Apple: Best To Go The Route With Cars That It Went With TV

About: Apple Inc. (AAPL), Includes: MBLY, TSLA
by: Jacob Urban

Apple is better off developing automotive software than an automobile.

Software development requires fewer capital investments and allows for a larger total addressable market.

Project Titan can evolve into another facet of Apple's ecosystem without creating an entire vehicle.

Apple's (NASDAQ: AAPL) entrance into the television market was not characterized by a beautiful monitor with a flawless display, nor was it defined by a capital intensive project that required rethinking an industry's solutions to various engineering challenges.

That is, rather than introducing a radical reinvention of the television, Apple provided technology that could augment the experience of existing TVs. By doing so, Apple avoided competing in an already crowded market and dodged the risk of being unable to offer any groundbreaking product.

With Project Titan, Apple's secret automotive market, Apple faces a similar choice: Manufacture a product from end to end or develop the software that goes inside the product. Though the appeal of developing a brand new car carries glamour and excitement to Apple fanatics, shareholders should encourage a move into developing the technologies that augment existing vehicles as it carries considerably less risk and less capital intensiveness.

The decision to focus solely on automotive software rather than taking on Detroit may have already been made by Apple, but fellow contributor Mark Hibben's analysis of Apple's recent letter to the National Highway Traffic Safety Administration (NHTSA) suggests the company may still be looking into manufacturing an entire vehicle. Any potential gain pales in comparison to the costs and inherent risk associated with the move when compared to the alternative of focusing on automotive software and driving experience.

Consider the capital intensiveness of automobile manufacturing: Only Tesla (NASDAQ: TSLA) has been able to do this with any measurable success in the past half century, and over six years after the firm's IPO, the company still widely outspends the cash it brings in from operations.

Source: Bloomberg

As the graph above demonstrates, the amount of capital required to scale manufacturing outpaces the cash brought in from operations even years after the company brought its first car to market. Tesla unveiled the roadster 10 years ago, placing it ten years and large investment sums ahead of Apple. Should Apple go down this path, it could similarly be years before any return is earned from the massive investments required, without any return guaranteed at all.

Of course, those who advocate for the development of an Apple Car are quick to point out the large sums of cash sitting on Apple's balance sheet. The company could certainly absorb the costs of setting up an automobile manufacturing business, but the return on this investment would be unfavorable compared to the alternative of investing in developing automotive software, as comparing to the margins of Mobileye (NASDAQ: MBLY) to existing manufacturers demonstrates.

Mobileye, a leader in artificial vision technology that provides "a 'smart' camera embedded with [a] state-of-the-art EyeQ® chip [that can be] easily installed on your inner front windshield" has achieved an operating margin above 32% and year-over-year revenue growth above 30% without issuing any debt. Whereas Tesla's cash flow suffers from unpredictability and high variability, Mobileye's cash provided by operating activities increased consistently each year with small sums of capital expenditures required, as highlighted in the chart below.

Source: Bloomberg

From an investment standpoint, providing in-vehicle solutions can yield greater returns quicker, and with less uncertainty. Bringing an entire vehicle to market, if done successfully and with scale, could increase Apple's revenues exponentially, but it will be competing in a well-established market that yields poor profit margins: Ford's (NYSE:F) and GM's (NYSE:GM) profit margins over the past twelve months were just 4.72% and 8.55%, respectively.

If Apple provides a solution capable of being implemented in any car, it will face fewer established competitors and be able to provide to a larger base of consumers. In this scenario, Apple's automotive solutions can be implemented in cars from all manufacturers, rather than competing against all existing manufacturers. Moreover, going the software route allows Apple to add to its ecosystem by creating another way of integrating its existing technologies into a consumer's daily life.

An iPhone app could serve as a key for the car, enabling locking at any time and thereby eliminating the risk of losing or forgetting keys. Apple's Maps function can assist in autonomous driving features; the iPhone can serve as a control for all other in-car functions.

Put simply, Apple ought to take the route with cars that it took with TV: Provide a product that augments the experience rather than develop the car itself. Doing so allows the company to earn a higher return on its investment and reach more consumers, all while reinventing another facet of modern life.

Investors Beware

This Friday, Seeking Alpha Contributor Mark Hibben pointed to increasingly mounting evidence that the company is not simply pursuing a software strategy, but is developing a full autonomous vehicle. For investors, this spells increasing volatility as earnings face more uncertainty and collapsing margins for Apple in the years ahead.

For Apple Investors who are holding the company as a cash-generating, high margin tech giant, any further evidence that the company is investing heavily in developing a fully autonomous vehicle may be reason to exit the position. The company will be subjecting itself to outsized future capital expenditures on a project that may take many years before becoming accretive to earnings. Worse yet, if Apple scales its operations and makes automotive its principal focus, the company can expect to achieve a margin that is unlikely to be much greater than 10%, halving its current 21.19% profit margin.

Conversely, for investors looking at Apple as a historical powerhouse of innovation, a move into fully developing an automobile may be the reason to hold onto Apple shares. It may, in fact, be the type of gamble these investors have been looking for Apple to take with the cash sitting on the company's balance sheet.

Consider Mobileye's cash from operations chart above. Just five years after being public, the company is gaining 133 million more from operations than it is losing on capital expenditures. Assuming Apple can generate this type of success in five years, the present value of the cash inflows is $82 million. This adds only about 2 cents' worth of value to shares presently (assuming a discount rate of 10%), but the company's multiple would also expand with this new business - Mobileye trades well above 80 times trailing earnings, reflecting anticipated growth.

In the best-case scenario, Apple adds Mobileye's 7 billion in market cap over the next five years by jumping into this business. In the worst-case scenario, the company loses less than 1 cent per share on the minimal capital investments necessary to dive into automotive software.

Going the Tesla route yields an obviously larger long-term potential prize for investors - Tesla's market cap is over 4 times greater than Mobileye's, for example - but will take years of intensive capital spending before a return is recognized. If Apple is extraordinarily fortunate to only have to match Tesla's estimated full year 2017 capital expenditures, and do so for five consecutive years, investors are gambling about 2.40 worth of cash per share. Should headlines suggest Apple is completely going the route of developing their own car, investors can expect to see shares fall to match the loss in immediate value for the sake of gambling big.

Now, should headlines indicate the opposite - that Apple is solely looking into licensing any software it develops or focusing on the driving experience - then investors looking to Apple as an investment that offers growth at a reasonable price should begin to salivate. Integrating the company's offerings into vehicles provides a new, highly profitable market that can unlock new value and expand the firm's multiple. Comparing the company to Mobileye is an imperfect example; the total prize in this scenario available to Apple far exceeds the segments Mobileye operates in.

There's another story to be told: Apple shifting the focus of its ecosystem from an end-to-end development philosophy and modeling the Apple TV approach can be extended into the home and workplace. If Apple is willing to dive into the automotive market as a provider of services, it will represent a paradigmatic shift for the company. The company will be able to enter market after market without needing to develop new, tangible products to do so. How can Apple leverage the iPhone, iPad, and its computers into the Internet of Things? The car is only a start.

If Apple takes the turn down the software route entirely, I'll travel along the path with them in anticipation of a multiple expansion.

Disclosure: I/we 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.