAAMG stocks.\nSource: author and Seeking Alpha data.\nSource: author and Seeking Alpha data.\nConclusion and final thought\nThis article analyzes AAPL, with a focus on its profit sustainability and scalability. This analysis examines the most two important aspects of profit Sustainability: return on capital employed (“ROCE”) and marginal return on capital employed (“MROCE”). They reveal the two most fundamental aspects of the same central issue of profit sustainability. ROCE tells us how profitable the business has been or is so far. And MROCE sheds insights into which direction the profitability is likely to go.\nThe results show that:\n\nThe ROCE has been on average about 150+% in the past and has been the highest among its FAAMG peers.\nBut the MROCE has been on average 45% in recent years. So this result suggests that the diminishing return is beginning to catch up on AAPL. The difference between MROCE and ROCE is too large to be caused by the uncertainties in the financial data and rounding off errors.\n\n\nHowever, AAPL investors do not have to panic yet - for two reasons at least. First, even when its high ROCE deaccelerates and eventually converges to 45%, it is still a very competitive level of profitability compared to the other FAAMG stocks.\nAnd second, even after the ROCE decelerates, AAPL’s ROCE-adjusted valuated is still quite reasonable compared to the rest of the FAAMG stocks.\nGiven the above considerations of profitability and valuation, my final verdict on this stock is a hold rating under its current conditions.","kind":"news","is_publish_news":true,"is_publish_highlight":true,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[{"id":884870678,"gmtCreate":1631883598594,"gmtModify":1676530660845,"author":{"id":"3582938826092533","authorId":"3582938826092533","name":"SFern","avatar":"https://static.tigerbbs.com/81a61c88544234a53cc63054a8f769b1","vip":1,"crmLevel":1,"crmLevelSwitch":0,"idStr":"3582938826092533","authorIdStr":"3582938826092533"},"htmlText":"Good","listText":"Good","text":"Good","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":1,"commentSize":1,"repostSize":0,"link":"https://ttm.financial/post/884870678","repostId":1157890009,"repostType":4,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"comments":[{"id":5903594,"gmtCreate":1631883608993,"gmtModify":1663234024349,"authorId":3582938826092533,"author":{"id":3582938826092533,"idStr":"3582938826092533","authorId":3582938826092533,"name":"SFern","avatar":"https://static.tigerbbs.com/81a61c88544234a53cc63054a8f769b1","vip":1,"crmLevel":1,"crmLevelSwitch":0,"individualDisplayBadges":[]},"repliedAuthorId":0,"objectId":884870678,"type":1,"supId":0,"prevId":0,"content":"Lol","text":"Lol","html":"Lol"}],"langContent":"EN"},{"id":884826301,"gmtCreate":1631880874803,"gmtModify":1676530660186,"author":{"id":"3584817540991212","authorId":"3584817540991212","name":"FALCON","avatar":"https://static.tigerbbs.com/c0d98873fea539ae720f8695900f4238","vip":1,"crmLevel":2,"crmLevelSwitch":0,"idStr":"3584817540991212","authorIdStr":"3584817540991212"},"htmlText":"Like","listText":"Like","text":"Like","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":1,"commentSize":1,"repostSize":0,"link":"https://ttm.financial/post/884826301","repostId":1157890009,"repostType":4,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"comments":[{"id":5903102,"gmtCreate":1631880896190,"gmtModify":1663234022637,"authorId":3584817540991212,"author":{"id":3584817540991212,"idStr":"3584817540991212","authorId":3584817540991212,"name":"FALCON","avatar":"https://static.tigerbbs.com/c0d98873fea539ae720f8695900f4238","vip":1,"currentWearingBadge":{"badgeId":"7a9f168ff73447fe856ed6c938b61789-1","templateUuid":"7a9f168ff73447fe856ed6c938b61789","name":"Knowledgeable Investor","description":"Traded more than 10 stocks","bigImgUrl":"https://static.tigerbbs.com/e74cc24115c4fbae6154ec1b1041bf47","smallImgUrl":"https://static.tigerbbs.com/d48265cbfd97c57f9048db29f22227b0","grayImgUrl":"https://static.tigerbbs.com/76c6d6898b073c77e1c537ebe9ac1c57","redirectLinkEnabled":0,"hasAllocated":1,"isWearing":1,"stampPosition":0,"hasStamp":0,"allocationCount":1,"allocatedDate":"2024.03.23","individualDisplayEnabled":0,"individualDisplaySort":0,"categoryType":1102},"crmLevel":2,"crmLevelSwitch":0,"individualDisplayBadges":[]},"repliedAuthorId":0,"objectId":884826301,"type":1,"supId":0,"prevId":0,"content":"ok","text":"ok","html":"ok"}],"langContent":"EN"},{"id":884828959,"gmtCreate":1631880750471,"gmtModify":1676530660162,"author":{"id":"3565819252889467","authorId":"3565819252889467","name":"e13v3n","avatar":"https://static.tigerbbs.com/387ab24895655e32d7ddaf87ded7da37","vip":1,"crmLevel":2,"crmLevelSwitch":0,"idStr":"3565819252889467","authorIdStr":"3565819252889467"},"htmlText":"like","listText":"like","text":"like","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":1,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/884828959","repostId":1157890009,"repostType":4,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"}],"hasMoreComments":true,"newsSizeData":{"likeSize":49,"commentSize":3,"repostSize":0,"favoriteSize":3,"likeStatus":false,"favoriteStatus":false}}