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.
- 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.
On April 9th 2021, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. Q1 2021 hedge fund letters, conferences and more Read More
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.
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).
Apple – 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.