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)

Apple Continues to Crush Samsung Where It Matters Most (BGR)

Tesla & Electric Vehicles: Disruption Usually Takes Much Longer Than We Think

The Box is a great book that I read after Bill Gates recommended it a couple years ago. It is the story of how container shipping took over the world.

One of the lessons I learned from the book is that it takes far longer for a disruptive technology to take over than people think. The more capital intensive the industry, the longer it will take.

The shipping industry is extremely capital intensive. Although the huge cost savings of container shipping were pretty much evident right from the start, it took a really long time, decades, for container shipping to completely take over. New ships, ports, and containers all had to be built to meet the rising demand.

An industry starting to see some disruption is the car industry with ride-sharing apps, self-driving cars, and the shift away from internal combustion engines to alternative power sources like all electric vehicles.

The car industry is another capital intensive industry. The disruption of the car industry will take far longer than we’re expecting. Matthew Lewis in the following “tweetstorm” about car use and the climate hits on a couple of reasons why EV adoption rates will be lower than some expectations.

We, people as a whole, are really good at creating expectations that far exceed precedents. If the past disruption of other capital intensive industries provides any lessons, it’s we’re grossly overestimating how quickly the car industry will be disrupted. Especially when it comes to replacing the internal combustion engine with alternatively powered cars like Electric Vehicles.

Behavior Gap in Effect Again

The behavior gap in effect.

In 2015, the average equity fund investor lost 2.3%, lagging the S&P by 3.7 percentage points. While that sounds awful, it’s actually a slight improvement in form. Over the past 20 years the lag was 3.52 percentage points, Dalbar reckons.

So who is to blame? As tempting as it is to point the finger at the financial services industry, the damage is self-inflicted. While it is well known that the majority of actively managed mutual funds lag the market, people keep using them in the hope that they have identified a winner. Then they pick another one and another.

One of the biggest ways we can improve as investors is to gain control over some of our irrational biases. It could be a system of checks and balances to slow our thinking down and prevent reactional trading. It might be as simple as employing a friend or family member to play devil’s advocate to run through a series of questions in order for us to engage our rational thinking system.

Overriding our short-term reactionary thinking system has clear measurable benefits.


The Market Rose, Your Portfolio Didn’t: Here’s Why (The Wall Street Journal)

What I Wish I Wrote ~ May 6, 2016

Four lessons learned from 20 years of DRIP investing. (Retire Before Dad via Dividend Growth Investor)

XXI Energy and Peabody Energy just filed for bankruptcy. What Twitter and Tesla, 2 non-energy companies, have in common with them. (The Confessions of a Contrarian Investor)

The Munger Operating System: How to live a life that really works. (Farnam Street)

Does the drop in short interest for Apple’s suppliers mean the worst is over for Apple? (Bloomberg Gadfly)

Microsoft has raised its dividend for 14 years now can it make it to 25 years and become a Dividend Aristocrat? (Sure Dividend)

Are you in the top 1% of net worth for your age group? (Financial Samurai)

Jim Chanos is shorting Elon Musk. (Marketfolly)

Notes from Jim Chanos’ interview with FT Alphachatterbox. (Waiter’s Pad)

Creating the right environment to avoid the weapons of mass distraction and destruction on your productivity. (Fundoo Professor)

Are payday loans really as evil as people say? (Freakonomics Podcast)

Humira’s Patent Loss Not as Ominous as it Looks

Ever since AbbVie (ABBV) was spun off from Abbot Labs (ABT) the major concern was the upcoming loss of patent protection for Humira. Humira is one of the most successful drugs ever and it provides over 60% of AbbVie’s revenue. Losing Humira would be a huge blow to AbbVie’s business.

The common misconception with Humira is that it is a small molecule drug like Lipitor. With small molecule drugs, as soon as patent protection is gone sales plummet as cheaper generic drugs hit the market.

Humira is not a small molecule drug, it is a large molecule biologic. Biologics use microorganisms to produce a protein, the drug, that is then isolated and processed for human use. The entire process is the drug. One change in the production can have large consequences. It is because of this that biosimilars have to undergo safety and efficacy tests just like the name-brand biologic.

A small molecule generic just has to prove that it is the exact same chemical composition and structure as its name-brand counterpart.

This makes biosimilars very costly to make. The companies that make the biosimilar can’t offer too big of a discount to the name-brand biologic as The Wall Street Journal reports.

Biotech drugs are more difficult and expensive to make than traditional chemical-based pills. That is true of their knockoff versions, as well, making biosimilar makers unwilling to sharply undercut prices of the original versions.

“I really don’t expect big relief from biosimilars,” says Steven Marciniak, vice president of pharmacy programs at Priority Health, an insurer based in Grand Rapids, Mich.

The first biosimilar on the U.S. market, a knockoff of Amgen Inc.’s cancer-care drug Neupogen, was priced just 15% below the branded drug late last year. During the three years before, Amgen had raised the list price of a vial of Neupogen by 15.7%, according to data firm Truven Health Analytics.

If I’m a Doctor or a patient knowing that a biosimilar may work as well or it may not as the name-brand biologic will I choose the biosimilar for a 15% discount? Some will, but will it be at the same rate as people switching to generic small molecules? No.

The loss of Humira’s patent is not as ominous as it looks.


Knockoffs of Biotech Drugs Bring Paltry Savings (The Wall Street Journal)