Apple’s High ROIC Needs Revenue Growth to Build More Value

Two major components for building long-term corporate value are Return on Invested Capital (ROIC) and growth. This is why Apple’s Q1 2016 earnings report was received so poorly.

Apple (AAPL) generates very high returns across several metrics:

  • Return on invested Capital = 33%
  • Cash Return on Invested Capital = 33%
  • Free Cash Flow Return on Invested Capital = 38%

With these high returns, Apple can continue to build long-term value with just a little growth and a lot of value with higher growth. But Apple’s ability to grow is now in question.

Apple reported its first year-over-year decline in iPhones sales and reduced its expectations for iPhone sales next quarter when compared to the previous year.

We think there has been a short-term overreaction to Apple’s Q1 2016 earnings report. However, in every overreaction there are kernels of truth.

Smartphone Market Still Growing

Investors expecting double-digit blowout growth from Apple like they saw during the iPhone 6/6+ upgrade cycle are expecting way too much. Apple is just too big now. Also, the smartphone is reaching a saturation point. Consumer upgrade cycles will lengthen as new smartphones will only have marginal improvements on previous models. New markets to penetrate become less and less. Smartphone sales and growth in developed markets will look more cyclical bringing global smartphone growth down to single digits.

Chart courtesy of intrinsic Investing. Click image to enlarge.

Chart courtesy of Intrinsic Investing. Click image to enlarge.

It may be single digit growth but it is growth. When you generate such high returns on invested capital like Apple does, a little growth generates lots of free cash flow that can be returned to shareholders through dividends and share buybacks. Apple raised its dividend another 10%.

Apple does have avenues for growth.

Brand Loyalty and Software Sales

Around 83% of iPhone users will buy another iPhone. This user base provides the opportunity for Apple to sell more services and software to its users. Tim Cook said as much during the Q1 216 earnings call.

Especially during a period of economic uncertainty, we believe it is important to appreciate that a significant portion of Apple’s revenue recurs over time…a growing portion of our revenue is directly driven by our existing install base. Because our customers are very satisfied and engaged, they spend a lot of time on their devices and purchase apps, content, and other services.- Q1 2016 Earnings Call

Sales of software and services are growing rapidly with 23% year-over-year growth.

Apple's Services Revenue from Q1 2016 Suuplemental. Click image to enlarge.

Apple’s Services Revenue from Q1 2016 Earnings Suuplemental. Click image to enlarge.

Software and services are arguably Apple’s weakest division too. At least it encompasses the products that people complain the most about, e.g. iTunes. Improving this division and generating more software and service revenues is a compelling driver of future growth.

While Apple’s current stock price action after Q1 2016 earnings says otherwise, it still has a lot of positives working in its favor.

This is not to say everything is rosy. There are issues and concerns which I’ll focus on in upcoming posts.

But the big item is growth. Apple is still growing and has levers to pull to increase growth. When you have a company that generates such high levels of returns on invested capital it is ok, actually preferable, to lower your ROIC a little if it leads to higher growth. The move down market with the iPhone SE, India, improved business relations with China, and a push to sell more software and services to its user base are those opportunities.


Why Apple’s iPhone Franchise is Sustainable (Intrinsic Investing)

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