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 Inc. (AAPL) 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.

Apple

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

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