General ThoughtsIndustry-Oil

Apple vs. Exxon Mobil

I read an article last week by Scott Fearon, who wrote the excellent book Dead Companies Walking (a good book about shorting stocks, which can benefit investors even if they don’t short stocks). The article basically posed a hypothetical question on whether Apple was a better investment than Exxon Mobil. Fearon goes on to explain why he thinks XOM is a better bet than AAPL over the long-term.

His points:

  • Apple is a consumer products company with the majority of revenues coming from one product class—the iPhone
  • Consumer products can be very difficult to predict and can go in and out of demand very quickly
  • Exxon is a more predictable company that sells products that are essential to the world’s economy
  • He implies that Exxon has a stronger balance sheet than Apple

While I often agree with many of Scott’s opinions in his posts, I’ll make just a few counterarguments to his opinion that Exxon is a better business than Apple. This isn’t a write-up on why I like Apple, or why I don’t like Exxon (I actually don’t have much of an opinion of Exxon either way). These are just a few comments on the two. At some point, I’ll discuss more details on why I do actually like Apple as a business.

Exxon Sells a Commodity Product

Scott mentions that he was concerned that once the iPhone sales started falling that the stock would fall with it. That has in fact happened just as Scott predicted. Apple’s revenue fell 13% and profit fell 22% in the recent quarter. That said, Exxon’s revenue fell 28% and its profit fell 63% due to the brutal conditions in the energy industry. 

The problem I see with Exxon is that while it is the largest integrated (diversified) oil company, it still sells a commodity product. The problem inherent to a business that sells a commodity product is that they have no control over the price of the main product they sell. Not only does a commodity producer have no control over the price of their product, but they have no idea what the spot price of that product will be in any given year. It could be 100% higher one year, and 60% lower the next year. It’s generally a difficult business when you have no control over the price of the product that you sell, especially when a good amount of your input costs are fixed (i.e. if oil goes from 100 to 40, there are certain operating expenses that don’t drop with it—some costs do fall, but not necessarily by 60%).

A lot of people are worried about Apple’s ASP (average selling price) falling as they face competitive pressures as well as a possible shift toward smaller phones. But the “ASP” of one of Exxon’s main products (a barrel of oil) has dropped from around 110 to 45 in the past 18 months. Exxon is certainly strong enough to survive this, but that’s a difficult business to be in.

Exxon is More Predictable

I do agree that it is easier to look out 10 or 20 years and visualize what Exxon will be doing. They’ll still be drilling and pulling oil out of the ground 10 or 20 years from now (yes, the developed world will still be using fossil fuels as a primary energy source a decade or two from now). But just understanding what a business will likely be doing 10 years from now doesn’t necessarily make it a great investment. The company might struggle to create incremental value for shareholders during that time.

Take US Steel for example. It’s quite predictable that US Steel will still be producing steel 10 years from now, but that doesn’t mean that the stock will end up being a great buy and hold investment. In fact, it doesn’t even necessarily guarantee that the equity will survive—but US Steel will still be making steel in a decade or two. But 25 years ago, X traded around 26 and today it trades around 16.

As Charlie Munger warned in his discussion on cattle at the Berkshire AGM, it’s probably best to avoid commodity businesses that don’t produce decent returns on capital.

US Steel

Just because you can visualize what a company will be doing in a decade doesn’t mean that the intrinsic value of the business will grow or that the equity is a good investment.

To be clear, Exxon Mobil is a much better business than US Steel. I’m not suggesting the two are similar (except that they are both commodity producers). My point is simply that predictability doesn’t necessarily lead to value creation. As Buffett rightly points out, being able to understand what a business will look like in 10 years is an important prerequisite for an investment, but being able to see what products and services a business will sell in 10 years doesn’t necessarily mean that there is a high level of predictability around the company’s earning power.

Apple’s Balance Sheet

Apple has a cash hoard of roughly $233 billion, and after subtracting all debt, Apple has a net cash position of $161 billion, or roughly $29 per share. Scott mentioned that Apple will need to use much of this to invest in research and development projects in order to continue producing innovative products.

Let’s take a look at Apple’s R&D spending the last five years:

  • 2011: $2.4 billion spent on R&D
  • 2012: $3.5 billion
  • 2013: $4.5 billion
  • 2014: $6.0 billion
  • 2015: $8.1 billion

To put these numbers in perspective, the R&D spending ranges between roughly 2.0% and 3.5% of Apple’s revenue. In the past 5 years, Apple has produced a combined $283.1 billion in operating cash flow (and this is after deducting the R&D expenses which run through the income statement). Apple’s total capital expenditures over that five year period were $47.3 billion—much of which would be categorized as “growth capex”. So even after deducting all capex, Apple has produced a combined $235.8 billion in cumulative free cash flow (FCF) over the past 5 years, or an average of roughly $47 billion FCF per year.

It’s hard to suggest—even assuming worse than expected sales declines—that Apple’s business model is going to require it to wind up using most of the cash hoard to finance capital investments and research projects when the operating business produces FCF that is 6 times larger than the R&D budget.

In other words, Apple could double or triple its R&D spending and still–even with worse than expected sales declines–add significant amounts of cash to its balance sheet.

Another way to look at the size of the cash is this: if Apple could somehow take its cash hoard and find a place to get 3% after-tax returns, it would produce $8 billion of interest from its cash, enough to finance the entire R&D budget from 2015 without even tapping principal. This doesn’t include the $40 billion or so of FCF that Apple will have this year to either pay out as dividends, buyback stock, or add to its growing pile of cash. I’m not suggesting Apple will or should invest in low-earning income securities, but this should help illustrate how much earning potential Apple has from its balance sheet to finance its spending.

Exxon’s Balance Sheet

On the other hand, let’s briefly glance at Exxon’s balance sheet. There is $4.8 billion of cash and roughly $43 billion of debt. Exxon has also produced a huge amount of cash flow over the past 5 years, and has historically produced a sizable amount of free cash flow as well. Over the past 5 years, the company has averaged $14.7 billion annually in FCF.

The problem is that over the past 5 years, Exxon has spent an average of $15.2 billion per year on stock buybacks and an additional $11.0 billion per year on dividends. So a business with around $15 billion of free cash flow is not producing enough cash to finance its $26 billion of average capital returns (buybacks and dividends). Obviously, buybacks can easily be cut as earnings decline, but in recent quarters, the free cash flow (the amount of money the business generates to pay for things like buybacks and dividends) is not enough to even support the dividend. This is largely the reason Exxon’s debt has gone from $15 billion to $42 billion over the past 5 years. In 2015, Exxon’s free cash flow was just $3.9 billion, which was significantly less than the $12.3 billion that Exxon spent just on the dividend.

Buybacks have dropped from $22 billion at the peak to just $4 billion last year, but if conditions in the energy industry continue, Exxon could be forced to either continuing taking on large amounts of incremental debt each year to finance the dividend, or cut the dividend down to a level that can be financed out of the company’s free cash flow.

I am not making a prediction or casting judgment on the future of Exxon’s business (or its dividend), but I certainly view it in a much more precarious situation than Apple (which will most likely do somewhere between $40 billion and $50 billion of free cash flow this year—plenty to pay for its $13 billion dividend payment and still have much left over to buy back shares or add to its massive cash position).

To Sum It Up

The two businesses are like comparing apples (no pun intended) and oranges, but the articles Scott wrote got me thinking about the two last week. 

I recommend his book, which is a good read regardless of whether you short stocks or not. Thinking like a short seller is a very important skill to develop for any investor, as it helps you poke holes in your own potential investment ideas with a more discerning eye.

As far as this comparison between Exxon and Apple, it is more of just a random thought experiment without much relevance (since the two are unrelated businesses). But still it was interesting to consider the respective futures of the two since they are two of the largest companies in the market. In the near future, I’ll probably put up a post on why I like Apple as a business and an investment, which might be contrarian in the value community given the current view that the company is just another consumer electronics business. I currently own shares of Apple. 

——

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

18 thoughts on “Apple vs. Exxon Mobil

  1. It is tough to compare apples to barrels of oil ( AAPL to XOM). The thing is that both could turn out to be cyclical companies if it turns out that we are at “peak earnings” for AAPL.

    I think that the main issue with AAPL might be the risk of obsolescence – will AAPL still deliver the cool technological gadgets that consumers are willing to pay top dollar for, despite the fact that there are other competing gadgets that provide a similar functionality but at a cheaper price. I have observed sales of Apple products that stop selling well, and it is not pretty .

    Of course, if they can keep people hooked on upgrading to a new apple iphone, iwatch etc, that is great and profits and revenues will keep doing well. But what if we are at the inflection point where it is selling iPhones but there are other devices that are cooler than that?

    They do have that ecosystem that everyone is talking about too. And people do like Apple products. But a lot of people have also liked their Sony Walkmans, Blackberrys, and Razr’s. Shifts in technology occur quickly – the leader in cellphones Nokia from a few years ago had its lunch taken from Apple. If Apple can maintain its position, they will do well for shareholders. Otherwise…

    1. Yeah valid points/concerns. I have a few comments that I’ll form into a post at some point. But I think there are just a few variables that really matter for an investment in Apple to work out well at these valuations. Very generally, it probably hinges on whether you think the company will continue producing high-end products that people will want to pay for. I just have a hard time imagining this won’t be the case, given the company’s track record in a variety of product categories. Blackberry saw its peak revenue in 2011 at $19 billion, and they introduced 10 new phones that year. Apple has always tried to focus on producing great products, and with that has come the ability to achieve and sustain very high markups (as it’s often reported, they account for almost all of the smartphone market’s profits despite having only around 20% market share). I think Apple’s approach has been much different than most of the previous consumer electronics companies that have failed, and their success in implementing their approach has led to what I think can be considered a consumer brand. I don’t think walkman, motorola, or even blackberry were able to achieve a brand than transcended the actual product the way Apple has.

      If you think that the brand is not resilient, then Apple won’t be able to maintain their huge margins. But so far, they’ve been able to achieve huge ASP spreads (and huge profit margins) over their competition, and it’s been the case for a fair number of years now, which would seem improbable if price was the primary competitive variable.

      Thought experiment: If Apple announced they were making a car that was going to be available in 2019 and were accepting pre-orders now at $1k a pop, I wonder how many preorders they’d get? My guess is a lot. I think it’s probably a good bet that most products will continue to see strong demand from people who are willing to pay up for a high-end product, and I think that’s probably over time one of the key variables.

      Who knows how many SE’s will sell or how well the iPhone 7 will do later this year? But looking out 2-3 years, I think it’s fairly predictable that Apple will still be doing quite well.

      I’ll have some more comments later.

      Thanks for the comment. It’s definitely an interesting, and maybe somewhat contrarian idea, but it will be interesting to see how it develops.

      1. Thank you for your response. You bring a good point about the value of the brand. Perhaps Sony was the closest to a good brand in consumer electronics, though not to a level of complete fan devotion.

        For me, Apple is in the “too hard pile”. I just don’t know who will eat whose lunch.

        But I think it would be a great case study either way. I am looking forward to reading your articles on Apple and hope you make a lot of money for your clients.

      2. Nice post, John.

        Extreme changes in Apple’s sentiment fascinates me.

        The view of obsolescence reminds me of Christensen’s theory of disruption. Relating to Apple, the theory suggests that as technology advances, interfaces standardise and companies will begin to specialise on pieces of the system, modularising the product. In short, it implies that ‘modular approaches to technology always beat integrated approaches’. However, I am not sure how this reasoning relates to consumer products.

        I think this view assumes that all consumers are rational and, therefore, choose the cheaper product that offers a ‘good enough’ functionality. Businesses don’t care about the user experience, they analyse cost/benefit. However, consumers are not rational. They value touch, feel and ease of use. They are subject to advertisement and switching costs. User experience is key.

        Comparing Apple to Blackberry and Nokia is also interesting. Their products were almost specialities in certain apps within a phone (emails, messaging) and then the iPhone come along and aggregated all these apps on one platform making a more expensive superior product. Also, the internet has changed the dimensions of the mobile game and it’s definitely beyond my competence to comprehend how any functionalities of the iPhone could be unbundled or how new technology could cause a ‘top-down disruption’.

        I agree with your point on a 2-3 year horizon the valuation looks attractive, however, for a long term investment it goes in the too hard pile for me.

      3. I certainly see your point, but aren’t quality and novelty far more significant components of Apple’s competitive advantage than they are with most of the major consumer brands out there? Hershey’s is perfectly good chocolate, after all, but they don’t have to come up with a new bar every year or two.

        I also wonder about how people-specific Apple’s quality of innovation is. If their best designers were to be poached, what would happen?

  2. Hi

    very nice write-up, thank you!

    “Thinking like a short seller is a very important skill to develop for any investor, as it helps you poke holes in your own potential investment ideas with a more discerning eye.”

    I totaly agree to that. As Charlie Munger says: “the only thing I need to know is were I am going to die, then I don’t go there.”

    Kind regards,
    valuetradeblog

  3. I dont believe these messages in the News. But this reason is a very good explaining of the investment.
    I also think about the Wal Mart of the new century, the biggest marketplace “Amazon” is a big hint for Buffett…

  4. Hardware is a commodity business too (prices may never decline but volumes can since competitors all co-operate on pricing. Actual feature/product differentiation is becoming negligible and brand value generated by a hit product erodes as it did when Steve left the last time). Management matters a lot in commodity businesses. When you bought APPL pre-Iphone or even after I-phones launch, what you were really betting on was a star manager / owner operator, not a commodity product with 0 recurring revenues and short innovation cycles.

    1. That is a good point, and I actually believe that management and the culture of the firm are key to the investment. That said, I don’t see anything that makes me want to bet against them continuing their dominance. On a related note, I’ve found that management is almost always a hugely crucial variable, regardless of what the company is doing. Very few businesses out there could be run by the proverbial “ham sandwich” and still be successful. Even Coke, which Buffett has implied in the past that it is a machine that could run itself, ran into problems in the 80’s that were largely because of poor management decision making. So I think it’s always key, but I agree in this particular case you’re making an implicit bet that the leadership at Apple (Cook, Ive, and others) will continue producing great products that people are willing to pay high-end prices for. I think that’s a pretty good bet to make, and at this particular valuation level, there seems to be significant room for error.

      As for the commodity aspect of the business, it’s true that the hardware components are commodities, but the end product certainly isn’t. An iPhone is much different than a Samsung, which is much different than an LG, which is much different than Huawei, etc… I think many of the inputs are commodities, but the output (the end product) is much less so. Compared to Exxon (or any other true commodity producing business), a barrel of oil or a gallon of gas is completely fungible. No one cares if the gas comes from Exxon, BP, or Shell, etc… They only care about the price of the gallon at the pump.

      I think Apple is probably more similar to a company like Nike, that takes commodity inputs (cotton, leather, rubber, etc…) to make its apparel and shoes, but then puts its brand on the finished product, which allows it to mark up their products more than competitors. Apple’s phones are certainly high end in terms of design and functionality, but the reason their ASP’s and margins are so much greater than the competition (they get 90%+ of the smartphone market’s profit despite less than 20% market share) is because I think they’ve developed a powerful consumer brand.

      Time will tell how durable the brand is, but I think there is a high likelihood of the company continuing its track record of producing great products that people are willing to pay a premium for.

  5. I’ve always been curious as to how Exxon manages to have as good an average ROE as they have had in such a commodity business, and from such relatively high-cost oil fields. (It would be different if their fields were chiefly in the Middle East or dry-land Norway.) It’s an interesting form of competitive advantage.

  6. As usual, great post John. Love what you’re doing here, I’ve learned a ton from your posts….

    I was a Coach shareholder at one point and sold even though I liked a lot about the stock, because I realized that at the end of the day everything hinged on consumer tastes and I had no idea how that was going to turn out. Too unpredictable.

    For me, both of these companies are selling commodities. Everyone needs a phone, and everyone needs gas. With the phone, consumers make a conscious choice about whether they want to pay extra for the fashion/features/vanity that comes with an iPhone, and AAPL’s growth depends on this. But nobody needs an iPhone, they just need a phone. Consumers have to want to pay up for the bling in order for Apple to be successful, and no matter how much AAPL invests in making them want to they’re still at the mercy of fashion tastes which are out of their control.

    On the other hand, gas is gas. People don’t flock to a brand of gas because it’s cool or because it works better. Fashion and features have nothing to do with it, the only consideration is need. My tank is empty… And in that setting, a company with the market share of XOM is guaranteed to get a huge portion of the business. Prices may go up and down suddenly and unexpectedly, but I would think a business like XOM got to the market share they have now because they are adapted to dealing with that.

    I definitely agree that rapid increase in XOM debt is alarming. I’m going to see if I can figure out whether this is something new in their corporate history, or whether this is what happens every time the price of oil peaks and plummets.

    1. Thanks for the comments Chris. Yeah the iPhone is definitely not a life necessity as nearly as much as energy is, which Exxon provides. I think of it more as a consumer brand like you might think of Coke or Nike. Those can certainly be attacked, as you mention with Coach, but I think Apple’s brand is more durable than many retail fashion brands. I think it’s also more valuable (some have estimated it to be the world’s most valuable brand, recently surpassing Coke and worth more than $100 billion: http://www.fastcompany.com/3018817/where-are-they-now/apple-tops-most-valuable-global-brands-list I’m not sure what the brand is worth, but I’m confident that it is worth a significant amount. Of course, this point can be debated, but my thought is that Apple will still be producing great products 3, 5, 10 years out.

      From an investment standpoint, I think that the stock is pricing in significant deterioration of the iphone business and possibly the brand. With $160 billion in net cash, a huge cash machine that even with the declines will do $40-$50 billion FCF for the next few years, I think the stock is quite cheap. I think the sentiment surrounding the company is terrible, which has created the current valuation. This sentiment can quickly revert to the mean, but I happen to think that Apple will in fact continue to produce high-end products that consumers want. I think the market isn’t pricing this as likely, or maybe the market participants are overly focused on the last quarter (first sales decline) or maybe the next few quarters.

      I can’t remember a brand this valuable trading at this cheap a valuation. But the whole investment case comes down to whether you think Apple will continue being a great business. If not, then it’s not going to be a great investment, regardless of the valuation.

  7. Apple does have inherent business model risks but this risk is more than compensated for with such a low valuation. Fairly decent growth prospects for Apple as well.

    There is definitely something to be said about commodity industries in that their product is likely not to go out of demand. Certain industries, even if in commodity industries, can obtain success. Mostly in food and beverage industries.

    Timberland is an interesting commodity investment because timber has appreciated in the 5-6% range for extremely long periods of time. Adding appreciation to the “dividend” added up to 14% p.a. since the early 70’s. Of course as most people point out with many publicly traded companies the only thing to worry about is demand but in commodity companies you have to worry about supply too.

    It’s also interesting to think about how the richest people in the history of the world have made their fortunes. Many are/were in commodity industries. The inherent utility of commodities I suppose.

  8. I get your point… The Apple brand is a very formidable thing.

    Even though I recognize that, for my own personal investing style I’ve never figured out how to get comfortable with the durability of something as intangible as a brand. I used to think MSFT made great products, but now I don’t. I was never a shareholder, but had I been I’m not sure when I would have been able to flip the switch from they’re-great-and-going-to-turn-this-around to they’re-no-longer-great. I do see how AAPL’s cash pile and market share gives someone with the right mindset time to figure that out.

  9. Apple was my largest position from late 2012 until last year, so I’ve been following Apple closely for several years. Even though (or perhaps because) Apple is a very secretive company, they are closely watched by so many people that there’s a lot information available online. For example, there is significant evidence from a number of different sources that this year’s new iPhone will look similar to the iPhone 6S: http://appleinsider.com/futures/iphone-7. Next year’s iPhone will be a major redesign: http://appleinsider.com/futures/2017-iphone (ignore the picture since it’s just a placeholder).

    Since last year, I have reduced my very large stake in Apple to a small position currently. I have no doubt that Apple will continue to produce great products that their customer will love. However, I don’t think that will result in as many sales as it did in the past. A lot of their growth in the past few years have come from selling to new customers. I see less opportunity for Apple to sell to new customers in the future since many of the people who wanted Apple products and could afford them own one today.

    But the bigger problem I see is that Apple customers are not upgrading their products as often. We have seen the impact of this on the PC industry, This is a major headwind for Apple. In 2014, iPhone owners upgraded their iPhone every 2 years on average. Today the average is 3 years and I expect that to continue to increase. This is somewhat remarkable when you consider how much better the iPhone 6S is compared to the iPhone 5. Clay Christensen would say this is an example of the product improving faster than people can change their behavior to utilize the improvements.

    Apple is excellent at managing resources. They will invest less in current products if they see an opportunity to invest more in something even better. I believe that’s why this year’s iPhone may be disappointing while they work on a major upgrade for next year. I think there will be better opportunities to buy Apple stock after the new iPhone comes out if its sales numbers disappoint Wall Street.

    In short, Apple will continue to make great products, but they will have more difficulty getting people to buy them. At the current share price around $100, I believe the margin of safety is less than when I purchased my shares, so I have reduced my position. At $100 a share, I believe Apple is a decent investment rather than a good or great investment. I would make Apple a significant position again if it gets near $80 a share.

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