Categories

The rear view mirror

In the Innovator’s Curse I reflected on the fact that a serial innovator cannot be efficiently financed or even rewarded for having figured out how to repeatably create. If anything, a serial innovator has to suffer a discount to peers who do not habitually (or ever) innovate. The innovation process is the proverbial goose that lays the golden eggs but is destined to perish due to the lack of faith in its existence.

So how can I back this up?

To start, this is partially evidenced in this graph of Apple’s price to earnings ratio since 2006 vs. the S&P 500′s. The S&P reflects the 500 largest companies in the US and is thus a proxy for the “average” company.

Screen Shot 2013-08-30 at 8-30-6.36.23 PM

[I added Apple's P/E excluding cash for additional perspective.]

The graph shows that during the period of time when iPhone and iPad changed computing and telecommunications, Apple was mostly held in contempt: the profits it was generating were not considered of “sufficient quality” relative to an average company. Since markets look forward, not backward (one assumes), the vote cast is decidedly that success cannot be repeated. Put another way: you can trust that a soft drink maker like Coca Cola (P/E of 19) or a utility like ConEd (P/E of 18) will continue in the manner we’ve seen them perform in the last year more than Apple (P/E of 12) will.

I can offer yet another way to consider this curse. Apple’s iOS business is designed to capture profits through the sale of hardware. That hardware is manufactured through a process where, while not being the manufacturer, Apple purchases tooling in a capital-intesive strategy to control the means of production.  I’ve discussed this at length before.

But Apple’s business is more complex than just enabling manufacturing. Tooling allows for production and production allows for supply but supply is nothing without demand. And demand of the product is driven by investments in software and services and design and marketing and countless details.

In other words, for Apple’s modus operandi, if anything should correlate with value it’s opex, not capex. It’s the investment in the people Apple employs not in the tools it buys.

And yet consider this graph:

Screen Shot 2013-08-30 at 8-30-6.50.57 PM

It shows how the market (though its pricing of Apple shares) values the company overlaid with a Apple’s spending on capital equipment (PP&E capex).

The relationship is uncanny. I’m not suggesting causality—that capex (which is publicly pre-announced) determines the share price level—but I am suggesting that there is a valuing of Apple as a producer of goods (for which tooling is a handy proxy). There is no sophistication to this formula. The more iPhones are built, the more the company is valued. Obvious.[1]

But it’s not obvious that prior to the iPhone there was iPod, which was a different business (and prior to it was the Mac, ditto.) The stock did not reflect the transitions nor does it assume that anything else will follow. It is, in other words, looking backward, not forward.

Notes:

  1. One could suggest looking at CapEx months in advance and predict the stock price, but who would believe such an absurd idea?
  • TekTonikShift

    capex intensive companies like TSMC are viewed this way. More CapEx => more value.

  • Christian Peel

    Rather than the CapEx predicting the stock price, the graph above seems to indicate that the stock price predicts the CapEx, except for the past four quarters. It seems to me that the stock price is influenced by how well Apple is doing in selling product, which also influences how many units Apple prepares to sell.

    • iObserver

      I also read it that way at first. However, Horace mentions that CapEx is announced months in advance. if you adjust the graph to when the CapEx was announced as opposed to when it took place you’d probably get the appropriate correlation.

      • Christian Peel

        Thanks!

  • BoydWaters

    Brilliant.

  • Sam Penrose

    Your null hypothesis appears to be that the stock price is the effect of some cause meaningfully related to Apple’s business. You work very hard to find it and, uncharacteristically, come up with only the “absurd”. Perhaps it is time to change your null hypothesis: maybe the stock price contains no business information at all.

    • Harmonica2

      Absurdity with a lower bound of book value, maybe.

  • stefnagel

    Wall Street sets value by how many marbles are in your pile? OK.

  • James C. Kim

    But isn’t the market pessimism more about Apple’s loss of profit share?

    • normm

      According to the Asymco article from Aug 21, Apple’s profit share in phones is currently about 65% of the total, down slightly from it’s peak two years ago of 70%.

      • James C. Kim

        This chart http://www.businessinsider.com/chart-of-the-day-smartphone-industry-profit-share-2013-7 shows that Apple has 53%. (And oddly Samsung has 50%) but the trendlines are what’s worrying investors.

      • r.d

        That chart is from Samsung’s favorite Analytic Firm.

        Why don’t you ask Samsung for their profit on
        Laptops, PC, and Tablets. If Samsung is so profitable
        why are they hiding the rest.

        Come one. Don’t come here with Weak Samsung Propaganda.

      • James C. Kim

        I had no idea about that firm being Samsung’s favorite but does that mean Apple’s profit share isn’t down?

      • close

        I think they are trying to incoherently summarise the already incoherent objections by Appleinsider to a different analyst report:

        http://appleinsider.com/articles/13/07/27/samsung-has-not-dethroned-apple-in-mobile-profits

        Note, I wouldn’t waste my time reading that if I were you. It’s total drivel.

        Appleinsider, on the other hand, seem to endorse the report that you link to. They quote the firm’s previous figures in the piece above and regularly publish the report you quote:

        http://appleinsider.com/articles/13/07/31/apple-takes-53-of-smartphone-profits-samsung-at-50-remainder-lose-money

        Which would be strange if they were some kind of front for Samsung PR.

      • Space Gorilla

        Apple’s profit share will always vary, but in no reality could any sane person make the case that it is bad or anything to be concerned about. Apple is firmly entrenched and dominating in the segment of the market they are targeting.

      • close

        You’ve misread the chart. The lines are moving averages over the previous 12 months. The dots show Apple at 58% (Samsung 42%) down from a peak of about 77%

        Also due to Apple’s sales cycle they’re almost certainly going to drop substantially this quarter too.

    • http://www.asymco.com Horace Dediu

      Apple was discounted before, during and after it developed the iPhone business.

  • Andy Orr

    Any discussion of Apple’s P/E needs to be informed by its size and other factors. these are obvious points but have a huge impact on how the market perceives the future growth of Apple. Smartphones are also a special product, maybe not a “once in a lifetime” one, but almost. What other object sells in the billions annually, is paid for over time and is considered a necessity of life?

    • stefnagel

      Cars.

      • Andy Orr

        Maybe in dollars, but not units. Other unique feature (probably diminishing) — relatively short replacement cycle.

    • r.d

      Education Loan,

      Housing Loan,
      Cars,
      Credit Card,
      Bonds (society pays for it in triple in 30 years)

      The Whole bloody economic system.

    • neutrino23

      How about jewelry? Tiffany sells diamonds for thousands of dollars. Many women own numerous pieces of jewelry. Diamonds are just sparkly rocks. Why isn’t Tiffany crushed by K-Mart selling cubic zirconia? Yet Tiffany has done well and now has a P/E of about 23.

  • obarthelemy

    2 main questions:
    1- is CapEx really a reflection of how many iPhones are/will be built ? Isn’t there a difference between iPhone production and how many new production lines are set up, and how they are financed, whether they’re for substitution or new sales… (assuming CapEx is mostly production lines) ?
    2- Doesn’t focusing 100% on “innovation” for valuation leaves aside other important parameters, ie market risks (subsidies, politics), diversification, strength of competitors, brand image… ?

    • Mark Howard

      As to question 1, yes there is a correlation. The gargantuan CapEx starting over a year ago points to the following: In a few days there will be, like last year, a simultaneous global roll out of not only the new 5S but the new C models as well. Satiating immediate, worldwide demand with adequate supply is the #1 concern, as the customer sat for those who aren’t able to get the phone they want is very low (negative?).

      The numbers also point to a China Mobile deal with it’s massive numbers. The naming of the C stands for multiple things in Apple fashion, the primary being Color but also China.

      Apple’s sales over the fall and through the Chinese New Year in January are going to be off the charts.

  • Oak Grove Capital

    Of course HD’s conclusion is true. Apple gets no credit for the option value that is inherent in its culture and its track record or its known pipeline. All of these increase the probability that Apple will succeed in a significant new product category. Yet Apple’s market value not only suggests an option value of zero, it also suggests that Apple’s existing business will contract immediately and on a sustained basis. This is where Icahn has opined that Apple is worth $700 with no new product categories. In his stated view, Apple gets to $700 on 10% growth of it’s existing known business. In my view, Apple will grow 10% on its existing ecosystem and is worth $600 plus optionality on its culture, track record and pipeline.

    • Harmonica2

      Looking at this as “glass half full”, Apple’s stock will never bubble and crater as long as investors maintain such a conservative outlook for Apple’s prospects. Apple’s stock price will lumber upwards as Apple innovates and sells more stuff, and the stock pays a dividend while investors wait. That isn’t so bad, is it?

    • Sacto_Joe

      Close. Apple’s option value is far from static. Indeed, the only other time we see the kind of volatility AAPL has is with start ups! There are huge bets being placed on Apple, and in both directions. Even the latest drastic selloff, looked at from a long range POV is just business as usual. A big chunk of that is precisely because Apple IS unpredictable in its earnings potential, or at least is unpredictable to many. To others of us, Apple is eminently predictable, and it’s obvious to us that Apple is destined to grow a great deal more than the market is predicting.

  • normm

    It seems to me that mobile devices is such a large market compared to almost anything else that, as long as Apple remains an information technology company, its future depends mostly on incremental improvements and continual integration of new functions (which they can buy when necessary) into existing devices, rather than entering dramatically different markets. So why focus on dramatic innovation?

    • obarthelemy

      My take on it:
      1- because the mobile market is vulnerable and unreliable both in global size and in OEM shares: a fair bit fashion-based (the “in” brand could change”), another bit subsidies (getting rid of subsidies hurts the high-end disproportionately), under strong price pressure (OK to good smartphones cost $200), the high-end’s 2yr renewal cycle may break once subsidies fade away… See RIM, Nokia, …
      2- because Apple’s skillset (design, logistics, …) and resources (Apple Stores, brand image…) can probably be used very profitably in other markets. Maybe Apple can pull yet another Apple is yet another market.
      3- because companies, like people, are bad at stopping.

  • mailermax

    “if anything should correlate with value it’s opex, not capex.” I’d be interested to see a chart w opex overlaid w capex and stock price

    • http://www.asymco.com Horace Dediu

      I added SG&A and R&D overlay

  • anon_coward

    the P/E peaked at the peak of innovation, the release of the iphone
    what’s wrong with it dropping as apple worked out the details and printed money. everyone knows that the law of large numbers was going to start coming into the picture soon

    • Steve

      you must be new here

    • The Silver Fox

      “…. everyone knows that the law of large numbers was going to start coming into the picture soon”

      I suspect that you don’t understand the law of large numbers, take a look at this: http://www.leancrew.com/all-this/2012/02/arrested-for-breaking-the-law-of-large-numbers/

      • NostraThomas

        That link is a great read.

    • http://www.asymco.com Horace Dediu

      If innovation peaks when a product ships then what do we call the time when the product is being developed? Is that when innovation bottoms?

      • obarthelemy

        No, we call it climbing, of course. It bottoms afterwards.

        Also, innovations within a lab are nice, but not great revenue-makers ? And since markets don’t know about unreleased innovations, well, they wait until release to put a value to them ?

      • http://www.asymco.com Horace Dediu

        That’s the whole problem. Why wait until release if you know there’s a process? You only value post-release precisely because you don’t think there’s a process.

      • obarthelemy

        Indeed. How many failed companies were celebrated innovators at one time ?

  • Christian Peel

    If Apple is constantly under-valued, and the management do not try too hard to manipulate the stock price, then it seems to me that it will be harder for them to become overconfident. Keeping the eternal chip on their shoulder may keep them focused on new products and new product categories. #lookingOnTheUpside

  • Walt French

    This looks like some good fun.

    Myself, I’d take the “forward value” that Horace tweeted yesterday as the contrast to the CapEx. No sense wondering how next year’s productive machinery is going to change the value of cash sitting in a tax-sequestered bank account.

    And boy, would I sure love to know what all that CapEx is buying.

  • poke

    It might not be lack of faith in the existence of the innovation process, but rather lack of interest. Do investors have an incentive to favour a serial innovator over a succession of innovative start-ups? If most of the advantages of being big are disadvantages when it comes to being innovative, why not punish serial innovators and reward start-ups? Perhaps the market, like Nature, favours the process of birth and death over rejuvenation? That is, the market already has a process for serial innovation (entrants disrupting incumbents), and it doesn’t need or want a new one. Apple’s price per share is a consequence of the market rolling its eyes at what it considers the equivalent of riding a bike without using your hands.

  • Mani Ghasemlou

    I’m going to play devil’s advocate. What if you’re overthinking AAPL’s valuation (referring to Innovator’s Curse)?

    A lot of tech companies like MSFT and ORCL have a big chunk of their revenues tied to lucrative (and low volatility) subscription models, so growth seems a lot easier when you’re going to have everyone minus your churn rate signing on again next year. All that your sales people need to do is sign more people than your churn rate and you will grow.

    Of course, all of this comes down like a house of cards when you’ve been disrupted — but that’s besides the point. Wall St is probably the last entity to recognize/account for disruption.

    Apple’s model, while highly lucrative, for the most part does not rely on a subscription model. It relies on far less tangible (to Wall St) factors such as user satisfaction, quality of interface, quality of ecosystem, stickyness of the ecosystem, and other similar notions. Those intangibles are what provides Apple with a consistently growing base of return customers. However, Wall St refuses to be convinced.

    Add to this the crazy seasonality of AAPL revenues and the resulting high sequential volatility of their earnings and this further increases Wall St’s unease and skepticism.

    • tedcranmore

      I have no doubt you are correct, but the question is why is Apple is given almost no value for ‘stickiness’. Yes, I hear the comparison to Blackberry and others (“they weren’t sticky were they), but I think there are so many indisputable differences;
      . size and value of the ecosystem (apps, developers, iTunes and content subsystem, computer and tablet business, iCloud, Apple retails stores and genius bars, etc etc etc.)_
      . customer sat rate, will buy again rates
      . users switching from Android to iOS being much higher than those switching from the other way (despite more choices in hardware options)_
      . value of customer time. Learning a new OS and replacing 145 apps may not cost that much in dollar terms, but in customer time it is huge. I find it incredible that every discussion here centers on dollar cost instead of time investment.
      . the belief the other products in other categories will arrive, and being in the Apple ecosystem has future value

      Yes, some of those numbers were good (like customer satisfaction) for Blackberry at their peak, but they were doing it with little perceived competition. It seems to me that giving Apple no credit for a stickiness factor is hard to justify.

      • Mani Ghasemlou

        Blackberry also enjoyed widespread enterprise and government adoption of the BlackBerry Enterprise Server. While I am unfamiliar with the pricing of this product, I will guess that there were support contracts and such tied to it. Furthermore the investment made in terms of infrastructure and staff to support an enterprise-wide BES deployment provided another moat. This furthered the reality (now illusion?) that BlackBerry is entrenched and switching costs impossibly high.

        BlackBerry handset + BES is analogous to Microsoft Office + Exchange Server. Both huge profit makers that are also ripe for disruption.

      • obarthelemy

        - I think the ecosystem is overrated: replacing all the apps customers run is about 10% of the phone’s retail price. ie, negligible compared to wanting a different device.
        - Customer sat rate are meaningful, but are partial and backward-looking: in a fast-moving market, I might be very happy with a supplier, but still go with another one because they offer a better/newer/cheaper product. Customer satisfaction for Mercedes is way higher than for GM, yet people still buy vastly more GMs. (http://www.forbes.com/sites/jimgorzelany/2012/07/09/car-brands-with-the-most-satisfied-shoppers/ , http://en.wikipedia.org/wiki/Automotive_industry#By_manufacturer). Also, price and features account for 81% of purchase decision, customer service and reputation, less than 10% (http://blog.amplifiedanalytics.com/wp-content/uploads/2013/07/Reputation-over-price.png).
        - the switching differential is more than made up by the first-timer differential. I’m sure companies will adjust strategies as rthe replacement market becomes more important. Apple are leading the way, because, having difficulties recruiting new customers, they have to be very defensive of their existing ones.
        - almost everyone I know use max. 10 apps regularly, plus games. Takes no time to reinstall. Also, arguing that skills are an asset is arguing for stagnation. Are we supposed to keep doing the same things, the same way till the end of time ?

        Actually, that blog posts the cart comes from is interesting: http://blog.amplifiedanalytics.com/tag/customer-satisfaction-ratings/ . Should we all be buying Lumias ?

      • Walt French

        Interesting that you note apps as a minor impediment to switching (<10% of phone price) yet you assume subsidy costs are too hard for consumers to understand, and promote people spending hundreds of dollars more than is in their interest.

        So far, anyway, the switching flow seems to be favoring Apple, perhaps because few Android users have much in the way of apps to buy a second time, or because they've fully amortized the investment in a game, weapons etc.

        I still like my model that Apple (and Samsung) sell premium-priced, quite high-quality devices, which sell well in the US, Japan and other high-income nations, with lower-cost models (perhaps, including iPhone4, etc) doing well in medium-income nations; low-income geographies, if they afford smartphones at all, necessarily go for the lowest-cost phones with very few who can afford the higher-priced, higher-featured (e.g., LTE) sets.

  • suddy

    Horace,

    Reading the 2012 – 10K ” The Company’s capital expenditures were $10.3 billion during 2012, consisting of $865 million for retail store facilities and $9.5 billion for other capital expenditures, including product tooling and manufacturing process”

    Reading the latest 10Q “The Company’s capital expenditures were $5.2 billion during the first nine months of 2013 consisting of $309 million for retail store facilities and $4.9 billion for other capital expenditures, including product tooling and manufacturing process equipment, and other corporate facilities and infrastructure. The Company’s actual cash payments for capital expenditures during the first nine months of 2013 were $6.2 billion.

    The Company anticipates utilizing approximately $8.5 billion for capital expenditures during 2013, including approximately $600 million for retail store facilities and approximately $7.9 billion for other capital expenditures, including for product tooling and manufacturing process equipment, and corporate facilities and infrastructure, including information systems hardware, software and enhancements. ”

    Between 2012 and 2013, reading the 10K and 10Q, they do not seem to be too different in CapEx outlays.

    What am I missing?

    Suddy

  • mjw149

    The best way to view Apple’s recent stock performance is to assume that all valuation is based on backwards-looking algorithms, not forward looking investors. Then it all makes sense. Algorithms don’t allow for exceptions.

  • mieswall

    Yes, a completely absurd idea, that will keep me watching the SEC forms more closely in the coming Q’s.
    Thanks again Horace for your amazing work. We are almost looking at the discovery of the wheel here, in this shocking graph.

  • Ms Informed

    I am surprised that you did not mention the passing of the serial innovator of AAPL, Steve Jobs. I can make an argument that AAPL PE ratio correlates to his deteriorating health and his death. Can someone think of an innovation from AAPL after Jobs?

    Yes, innovation takes time and we have not seen what the new management is working on. But I cannot see how AAPL is suffering from the innovator’s curse because, at this point, there is no evident that AAPL can keep innovating without Jobs. The PE multiple discount reflects the fact that the proverbial goose (to borrow your analogy) is gone and a replacement has not been surfaced, IMO.

    Take a look at GOOG, keeps innovating and consistently trading at a higher PE than AAPL and SPX. So, how come AAPL suffers from the curse but not GOOG?

    • eN

      This chart includes Jobs’ reign. The market has nearly always treated Apple this way, undervaluing it while propping up other companies. Remember when the iPhone came out and then the stock dropped because iPod sales were down?

    • http://www.asymco.com Horace Dediu

      I’m confused. You mention a serial innovator at Apple but not the serial innovator at Google (referring to the company instead.) Does Google possess the magical powers of an individual?

      • Ms Informed

        I am not sure what you are trying to inquire. All the Apple innovations I can recall happened when Jobs were around. IMO, Apple = Jobs, until the new management can prove that they can innovate without him.

        I am sure Google (the stock) will not perform well if a key executive is gone. Larry Page had a health issue last year and caused some concerns on wall street.

        I would very much like to see a blog post to explore the topic of why some companies suffer from the innovator’s curse, but some don’t. Why wall street being so unfair to Apple, but not Google, Amazon, Salesforce, Nike,..

      • http://www.asymco.com Horace Dediu

        If your theory is that corporate-scale innovation is a function of a person then who is that person at Google? If it’s not a person at Google but rather a system at work, then why is Jobs relevant?
        I subscribe to a theory that large companies are systems and fall under a systems analysis framework. I do not subscribe to the theory that large companies are personal fiefdoms and thus must fall under a psychoanalysis framework.
        You must state which you believe in. If you believe that some companies are systems-based and some are super-person based then you have to state what are the cultural conditions which set one company on that path. For example how do you classify Microsoft?

      • Ms Informed

        Any entity, regardless of size, thrives (or falls) with their leader(s). Microsoft is a good example, isn’t it? I can think of many cases where a bad leader takes down a well established company (Jerry Levin, Jim Basillie, John Thain ). And many cases where a good leader turns around a bad situation (Robert Benmosche, Alan Mulally, and hopefully, Marissa Mayer).

        A great leader, a great innovator matters in my investment selection process. If you do not subscribe to the theory that large companies are personal fiefdoms (btw, thanks for the new word. I had to look it up), then Facebook is not your cup of tea.

        if Apple comes up with the next innovation, do you think the stock’s performance will still be suffering because the company is cursed? or do you think the curse will be cured by the innovation?

  • JDSoCal

    Because markets are never wrong, and always price to perfection. #EyeRolls