Danger Zone 5/13/2013: Apple Inc. (AAPL)May 14, 201375Comments by David Trainer Not a Member Yet? You need a Gold Membership or higher to view the content on this page. Start Your Gold Membership Today | New Constructs Member Login 75 replies to "Danger Zone 5/13/2013: Apple Inc. (AAPL)" Tom Jones May 14, 2013 Aapl currently has ~ $149 per share of cash If Aapl’s ROIC declines to 20% you value the company at $162 per share- In that case is your estimation of the value of the Company’s future cash flows $13 per share? What would this ROIC imply for Aapl’s operating margins on $170b of revenue per year? Thank you David Trainer May 14, 2013 Tom: Thanks for your comment and great questions. The link below shows my calculations and data values behind $283 share price implied by he 70% ROIC and behind the $240 share price implied by 50% ROIC. The link is to a file showing my model, which I think is the most transparent way to explain my calculations. http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_Model_AAPL_valuationBasedOnROIC.pdf This link takes you to the “Investing 101” section of my site, which provides definitions for ROIC, NOPAT and Economic Book Value. Once you see how my model works, you can perform your own scenarios on valuation based on whatever margins, ROIC, or revenues levels you want. Specifically, a 20% ROIC implies a 3% NOPAT margin, which would yield $5.1bn in NOPAT on $170bn in rev. That level of NOPAT implies a share price of about $192/share. Thanks for the great question. http://www.newconstructs.com/category/investing-101/ David Trainer May 14, 2013 Be sure to download the http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_Model_AAPL_valuationBasedOnROIC.pdf file – if you view in the browser, you might not be able to see my notes explaining how it works. Ken C May 14, 2013 “Without another ground-breaking innovation like the iPhone, Apple is destined to be just another consumer electronics company” “destined”? You can tell the future? “I think is inevitable after the departure of Steve Jobs.” “inevitable”? First, “destined” and now “inevitable”. Other than your gut, on what basis is it “destined” and “inevitable”? “Add the lack of innovation and issues with new products” Ah, the “lack of innovation” meme. How often does a company like Apple launch a disruptive product? Every year? Every other year? Try, once ever 7 years on average. Apple has been in existence about 35 years. They’ve released what many consider to be 5 disruptive products, the Apple II, the Mac, the iPod, the iPhone and the iPad. That’s 5 in 35 years. It’s only been a few years since the iPad, so Apple isn’t exactly due for a new product. Any reference to “lack of innovation” indicates a lack of historical understanding of the tech business. “Without significant product differentiation, Apple cannot maintain the ultra high profit margins and ROIC” That would be true for any company, but what evidence do you have that Apple cannot continue to differentiate? I mean, they’ve done it for 35 years, why would they stop now? “If we assume Apple can maintain an ROIC close to Microsoft’s, around 75%, then the stock is only worth ~$295. If Google’s 34% ROIC is the benchmark, the stock is worth only ~$191. If we assume Apple can maintain a long-term ROIC of 20%, which is still high in the consumer electronics sector, the stock is worth ~$162.” Why compare Apple to Microsoft or Google? Microsoft makes software, and a little hardware. Google makes over 90% of their income in search. Apple is a hardware company that differentiates with software. They don’t do search. Further, Apple is very likely to have ~$200 in cash per share within 2 years. “Apple has not come up with any significant new innovations and appears to be falling a bit behind the competition. ” Clearly, your notion of “innovation” is different. Features are NOT “innovation”. Apple has never had the most features, so nothing’s changed. “The Apple Maps fiasco last year revealed how much the company missed his attention to detail.” Again, one wonders if you understand the subject upon which you base your opinion. Maps was not a fail based upon lack of “attention to detail”. In fact, the Maps app itself is excellent, with its vector-based images, a significant improvement for mobile mapping. It was the mapping data which failed. That came from 3rd parties. The maps “fiasco” is in fact, less of a issue than the iPhone4 antenna problem. The maps will always improve with time as data is updated. The antenna problem couldn’t be fixed with software. That was under Steve’s watch. It’s easy to eulogize Steve as perfect, but he made plenty of mistakes. “but that amount was reduced 50% on appeal.” This is a clear mistake. There has yet to be an appeal. The adjustment was due to an error by the jury, but the final judgement could be higher than the original award. The media has mostly gotten this wrong. You need to read Fosspatents to get the correct legal interpretation. “Google, Samsung, Blackberry, Microsoft and many other firms will continue to put out phones, computers, and tablets that will be increasingly competitive with or better than Apple products” As of right now, only one firm, other than Apple, is making any significant amount of income from hardware products. Not Google, not Blackberry, not Microsoft, not Nokia, not Sony Ericsson, not HTC, not LG, not Motorola, etc. Since the iPhone launched in 2007, the landscape has become less and less competitive, rather than more competitive. This article might not even be good enough for Seekingalpha.com and that site is a joke. Monstershortguy May 14, 2013 You should go to jail for this report dude. Tom Jones May 15, 2013 David thank you the response appreciate your work Wilton May 15, 2013 Ken C makes some interesting arguments and has a valid criticism of part of your thesis. If Ken C is still out there reading this, I would like him to form a conclusion on his valuation for AAPL–especially assuming his expectation that AAPL may have $200 bil in cash within 3 yrs. MDL-Wilton Ryan May 15, 2013 http://video.foxbusiness.com/v/1656728485001/analysts-underestimating-apples-growth/ Obviously people are allowed to change opinions, but I found this interesting. Ryan May 15, 2013 David, I apologize. I saw that you acknowledged your previous feelings on Apple. In regards to ROIC. Maybe I missed this too, but if there is constantly more invested capital wouldn’t it make sense for ROIC to go down? Isn’t this inevitable? If Apple invested $100 billion and gets a 20% return isn’t this still a good thing as it is above the cost of capital? Kelvin Lee May 15, 2013 I wonder who is paying David to put out this report? That is the real question we should be asking. Mickey Mouse May 15, 2013 Nothing like selling fear on Wall Street, this article is laughable. JAS May 15, 2013 can you explain how you go from economic book value to invested capital? Bill May 15, 2013 Trainer clearly doesn’t have a clue what he’s talking about. He’s desperately trying to pound a square peg into a round hole, it doesn’t fit, so he blames the peg. There’s nothing at all wrong with the peg–aapl–but the hole is seriously flawed. Bill May 15, 2013 ROIC 271??? Where? Your own chart/calculations appear to show ROIC of 70.4% for 2012, which would appear to trash your thesis. Chris May 15, 2013 at $240 over 60% of the companies value would be in cash right now. in under two years apple’s cash would equal its marketcap at $240 ….. David Trainer May 15, 2013 Bill: Good point. That model is modified to show the implications of the lower ROICs. The unadjusted model is here. http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_AAPL_Model_Unadjusted_Overrides_inactive.pdf Kevin May 15, 2013 You are grossly warping the meaning and importance of free cash flow to serve your argument. I suppose you’re a smart guy, so I’m wondering if some perverse motive is in play here. Time constraints preclude me from indulging in any serious back-and-forth. I’ll simply “bottom-line it”, and assert that AAPL is more appropriately valued at 600+. Richard Foree May 15, 2013 Hi, “The differences between the iPhone and the Samsung Galaxy … are no longer enough to justify a major difference in price.” David, isn’t the new Galaxy MORE expensive than the iPhone? Do some research; you’re embarrassing yourself! BuhBye! John May 15, 2013 I think you made a good point that apple is losing its edge on the innovation, therefore causing a loss on their profit margin. However ROIC is not the only metric you need to look at. Simply put, if Apple lowers its margin, will it rapidly expand its market share which stands at just 9% now? How would that dynamics play into the valuation metrics? Bob May 15, 2013 Two thumbs up to Ken C for completely discrediting this nonsensical article and model. It’s people like you, David, who give Wall Street an awful name. This is elementary grade bush league jibberish. Formulate an articulate rebuttal to Ken C please. He tore you a new one, Mr. Expert Bob May 15, 2013 Oh and one more thing: http://video.foxbusiness.com/v/1656728485001/analysts-underestimating-apples-growth/ So just one year ago, when AAPL was trading in the mid-$500s, you were bullish and advising clients to get it. What, have you now switched to the other side and gone short? And you need to make a name for yourself to pump and dump? All indicators point to yes. Get off the airwaves clown danny May 15, 2013 How do you account for AAPL (or other companies) cash on hand in your model. If you have 2 stocks that have the same ROIC, but one of them has an extra $100 billion in cash, do you value them the same? th3uglytruth May 15, 2013 Hey David! I’ve always wanted to see a “numbers guy” go thru AAPL’s FS; good for you! Have you ran your model against GOOG, NFLX, CRM, AMZN, DELL, MSFT and PCLN? What does your valuation look like? Or, lets just pick a few…AMZN, NFLX and GOOG. I look foward to your response. Vincent May 15, 2013 Hi Mr Trainer, Could you kindly respond to Bob Posting as shown below: “Posted May 15, 2013 at 10:33 am | Permalink Oh and one more thing: http://video.foxbusiness.com/v/1656728485001/analysts-underestimating-apples-growth/ So just one year ago, when AAPL was trading in the mid-$500s, you were bullish and advising clients to get it. What, have you now switched to the other side and gone short? And you need to make a name for yourself to pump and dump? All indicators point to yes. Get off the airwaves clown” ugh May 15, 2013 why does excess cash increase by $38bn in the face of a Y-Y decline in FCF? ugh May 15, 2013 scratch that…how did aapl manage to get $118bn in excess cash in the first place? all of the FCF doesn’t add up to anything close to that. OPBD May 15, 2013 David – I came across you on Fortune and PED. I posted there that you model is flawed on NOPAT and FCF. It appears in #16. above you correct that and now the stock is worth $796?? Is that right? Are you going to call CNBC? or did you get the publicity you were looking for and now hope nobody will notice? Contradan May 15, 2013 Sorry, but I’m not following your math. Every year up until 2011, your Net Operating Profit After Tax (NOPAT) correlated to GAAP Net Income (GAAP NI), which the rest of the world watches, to within 10%. Makes sense. Suddenly, in 2012, your NOPAT is 75% less than GAAP NI. What gives? Are you aware of some $30B tax Apple had to pay in 2012 that I’m not aware of? David Trainer May 15, 2013 Contradan: I think you are looking at the adjusted model, where the NOPAT reflects the lower ROIC. The unadjusted model is here. http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_AAPL_Model_Unadjusted_Overrides_inactive.pdf David Trainer May 15, 2013 OPBD: The first model (http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_Model_AAPL_valuationBasedOnROIC.pdf) shows how I adjust my model to derive the share price implied by 70% and 50% ROICs. The second model is the unadjusted model. David Trainer May 15, 2013 Ugh: Thank you for your comment. The issue is not how much cash the company generated in the past, it is what it can do in the future. My model (which you can view via links above) gives AAPL credit for $126/share in cash. There are other liabilities (options, taxes and debt) that offset much of that. The point is my analysis accounts for all the financial variables. joe May 15, 2013 Fairly absurd analysis. What is the mechanism, competitive or otherwise for the co to drop to $8bn in NOPAT from $40bn today? You essentially assume it happens instantaneously, which given smartphone demand and total global capacity is likely impossible. A much fairer analysis for the bear case would be a model that incorporates demand, capacity, share and gross margin across important categories (phone, tablet, mac/pc) and has apple going to a lower ROIC target over time. For every quarter that your low-ROIC case doesn’t happen the co is stacking up $10bn cash. Another way to sanity check this: what are the 2014 revenue and margin assumptions required for your $240? The co would have to dive off a cliff. I’m sure there are decent analogs out there for high ROIC co’s that faced competition over time. David Trainer May 15, 2013 Vincent: Thank you for your comment. That video is from 2012 not 2013. The most recent video before today’s is my Jan 25th CNBC interview: http://www.newconstructs.com/nc/news/display.htm?newsItemId=402880a83c74a33f013c83906d3b0ed2 For the record, New Constructs rating on AAPL went from “Very Attractive” to “Neutral” on Nov 2, 2012. I liquidated all of my AAPL holdings in my fund by Jan 24, 2013. Bob May 15, 2013 Okay, I took about 30 minutes out of my day to study your model. Forgive me if I’m missing something, but what you did seems to be deceitful. The first model you published is adjusted down to meet your assumption of what AAPL’s ROIC will be in whatever amount of years you came up with; however, in your model, this arbitrary prediction you came up with is labeled “Current.” Rather than having the ROIC formula, NOPAT/Invested Capital, drive your ROIC, your model does the opposite. So you show AAPL’s ROIC being 52.0% “Currently,” which drives NOPAT down to $8,004.40 (in millions). For “2012,” you pegged AAPL with a 70.4% ROIC which equates to $10,827.34 in NOPAT. Average invested capital is constant at $15,378.34. A 70.4% ROIC yields a Valuation of $283.24 and a 52% ROIC yields a value of $240.03. Your amended model uses actual, real-life numbers (as opposed to arbitrary projections). AAPL’s actual NOPAT in 2012 was around $41B, which is reflected in your model ($41,691.52). Average invested capital is again $15,378.34. This yields a ROIC of 271.1%. BASED ON YOUR OWN MODEL, THIS YIELDS A VALUATION OF $796.20. So please, let me make sure I understand your “model” correctly. You created a model based on actual ROIC for AAPL over the past 15 years. Your own model valued AAPL at almost $800 based on current figures. You then looked at “competitors” such as MSFT, who by the way has been a lackluster stock for the past decade, and assumed AAPL’s ROIC would reach its level in and undetermined amount of time. You then forced that ROIC into your model which in turn, drove real NOPAT numbers down to 20% of what they actually are and fit your thesis of a $240/share valuation. And finally, you passed this off as a current valuation. You then went to CNBC and told them that this is the fair value?? Please please correct me if I missed something. In the time period that you “analyzed,” ROIC peaked at 338.7% in 2011 and now sits at 271.1%. While that is a real % decline of 67.6%, you have to look at total figures to avoid skewing your projections. Since the release of the iPhone in 2007, Average Invested Capital has grown by 600%. Meanwhile, NOPAT has grown 1,215% over the same period. To get to your 50% ROIC, you assume Average Invested Capital remains constant at $15,378.34 but NOPAT takes a nose dive of 80% (I understand that you are doing the opposite, plugging in an arbitrary ROIC to arrive at the NOPAT, but I’m illustrating how absurd your analysis and projections are). Please, I would love an explanation. I feel you should make all of this clear during your next round of interviews… David Trainer May 15, 2013 Excess cash is removed from invested capital, see my invested capital model here: http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_AAPL_Model_InvestedCapitalPage.pdf David Trainer May 15, 2013 For the record, New Constructs rating on AAPL went from “Very Attractive” to “Neutral” on Nov 2, 2012. I liquidated all of my AAPL holdings in my fund by Jan 24, 2013. David Trainer May 15, 2013 Lowering margins for AAPL means acknowledging the competition has a viable product and, so, I think market share will shrink too. AAPL has a great first-mover advantage and created a highly profitable brand (330% ROIC in 2011 is amazing). But now that all the competition is in the game, the pie is divided up among more companies and that will only get worse. I thing the number of pie pieces is growing faster than the overall size of the pie. Bob May 15, 2013 David – Can you please review my post (#33)? I am not looking for a fight, I honestly want to understand how you arrived at your conclusions. I will be candid – I think your methodology is at best flawed. Thank you David Trainer May 15, 2013 Bob: The reason for the two models is that one shows the valuation implies by the lower ROICs. The Economic Book Value analysis in the unadjusted model shows the value of AAPL if their ROIC remains at 270% forever. The main point of my article is that AAPL cannot sustain such a high ROIC. Therefore, it makes sense to assess what level of ROIC might be sustainable. The first model (http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_Model_AAPL_valuationBasedOnROIC.pdf) shows how I adjust my model to derive the share price implied by 70% and 50% ROICs. The second model is the unadjusted model. The first model ( Victor May 15, 2013 “Lowering margins for AAPL means acknowledging the competition has a viable product and, so, I think market share will shrink too.” That doesn’t even begin to make sense!?!? Analysts are clamoring for a “low cost iPhone” to increase market share, but in your logic all those analysts are wrong? So if Apple made a 200$ pricecuts on all their phones, you could get an iPhone4 for the same price as a midrange Android handset, you seriously think that their marketshare would fall, and iPhones WOULDN’T be mr. 1 and 2 on the list of best selling phone models, like they were recently? All the real world data point to you being embarrassingly wrong though. Look at the launch of the iPad Mini. Lower margins, but its selling like hotcakes and maintaining their marketshare. David Gekiere May 15, 2013 David, you haven’t actually answered the first comment. Tom Jones didn’t ask you how you came to the valuation. The question is whether you think Apple’s future cash flow is worth no more than $13. th3uglytruth May 15, 2013 David…what is the valuation for AMZN, GOOG and NFLX using your model? juanm105 May 15, 2013 why are there 34 comments on this? and now my comment which is 35? the whole thing is just plain dumb. sorry, it makes no sense. stop posting and giving this guy hits. Contradan May 15, 2013 David; Could you please clarify that, using actual, current data, your model values AAPL at $796? Is this correct? Bill May 15, 2013 Is there a real analyst on the face of this earth who thinks Trainer’s model is anything but gibberish? I seriously doubt it. Further, I seriously doubt Trainer believes it because if he did, not only should it be a “sell”, but he personally should hold a large short position. I would. ROIC? Pulleeeze. My guess is that (probably) those interests who (probably) financed Trainer’s silly analysis, (probably to mask price manipulation) are the one’s who (probably) got the best ROIC. But that’s just me. Tim May 15, 2013 The only comment I can write is that every so called “analyst” has his own agenda to push the stock in the direction he wants. Here we have a great example how it is done by one guy with connections that is manipulating the market… Dave May 15, 2013 This analysis has 1 key assumption that a lot of people probably missed. It assumes that ROIC falls solely because the “R” (eturn) plummets, not because the “IC” also increases, which is what has tended to happen as companies like Microsoft or Google mature (admittedly the Return did plummet at Blackberry and Dell.) Take $20 billion of the cash and instead of distributing it, use it to double the invested capital in the 50% or 70% ROIC case. Tell me then what the share price is. I guarantee that it increases dramatically. Jon Tseng May 16, 2013 In response to Bill (#45) I am a professional investment analyst. And no I don’t think its gibberish. I think he certainly makes some assumptions which could be considered bearish, but he also makes others (around WACC) which are actually quite charitable. FWIW he’s effectively taking the earnings power implied by Apple producing returns inline with its peers and capitalising as an annuity (i.e. assuming Apple remains a the same level of profits forever). He then nets off cash and debt on the balance sheet to arrive a his valuation. It’s a simple calc but its not a stupid way of doing things. His underlying point – you should think about ROIC not P/E ratio has always been a valid one. Effectively he’s saying Apple will not be able to retain its supra-normal returns and in the long run declines back inline to its peers. That is a perfectly reasonable assumption to make – if you are thinking in the year 2050 or 2099 or 2500 Apple will still be producing a 270 ROIC you are smoking dope to a grand degree (thought experiment – which leading companies from 100 years (railway stocks???) ago are still producing premium ROICs?). A few caveats: 1) His logic implies ROIC falls immediately to 70%. That’s unlikely in the real world so charitably you should factor in a few more years of excess returns (this is called the Competitive Advantage Period). 2) On the other hand he is making the assumption that AAPL’s earnings stay at that level FOREVER (think back to my comment about companies from 100 years ago). I think that’s generous. 3) He uses a very low WACC of 6.5% to capitalise Apple’s future earnings. That actually makes his NPV HIGHER. I think a 9-10% WACC would be more suitable which would significantly reduce his valuation of future cashflows. I hope that’s helpful Jonathan Bill May 16, 2013 Mr. Trainer– Why stop at 50%? With Dell, the S&P and tech @20%, why not use 20% (or would that expose how ridiculous your modeling actually is)? What present value for AAPL does your model generate for a 20% ROIC? Bill May 16, 2013 Never mind. You claim AAPL is worth $162 at 20% ROIC. Unbelievable (as is your entire model). th3uglytruth May 16, 2013 David… What value does your model give GOOG, NLFX, DELL, CRM and AMZN? please provide the same spreadsheet for the assumptions. I think this should provide some clarity to help people who question the approach, Patiently waiting… David Trainer May 16, 2013 Jon Tseng: Thank you very much for your very reasoned comment. Quite refreshing. Bill May 16, 2013 Jonathan– http://www.blogger.com/profile/01916149961326205602 Helpful? No, not helpful at all. His “model” makes unproven assumptions, and tortures/misrepresents/”adjusts” data, to arrive at a claimed present value–which no one in his right mind believes. He doesn’t just “make some assumptions which could be considered bearish”, he makes some assumptions which could be considered nuts. And, without those unrealistic assumptions–his skyhook–he couldn’t come up with his headline grabbing/CNBS pushing $240 valuation. And that’s being kind. Jon Tseng May 16, 2013 You’re welcome. Interesting approach; if you were involved in CS/HOLT I guess you don’t need reminding about CAP! But I do reckon even a couple more years of super-normal returns might have an impact on the valuation (although the high cash balance will dampen down the impact on the overall equity value). Then again I guess the whole point of the last six months is that the market has dramatically reassessed its view of AAPL’s competitive advantage period!! Def a worthwhile prism tho. Need to revisit my valuation over the next few weeks anyway will be interesting to see if the EVA and the PE are telling me different things. That might be a solution to the perennial “oh its cheap on an ex-cash PE” dilemma. All the best Jonathan PS Was having a look a NVDA the other day – the opposite a stock that’s dead cheap on an ex-CASH PE but also has a good record of producing excess returns! Jon Tseng May 16, 2013 Bill I wouldn’t consider a 70% or 52% ROIC assumption to be particularly nuts or unrealistic. Let me walk you through it. The ROIC is the annual payment you get for investing your capital. So the 2% interest on your checking account – thats the ROIC on the cash you have stashed in there. Similarly the long run return on US equities is – what? 10%? Something in that ballpark or used to be (obviously slightly depends on your time period). So in that context making even a 50% or 70% ROIC assumption is pretty heroic. Tell me another asset you can invest your capital in that will produce those returns… You also need to think about the sustainability of those returns. With the bull case not only are you arguing that you get very high returns but they are sustainable for a number of years (Competitive Advantage Period). That is definitely tricky. For context a good asset-light business model (say a software company) could probably do you 20%+ ROICs sustainably. But that’s pretty damn good. Again link it back to your bank account – how easy is it to find places to put your capital that increase it by a fifth every year. Now as I pointed out there as a couple of issues with DTs model. In particular its massively sensitive to the initial NOPAT number you are capitalising – perhaps enough to make it useless. I’d like to see it rebuild as a standard HOLT-type EVA with a longer fade and an adjustable CAP to sense-check. But I don’t think his basic approach is unsound, or he’s particularly misrepresenting anything (woulnd’t mind checking IC calc to be sure on that). All the best Jonathan David Trainer May 16, 2013 Contradan: The unadjusted model based on the current 270% ROIC shows the Economic Book Value at $796. The purpose of my article is to show the implications on valuation of lower ROICs. David Trainer May 16, 2013 David Gekiere, MY model answers your question. And all other like it. That’s why I gave you the model th3uglytruth May 16, 2013 David… I continue to patiently wait for the value your model would peg GOOG, DELL, AMZN, NLFX and CRM. You’ve answered other questions; my simple question shouldn’t really be that hard to answer. Bill May 16, 2013 Jonathan– “In particular its massively sensitive to the initial NOPAT number you are capitalising – perhaps enough to make it useless.” Bingo! Bill May 16, 2013 Article– “The problem is that AAPL is priced to maintain a sky-high ROIC of 124%.” The problem with your problem is that your graph shows that AAPL has been above that “sky-high ROIC of 124%” since 2004/2005. Your entire adjusted model simply boils down to your assumption that Apple can’t keep going, and you make up (“adjust”) numbers to bootstrap your assumptions. Dave May 16, 2013 I think based on Mr. Trainor’s model that I can roughly answer my own question from above – suppose that Apple invests another $20 billion of excess cash in the business and ends up with a 70% ROIC? That implies: – Additional $14 billion of NOPAT; – Capitalized at his WACC of 6.5% (which I actually think seems low, BTW) is $215 billion of additional value – Removing that $20 billion of excess cash means a net value increase of $195 billion I believe that equates to a value of roughly $490 per share. Yes, this includes a lot of assumptions, but I fail to see how they are any less plausible than Mr. Trainor’s assumptions. His implicit assumptions are (i) that ROIC plummets and (ii) that Apple stops investing in its business – basically that it cannot find any way to put capital to use productively. In other words, not only is average ROIC 70%, but Apple’s incremental ROIC is dramatically south of that. He is making the first assumption explicit but not the 2nd assumption. The point is that playing around with this type of model is illustrative of certain scenarios, but it is also extremely sensitive to changes in assumptions around ROIC, WACC, and amount of invested capital. I ask Mr. Trainor to say where my analysis is wrong. th3uglytruth May 16, 2013 David… I continue to patiently wait for the value your model would peg GOOG, DELL, AMZN, NLFX and CRM. You’ve answered other questions; my simple question shouldn’t really be that hard to answer. David Trainer May 16, 2013 th3uglytruth, Thank you for your patience. You are welcome to buy my report on any stock. David Trainer May 16, 2013 Jon Tseng, Thank you for your comment. Here is the invested capital model for AAPL. http://www.newconstructs.com/wp-content/uploads/2013/05/NewConstructs_AAPL_Model_InvestedCapitalPage.pdf I am happy to share any other pages from the model that you wish. th3uglytruth May 16, 2013 Buy? What no public service ala AAPL? Why is that? Bill May 16, 2013 No one paid him to squeeze out an attention grabbing link-bait story as a “public service” on those others. mike millman May 16, 2013 Apple reported net income of $13.1 billion in the December 2012 quarter, $9.5 billion in the March 2013 quarter and I am projecting $37 billion for the year. However, in Trainer’s analysis he has NOPAT (which is close to net income) of only $8 billion for the year. Unless he is expecting Apple to lose money for the rest of this year, I don’t think the analysis makes sense. Richard May 16, 2013 In studying David Trainer’s valuation, I’ve come to the conclusion that his assumptions and model are quite nonsensical. Let me start out with a question. What’s something that is really unusual about Apple compared to all other companies? Answer: They have MASSIVE amounts of cash. This large cash position will not continue to exist into the future. They will distribute it to shareholders or make acquisitions, but for now, they have it sitting on their balance sheet. Now David’s main rationale for why AAPL is overvalued is that their ROIC is unrealistically high. But he’s looking at the wrong financial ratio. That’s because; ROIC is calculated as (Net Operating Profit – Adjusted Taxes)/(Invested Capital) And Invested Capital is calculated as: Total Debt and Leases + Total Equity – Nonoperating Cash and Investments As you can see, Invested Capital is greatly influenced by the amount of Nonoperating Cash and Investments which the company possesses. In the case of Apple, they have a TON of Nonoperating Cash. David uses an ROIC of 271% that was calculated by a data provider which may include the debt Apple just added to the Capital Structure. But just to show you how much non-operating cash skews the ROIC calculation, let’s just see what the ROIC looked like before they added $17B of debt to the capital structure. ROIC prior to debt comes out to: (Net Operating Profit – Adjusted Taxes) = $38.685B Invested Capital = ($135.5B in Book Value of Equity + no Debt + $3.87B in Leases – $144.7B in Cash) = -$5.33B ROIC = (38.685)/(-5.33)= -726% So considering Apple’s massive cash position, it’s not possible to calculate anything BUT a nonsensical number for ROIC. Additionally, it’s a terrible financial ratio to use if you want to conduct a relative analysis. David compares Apple with Microsoft and other competitors, yet each of them has their own cash issues, therefore making them impossible to compare using ROIC. Perhaps most disturbingly, instead of doing a DCF valuation, which is the appropriate thing to do for Apple, David does a perpetuity cash flow valuation. In addition, he uses NOPAT, which is only an estimation for FCFF. But you can’t use NOPAT if there’s going to be any growth. That’s because, among other things, investments in CAPEX and depreciation don’t match up. So instead of dealing growth and future investments in CAPEX, working capital, etc., he decides that starting TOMORROW, Apple does not grow and its margins will plummet. That way he can use NOPAT and a perpetuity formula that models zero growth. Additionally, Under the perpetuity assumption, Apple is going to suddenly start paying out all available cash to shareholders. Meaning all cash that’s left over after they cover all debt obligations and maintenance CAPEX (where CAPEX = Depreciation). Apple doesn’t have a history of doing any of these things, nor have they shown any desire to start doing it now. So why would he model that in his valuation? Next, David’s rationale for slashing Apple’s margins is that profitability levels should naturally revert towards the mean in a free market economy, to which I agree. HOWEVER, this doesn’t happen overnight. He’s completely ignoring market forces, economics, and general common sense. I estimated his valuation breakdown looks something like this: Perpetuity Value = NOPAT/Cost of Capital ($7.69B NOPAT)/(7.15%) ≈ $108.6B $108.6 Perpetuity Value + $150 cash per share – $17 debt (The debt they just took on) – $1.6 option value per share =$240/share Now hold on as I explain just how extreme David’s assumptions are: The perpetuity value based on NOPAT is calculated assuming that Apple’s NOPAT will fall from $41.7 Billion last year to $7.69 starting TOMORROW. That means that the NOPAT Margin falls from 26.6% to 4.9% IMMEDIATELY. Then, to discount this cash flow estimate, it appears that he used an average of the WACC from the last two years that he obtained from a data provider and came up with a 7.15% cost of capital. Which seems aggressively low considering Prof. Damodaran’s WACC (before the addition of debt) is 11.29%. Had he used the same WACC as Prof Damodaran, he would have found a price per share of $176.50. Well below the $428 it is trading at today and close to the $150 it has in cash. At the end of the year, Apple will probably have $176.50/share in cash alone! Summary of his assumptions – Zero growth starting tomorrow. – Maximum dividend payouts starting tomorrow. – Massive reduction in operating margins starting tomorrow. Now, If David wanted to do a better comparison, how about ROE which is not skewed by cash holdings. Microsoft’s ROE is 22.58% and Apple’s is 33.34% according to yahoo finance. Now you could suggest that Apple’s will skew down below MSFT overtime because AAPL is a hardware and software manufacturer and they tend to make lower ROE. If he went with ROE instead of ROIC, his report would have more credibility. So I decided to determine what a “worst” case might look like. Using Prof. Damodaran’s DCF valuation spreadsheet for Apple. I Changed two of his normal case assumptions; First I changed growth to the following pattern: -5% growth for years 1-5 and for years 6-10, growth slowly recovers from -5% growth to 1.73% growth at the Terminal Date (Year 10). Using this assumption, Apple’s sales fall from the most recent year, $169B, to $126B in the terminal year (year 10). Also, their Operating Margin lowers in a straight-line manner from 31% in their current year to 12% in year 10. Under this scenario, the stock is worth $334.72/share. According to these assumptions, the stock would be 28% overvalued. But keep in mind, they are “worst” case assumptions. Under Prof. Damodaran’s valuation, the stock is 37.3% undervalued based on his intrinsic value of $588/share. So, David’s “valuation” = $240/share, or 44% overvalued. My worst case scenario = $334.72/share, or 28% overvalued. Damodaran’s normal case scenario = $588/share, or 37.3% undervalued. I still feel quite comfortable with Apple’s current risk/return profile, especially considering the fact that David’s valuation holds no water. So I’m content to keep Apple in my portfolio moving forward. Jon Tseng May 17, 2013 Richard > What’s something that is really unusual > about Apple compared to all other > companies? Answer: They have MASSIVE > amounts of cash. The point of a ROIC/EVA is to only analyse the returns the company is generating on the capital that’s deployed in its operations. That is why the cash is stripped out of the numerator (note that NOPAT is calculated on a pre-interest basis) and the denominator (IC) strips out cash and debt. Imagine if the Bill & Melinda Gate Foundation ran a souvenir shop which make $1000 of NOPAT a month. To calculate the ROIC you’d divide that by the assets it had (the shop, the stock etc). You wouldn’t divide it by the total cash and assets of the foundation. > David compares Apple with Microsoft and > other competitors, yet each of them has > their own cash issues, therefore making > them impossible to compare using ROIC. That’s precisely why you strip non-op cash out of IC. To ensure comparability with other companies. re: Your point about debt see the IC calc posted above – note this is calculated from the 2012 balance sheet so there is no debt issuance to cloud the issue. > Perhaps most disturbingly, instead of > doing a DCF valuation, which is the > appropriate thing to do for Apple, David > does a perpetuity cash flow valuation. Errr, why is a DCF not a perpetuity cashflow calculation? When you have your terminal value +10 years out and you capitalise it at (WACC-terminal growth) that looks to me a lot like a perpetuity cashflow calculation. Or am I missing something? The answer is that DT is doing a DCF valuation – he is just assuming zero growth. That’s what you call a perpetuity. > Next, David’s rationale for slashing > Apple’s margins is that profitability > levels should naturally revert towards the > mean in a free market economy, to which I > agree. HOWEVER, this doesn’t happen > overnight. Yes, this is the Competitive Advantage Period issue I flagged above. However we can do some back of fag packet sensitivities around this. DT’s run-rate of NOPAT is $10bn. Consensus net income (ignore interest for sake of simplicity) is roughly $30bn. Therefore each year of ongoing competitive advantage assuming current return levels is worth about $30bn or $32 /share. Assume this fades linearly over a five year period (believe me that’s more than enough to see a CAP eroded – viz Nokia / Blackberry) that implies an additional $90 /share of cash generation on top of the $240 base case. That gets you to $330, or 24% below the current share price. This roughly correlates with your worst case DCF. That’s not surprising as effectively when you cut margins to 10% you are doing the same this as DT cutting ROIC to 70%, you are just inputting it into the model from different cells. Remember the DCF and EVA are mathematically identical, just the cells have been reordered. So reconciling the two: If you believe AAPL will lose its competitive advantage over the next five years, then AAPL’s shares are worth roughly $330 on either DT + Fade or lower-margin DCF analysis. A thought experiment: What competitive advantage does the iPhone + Siri + iCloud have over the Galaxy SIV + Google Now + Google? If you are saying Apple’s current ROICs are sustainable you are implicitly saying the Apple package has an overwhelming competitive advantage over the Android package. Ahem. Ajay Nagpal May 19, 2013 David, I someway agree with your opinion of apple loosing its charisma of coming up with innovation or new magnetic functionalities in existing products. Competitors like Google, Samsung and Amzon are catching up fast on phone, ipod kind of products. Apple is facing too much market share issue from Samsung in developed and emerging markets, as Samsung is fast in producing good phone stuff, thanks to Android software. Let’s wait and watch in next 2-3 months when apple hold its marketing gimmick show to show what it is holding under wrap. If it is something that no one has expected then IT IS ALL APPLE. Having billion of cash in pocket has not much worth if company cannot use it to improve future earnings and at the end of day, they have to distribute it to shareholders. David Trainer May 21, 2013 See posts 48 and 55. David Trainer June 4, 2013 Nice article on diminishing competitive advantage of AAPL: http://www.forbes.com/sites/nigamarora/2013/06/03/next-big-thing-in-smartphones-could-be-coming-from-google/ The barbarians are at the gate and they are only getting stronger and louder. David Trainer June 4, 2013 Samsung Electronics notched a high-profile legal victory against Apple, when the U.S. International Trade Commission said it found some of the iPhone maker’s products violated a Samsung patent and issued a limited ban. The commission issued an exclusion order barring the import of a set of Apple mobile devices. Among them is the iPhone 4, the iPhone 3GS, the iPad 3G, the iPad 2 3G and the iPad 3. The latest Apple products, the iPhone 5 and the fourth-generation of the iPad, were unaffected. http://online.wsj.com/article/SB10001424127887323469804578525723885896616.html?mod=djemalertNEWS Henro July 4, 2013 Mr David Trainer, Greetings from Argentina. What are your comments about your statement on May 14 2013 almost 2 months later ?. Thanks a million and all the best. David Trainer July 9, 2013 Henro: Thanks for reading. I continue to believe everything I wrote here and think a long term decline in Apple’s ROIC is going to happen. In fact, I went on CNBC just last week to reiterate my argument, which you can see here: http://video.cnbc.com/gallery/?play=1&video=3000180395 Leave a Reply Cancel ReplyYour email address will not be published.