Right now Apple (AAPL, Financial) has a big problem. It’s an enviable problem in a way but still a problem.
Apple generates tons of free cash flow but has hit a wall when it comes to growth. In fact over the last 12 months revenue has actually decreased from $233.7 billion in fiscal 2015 to $227.5 billion. It seems that Apple is suffering from the twin problems of a longer iPhone upgrade cycle as well as slowing growth in the cell phone market as whole.
One of the new products Apple is working on to restart growth is the Apple car, code named Project Titan. In talking with clients and some Apple investors (to be clear, we don’t own Apple) it seems to be the thing they are most excited about regarding Apple’s future. However, Apple investors should not count on the Apple car to be Apple’s savior.
The automobile manufacturing industry is terrible
The automobile manufacturing industry as it is currently composed is a terrible business to be in. Competition is intense, profit margins are low, returns on capital are abysmal, and the business is highly cyclical. The table below shows the returns on capital over the past decade for eight large automobile manufacturers: Ford (F, Financial), General Motors (GM, Financial), Daimler (DDAIY, Financial), BMW (BAMXY, Financial), Honda (HMC, Financial), Toyota (TM, Financial), Fiat Chrysler (FCAU, Financial) and Nissan (NSANY, Financial) as well as for Apple.
(Data via Morningstar.com)
Apple has earned average returns on capital of 30% over the past decade. Getting into a business where returns on capital average under 5% does not seem like a decision that will benefit shareholders.
In some ways I don’t blame Apple for focusing on cars. Apple is one of the largest companies in the world with sales over $227 billion. In order for Apple to move the growth needle it needs to think big, and the automobile market is big. Additionally, according to KPMG the global market for automobiles is expected to grow 4.1% (outpacing global economic growth) annually reaching 111 million units in 2020.
The question is will Apple be able to enter the auto market and create value for shareholders?
What Apple needs to do to succeed
If Apple is going to have even a small shot at creating shareholder value with its Apple car business, it is going to need to do several things.
1. Sell direct to consumers without a dealer network. According to analysis I did for a previous article on the auto industry, automobile dealers capture about half of the net profits available from selling a vehicle. That is, profits from the sales of new automobiles are split about 50-50 between the manufacturer and the dealer. By going direct to consumers like Tesla (TSLA, Financial) is doing, Apple can double its available profits compared to other manufacturers saddled with deeply entrenched legacy dealer networks.
2. Create a halo around its products just like its consumer electronics business. The insides of a Mac and a PC are pretty much the same yet Apple is able to charge a premium because of its brand name, slick easy-to-use operating system and seamless compatibility with the Apple software and cloud ecosystem. Will Apple be able to do the same thing to cars that it did to PCs? I’m not sure how. The playbook for cars is vastly different from consumer electronics.
The best it can hope for is a BMW or Mercedes-Benzlike premium on the vehicles it sells. Looking back at our table of average ROIC over the past decade BMW and Mercedes seem to have been able to squeeze out a few more percentage points in returns on capital versus mass market companies like Ford or Fiat Chrysler.
3. Focus on a niche. Trucks, SUVs and luxury marques have the highest profit margins. Apple should position its vehicle in a similar position in the market. The position could be only making self-driving cars (if that’s what the future is) or positioning itself as a luxury marque. Apple was tremendously successful in getting as many men, women and children around the globe as possible to use iPhone and iPods. Following the same strategy and attempting to make an iCar (or whatever the name ends up being) for everyone and competing in the lower end of the automobile market will drive down profits and returns on capital.
Can Apple create value?
For 2015 the average ROIC for a Standard & Poor's 500 company was 10.8%. The average auto manufacturer from our sample had an ROIC of 4.1%. Let’s assume Apple is able to do everything it needs to succeed by selling direct to consumers and charging a premium price. What would its hypothetical ROIC look like? Well if half of the profits in the industry are earned by dealers, we could double Apple’s profit margins compared to competitors. But it might not necessarily double ROIC. Additional capital would be required to earn those profits. The table below shows the average ROIC for the large publicly traded auto dealers. We are going to use the average excluding GPI which does business in Brazil due to the economic issues in the country.
(Data via Morningstar.com)
The average ROIC figures for dealers are really quite similar to auto manufacturers. You could make a case for ROIC increasing for Apple since it would be fully integrated. Less capital investment may be required versus the traditional dealer network. Apple would be able to centralize everything. In the traditional dealer network huge amounts of inventory are scattered around the country, many back office functions such as finance are duplicated at each dealer, large showrooms and huge plots of land for inventory are needed, and the list goes on.
If you want to be generous to Apple, one could make the case for the ROIC of Apple’s dealer operations improving a few percentage points over the average. Next if we assume Apple is able to charge a premium it should generate 1% or 2% more incremental ROIC as Daimler and BMW do. So adding everything up we get an ROIC of around 6.45% ((4.4% + 2% premium + 4.51% + 2% improvement due to vertical integration) / 2).
Apple’s new project is likely to earn below average returns on capital. It behooves us to remember Warren Buffett’s sage words: “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.”
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