Apple's Return On Capital Employed Is Not Sustainable

| About: Apple Inc. (AAPL)
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Much has been written about Apple's (NASDAQ:AAPL) profit machine, its growth potential, and -- despite last quarter's earnings miss -- the blowout holiday quarter that it is presumably having now, whose results are expected late January. Some of the articles have a strong basis, but the recent stock sell-off is perplexing to many. In my first article on Apple, I raised the question on the potential for margin compression at the company, citing various factors. In the comments on a follow-up article, I highlighted that Samsung's flagship Galaxy SIII smartphone's leading sales data in the third quarter was a key "inflection point" for Apple, and I hypothesized the possible strategic discussions inside Apple. In the past week, since AAPL has declined by 9%, many media pundits are now citing the very same concerns I voiced earlier.

Seeking Alpha contributor Ashraf Eassa analyzed Apple's recent decision of dropping ARM Holdings' (NASDAQ:ARMH) designs. While this is happening on one level, Apple is also talking to Intel (NASDAQ:INTC) to manufacture its A6X processors, and announced plans to bring production back to the U.S. One benefit of these moves, in addition to customizing the designs to the optimal needs of Apple products, is that it allows Apple to "backward-integrate" its value chain to capture a bit more of the margins in the value chain and retain a bit more control of manufacturing, given the issues at Foxconn.

However, whether these moves make commercial sense for investors is based on two key assumptions: 1) That the return on capital employed (ROCE) from internalizing this part of the value chain is comparable to Apple's current ROCE, and 2) Apple's internal cost structure and operational efficiency to manage this part of the value chain is equal or better than the partner it ditched and the one it is talking to. Unless one is privy to confidential internal cost and bill-of-materials data at these companies, it is difficult to validate the second assumption. If Apple is not able to manage this part of the value chain well, then the decision to internalize is value eroding from a commercial sense, though it might still make strategic sense.

The first assumption, however, can be assessed by looking at the historic ROCE or ROA (return on assets) ratios of both AAPL and ARMH. I have added INTC's data for comparison as well in the table below. To avoid the distortions caused by differences in tax rates, leverage structure (interest), other income/expenses (unrelated to core operations), depreciation and amortization, I used operating income to represent the true business "return" (numerator) of the ROCE and ROA ratios.

Apple ARM Holdings Intel
ROCE, ttm (OI/TA-CL)^ 40.1% 13.8% 29.6%
Indexed ROCE 290 100 214
ROA, ttm (OI/TA)^ 23.61% 9.54% 13.87%
Indexed ROA 247 100 145
Profitability/Employee $759,000* $133,000* $231,000*
Indexed profit/employee 571 100 174
^ OI (Operating Income = EBITDA - other income/expenses), TA (Total Assets) and CL (Current Liabilities). Figures from company Balance Sheets based on most recent full year data available at Yahoo Finance.

* Calculated as EBITDA margin% x Revenue/Employee, using last 12 months data.

While Apple's near-term strategies are reflective of the macro-business environment and issues it faces, the ratio data makes it clear that internalizing chip design (compared to ARMH) and production if it chooses to (compared to INTC), is likely to be value-destroying for AAPL shareholders. Apple has enviable ROA and ROCE ratios, far higher than the chip design and semiconductor giants (ARMH and INTC) that it is engaging with, so internalizing anything either ARMH or INTC is doing today does not make financial sense. A capital allocation decision makes sense only when an activity promises to deliver at least much or more than the current ROCE.

Financially, AAPL investors are better served by Apple outsourcing its processor and system production. Even bringing the manufacturing jobs to the U.S. as Apple is considering should be evaluated on similar metrics. Although some believe that Apple's announcement on U.S. manufacturing may be a PR stunt or just a token gesture, but investing $100 million for manufacturing sounds like an expensive "token" to me. Moreover, Tim Cook openly said "We have a responsibility to create jobs," which is diametrically opposite to Steve Jobs' retort to President Obama "those jobs aren't coming back." Going by current ROCE figures, Apple should generate at least $40 million annually in operating income for every $100 million in capital it invests for this to make financial sense ("value accretive") to current investors.

Unless return on invested capital for any new project exceeds current ROCE, how can it be value-adding? Also, the comparison should be against employing the same capital against highly profitable avenues that Apple has at its disposal, namely, opening new Apple stores around the world. An estimate says each Apple store costs about $10 million, and a Seeking Alpha research article estimates that each Apple store makes an average of $13 million in operating income (on average revenue of $51.4 million) per year. That's an ROCE of 130%. Doesn't opening 10 new Apple stores (at $100 million total cost) make more financial sense than investing the same $100 million in manufacturing? Perhaps Cook plans to run for a public office after his tenure as Apple CEO. Otherwise, he must explain to its investors how investing $100 million in U.S. manufacturing will generate the same $130 million in operating profit for Apple each year that opening 10 new stores will.

Doggedly pursuing its "in-sourcing" strategy for processors or manufacturing will likely reduce its profitability per employee for that portion of its operations closer to ARMH's or INTC's ratios (see table above). Profitability/employee is an important metric for people-intensive operations like manufacturing, for instance. Looking at things from this perspective does not serve the investor as well. It sounds unlikely that Apple will be able to wring so much efficiency into the processor design and system manufacturing so as to be substantially higher than what industry leaders like INTC or ARMH are already operating at. Foxconn margins, despite having "surged" to 9.5% in recent quarter, are not even worth talking about as a manufacturing reference point for Apple, though as a mega-manufacturer of Apple products, it is the closest manufacturing benchmark for Apple. Warren Buffett famously said in the past: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." Not that ARM's and Intel's businesses have "bad economics," but financially speaking, they are certainly inferior to Apple's. About Foxconn's economics -- the less said, the better.

While any number of reasons can be attributed to AAPL's recent decline, from the rational (margin compression in recent quarters) to the temporal (capital gains tax fears) to the bizarre (clearing firms raising margin requirements), I think the recent "operational" decisions of in-sourcing are also material factors weighing on the stock's future. It looks like the $475-$500 range, which I called "delicious" earlier, may be realized sooner than later. Those wildly bullish on AAPL may still brush off the impact of these recent decisions, but I wonder if this shows Apple management's inclination to discount ROCE as a factor in its capital allocation decisions. Such operational decisions could materially erode the superb ROCE of Apple and will eventually reflect in the financials of this iconic company.

Apple can certainly make strategic arguments and earn political brownie points in support of its recent decisions, but all strategic decisions of a company should also have an underlying financial thesis. Investment allocation is perhaps the most important financial decision a company makes, and I hope Apple will share more data to explain to its investors why it believes, from a financial perspective, in-sourcing the processor designs and manufacturing makes sense for investors. The recent announcements from Cupertino are not convincing me that Apple will be able to maintain its ROCE.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.