Background and Thesis
The purpose of this article is to calculate the returns one can reasonably expect by buying Apple (AAPL). Up until the last earnings conference call, we were getting bullish on Apple. Even though the company is facing some headwinds, we were operating under the assumption that being the innovative company that Apple is, it would announce the launch of some new products that might boost shareholder returns and management were going to announce a large return of cash to shareholders, either in the form of buybacks or dividends. Unfortunately nothing was announced.
We think the fundamental problem with Apple is the misalignment between shareholder and management goals, in other words poor corporate governance. CEO Tim Cook can reasonably claim that he is doing a good job managing the business, as sales will most likely continue to grow at a mid-to-high single digit pace over the next 5 years, however, the share price could probably continue to remain depressed. As part of his retention package, CEO Tim Cook received 1,000,000 restricted stock units, of which 500,000 vest in 2016 and another 500,000 vest in 2021. The retention package is not tied to share price performance.
Our feeling is that Tim Cook perceives Apple's cash in the bank as his safety net to ensure the preservation of his gigantic retainer package. It may well be that no cash is returned to shareholders until 2021, as Tim Cook has 8 years to pull a rabbit out of his hat.
We've set out below a couple of scenarios. The worst case is based on Apple hoarding cash, no buybacks, no dividend increase, and no surprise new products that are going to blow consumers' minds. The slightly better case assumes Apple pays the Federal tax due on its cash hoard, distributes it to shareholders, and continues to hand back future cash generated to shareholders and that there are also no surprise new products that are going to blow consumers' minds.
Still a strong cash generating machine ...
Where some of this cash generation is going ...
How cash is deployed (77% of cash is banked) ...
Ever increasing invested capital (Property Plant Equipment, Goodwill from Acquisitions, R&D, Working Capital) ...
Revenues / Invested Capital are declining. This is hurting ROIC. Unless we see a new product that blows consumers minds, then we could see a reversion to mean...
Margins also seem to have peaked for now and look like they are in decline. We have adjusted them for R&D expenditures and the red line shows where Samsung's (GM:SSNLF) margins are. Could we be heading there?...
Given the decline in Revenues/Invested Capital and NOPAT Margin, Returns On Invested Capital are in Decline (10-Year Average 51%)...
We crunched the numbers and concluded that based on the current product lines, Apple should be able to grow revenues approximately 5.8% per annum for the next 5 years.
In terms of iPhones, Global Smartphone sales volumes are expected to increase from 717.6m in 2012 to 1405.3m in 2016 (source IDC). Apple currently has 21% volume market share (source Bloomberg). We have assumed that Apple's market share falls by two percentage points each year through 2016. We believe that there is no space in the market for 3 operating systems. It is just too expensive to design apps for all three. Long term, a maximum of two seems feasible. This is a big positive for Apple as long as it doesn't let Microsoft (MSFT) displace it with its Windows Phone.
We assume iPad volumes are set to grow 15% a year as the market continues to grow strongly and we assume Apple keeps its market share. (Tablet market projected growth rate of 174.5% between 2012 and 2017 source IDC). We do, however, expect weak pricing trends in the iPad due to competitive threats.
Our worst case scenario below assumes invested capital yields a 51% return on invested capital (long-term average ROIC) resulting in an 11.4% annual EPS growth contribution. However an overall decline in ROIC will almost fully erode the gains from invested capital. As there are no significant buybacks and some continued dilution from stock compensation, we could be looking at -1.4% EPS growth annually over the next 5 years.
Our better case scenario below assumes that a significant sustainable buyback plan is initiated, in which case we would be looking at 9.5% EPS growth annually over the next 5 years.
Assuming Apple continues to trade on a P/E of 9.8x trailing earnings, our worst case EPS growth scenario above and zero cash returned to shareholders (excluding the current small dividend), we are looking at 0.4% IRR over the next 5 years.
Assuming Apple continues to trade on a P/E of 9.8x trailing earnings, our better case EPS growth scenario above, federal taxes paid on net cash balances and all cash returned to shareholders (excluding the current small dividend), we are looking at 15.1% IRR over the next 5 years.
The most conservative scenario assumes that buying Apple at the current price earns you nothing over the next 5 years and the better case scenario would earn you a 15% annualized return. If you believe that Apple might launch a new blockbuster consumer product, you may get an even higher return than 15% but this is just pure speculation.