Special Situations: Valeant Pharmaceuticals Public “Private Equity” Restructuring

Valeant Pharmaceuticals

Special Situations: Public “Private Equity” Restructuring

August 13, 2016


  • Recent PPS: $24.92
  • Shares Out: 355 million
  • Market Cap: $8,847
  • Net Debt: $30,085
  • Enterprise: $38,932


***Disclosure: This is a distressed, leveraged special situation trade with only the potential to turn into a medium- to long-term investment.***

I have been involved/followed the VRX saga for the last 2+ years, and have outlined my thoughts and analysis in detail via the following write-ups:

Since ‘puking’ up the stock in the first week of November (second November write-up) I have been firmly on the sidelines, resisting the urge to even trade the stock; but as of this week I am back in – for a trade (potentially an investment) – as I believe the latest earnings report turned VRX into a trade-able (potentially investable) special situation. In summary, my working thesis is that VRX is currently akin to a private equity restructuring (i.e. the ill-fated  2007/2008 Hilton PE deal consummated just prior to the GFC and restructured back to profitability by late 2013) that happens to be taking place in the public markets. [Pershing Square has long described its activism approach as a ‘public private equity’ methodology, and happens to be involved in this situation – but that is merely ironic, as a public restructuring was far from Pershing’s original thesis for VRX.]

Before walking thru the situational review, a quick note on price action…

Price Action

The use of price action to inform fundamental analysis can be a slippery slope, as the market can quite literally do whatever it pleases in the short-term, and at extremes (think, March 2000 and March 2009 for the broad market) is by definition wrong. But within an investment ‘mosaic’ comprised of valuation, direction of fundamentals, sector/broad market backdrop, and an analysis of key holders, high-volume price action around key news items or a lack of news can be informative. My use of price action – outlined in the second November 2015 write-up attached above – allowed me to cut my losses in VRX in the first week of November 2015 when the stock declined on high volume on no news. In the November 2015 “Quick Thoughts” post cited above I said:

“Perhaps I am wrong – but after further discussion with fellow investors re biz model, the high volume annihilation to materially below $88.50 on virtually no news is greatly concerning to me.

“Perhaps the ‘short’ thesis will ultimately be proven correct; but at present, the two key drivers of VRX’s stock price liquidation are 1) an extremely concentrated ‘stuckholder’ base, and 2) uncertainty around future organic growth. It appears VRX’s business model was/is legitimate, but extremely aggressive; and when taken in the context of the extreme stock price liquidation, I believe the market is ‘telling’ us something. Maybe all is well and I just missed the home run buying opportunity I’ve been looking for down here – but I suspect the market is ‘telling’ us that the revenue base needs to be materially adjusted, and the valuation work needs to move to a more extreme downside scenario…

Fast forward to August 9, 2016 when for the first time since VRX’s trading volume broke 100 million shares in a single day (third instance since March 15, 2016) VRX’s stock price rose on volume greater than 100 million shares. The stock was up ~25% and accelerated into the close, which IMO is indicative of more than simply short covering. A brief history of VRX’s stock price movement around 100 million share days:

  • March 15, 2016: 138.95 million shares – stock falls from $69.04 to $33.51
    • Stock goes on to bottom at $26.30 on 3/31
  • June 7, 2016: 104.12 million shares – stock falls from $28.85 to $24.64
    • Stock goes on to bottom at $18.73 on 6/27
  • August 9, 2016: 105.85 million shares – stock rises from $22.45 to $28.16

Taken within the context of what I will outline below, I believe the high-volume response to what appears to be the first signs of stabilization in VRX’s earnings power is a bullish sign for trading purposes. Lots of hurdles left to clear to make VRX an investment, but 8/9 was a start.

Quick caveat: I was dead wrong in my interpretation of the late-October price action in the November 2015 “Situational Review” cited above, so I am taking my own interpretation of recent VRX events with a fat grain of salt and keeping the position on a tight leash.

Thesis Summary

  1. Large assets rarely go to $0
  2. Credit markets are relatively benign toward VRX
  3. Segment restructuring/transparency/asset sale guide precedes big restructuring push
  4. Pershing Square tripled down and is likely to fight
  5. Covenant relief catalyst toward big restructuring push
  6. Joe Papa sly like a fox?


(1) Large assets rarely go to $0. The ‘shorts’ have done unbelievable work on VRX, particularly with regard to the clearly unsustainable organic growth rates barfed up by Mike Pearson on a quarterly basis. The big reset in VRX’s sales base, IMO, proves this out. And while there is perhaps more erosion to go in the ‘core VRX’ sales base, I believe the bottom is close. Where I differ from the shorts is that VRX is a donut that generates little in the way of true cash flow. I fully agree that the non-GAAP EPS and EBITDA figures VRX guides to overstate true underlying earnings power – but A) not by much, and B) not to the extent that cash flow generation is nonexistent. For example…

In 1H16 VRX’s ‘adjusted’ EBITDA was $2,095 million, or 43.7% of sales. But after adjusting operating cash flow for working capital, interest expense and taxes, ‘cash flow statement equivalent’ EBITDA comes in at just over 300 basis points lower (as a % of sales) than the non-GAAP figure. And regarding cash flow generation: in 1H16 net debt fell by $276 million; but after adding back contingent and deferred consideration payments of $561 million and subtracting $111 million of asset sale proceeds, implied FCF to Equity generation in 1H16 totaled $725 million. Not bad for the “Enron of Pharma” thru a volatile business model transition period.

The fact of the matter is that not only is it rare that large cash flow generating assets go to $0, but it is even more rare when credit markets are wide open…barring a large exogenous event, such as wire fraud. Simplistic I know, but look at the untold number of ‘bankrupt’ E&P firms currently trading with material equity market cushion to their capital structures. Look at TSLA. Look at POST.

(2) Benign credit markets. If a bankruptcy-inducing wire fraud ruling is coming down the pike, credit markets certainly are not indicating as much. VRX’s unsecured 2025 debt currently yields less than 9% per annum to maturity, and its 5-year CDS is less than 800 basis points. While certainly elevated for the current market environment, these credit readings, IMO, are more a sign of operational uncertainty than pricing in certain default. As some folks closer to these markets have told me, there is a structural component to these ‘benign’ readings…but the CDS market is quite telling, IMO. Using CHK as a ridiculous comparison – CHK’s 5-year CDS is well over 1,000 basis points.

The credit market is not the be all, end all – but it is to be respected. If VRX bonds were currently north of 15% YTM, I would not even dream of touching the equity.

(3) Big restructuring push. In the 8/9 earnings release VRX unveiled a simplified reporting structure (initiates 3Q16) – B&L/International, Branded Rx and Run-Off – with detailed revenue growth and margin guidance thru 2018, as well as asset sale guidance. IMO, this is the direct result of VAC/Pershing involvement and precedes a big restructuring push.

(4) Pershing likely to fight. Nobody is impressed with Pershing at the moment, and likely never will be again. But I think they deserve a bit more credit for their investment acumen than zilch. They had numerous opportunities to cut their losses in VRX, ala JCP. But not only did they choose to double down financially, they sought board representation, which serves to limit their loss-cutting ability even further. I believe the probability of Pershing putting up a huge fight to save their investment is quite high…even if VRX’s ultimate destiny is a wire fraud-induced donut.

Tough to know what a restructuring push will look like in advance, but at minimum a push to break up the Company if not a sale in its entirety.

(5) Covenant relief. On the 8/9 earnings call VRX announced they are looking to obtain further covenant relief, which I believe is likely the key reason for the post-earnings call weakness in the stock, as rumors of negotiation details can whip the stock around until an official announcement. Lenders have very little incentive to push VRX into default, so obtaining relief is a high probability, IMO. Once relief is obtained, I believe the path for a big restructuring push is set.

(6) Joe Papa sly like a fox? Many cite Papa’s awkward resignation from PRGO just prior to a decline in operational performance as reason to not trust what he says at VRX. But is it perhaps more appropriate to view his exit from PRGO as masterfully timed? And thus perhaps he sees something in VRX that we on the outside do not? At minimum, something to consider.


I will leave the valuation work to the PDF attached below, as I believe the above ‘investment mosaic’ is a sufficient case for at minimum a trade in what – under stabilized operating conditions – is a severely undervalued asset.

VRX 2Q16 Earnings Presentation

17M VRX Analysis August 2016

Events: Johnson Controls Deal(s) Overview

Johnson Controls

Events: Deal(s) Overview

August 7, 2016


Johnson Controls

  • Recent PPS: $45.52
  • Shares Out: 639.71 million
  • Market Cap: $29,120
  • Debt: $7,027
  • Enterprise: $36,147
  • 2016 EV/EBITDA: 7.9x
  • 2016 PE: 11.5x

Tyco International

  • Recent PPS: $45.32
  • Shares Out: 426.18 million
  • Market Cap: $19,315
  • Debt: $2,559
  • Enterprise: $21,874
  • 2016 EV/EBITDA: 13.6x
  • 2016 PE: 22x


Summary. Johnson Controls is merging with Tyco International in early September (S-4 went final 7/6/16; shareholder vote is 8/17/17) then spinning off its Automotive Experience segment (Adient) to NewCo shareholders soon after. Post-Adient (seat manufacturer), NewCo will be a diversified industrial with $31.9 billion of 2016 revenue derived from the following segments: HVAC & Controls (~45%), Fire & Security (~30%), and Power (~25%). The Companies expect $500 million of operational synergies within three years, as well as yet-to-be-quantified revenue synergies. On a combined basis (with some estimates on my end), JCI and TYC management teams project top-line growth of approximately 6.2% and EBIT growth of 11.8% thru 2020.

Adient is projected to generate $16.7 billion of revenue and $1.6 billion of EBITDA in 2016. Projected growth is ~0% thru 2020.

Capital Structure. Post TYC and Adient, NewCo will be modestly levered at 2.68x gross debt to 2016 EBITDA. Adjusting the balance sheet for TYC-related intangibles (including GW), tangible net operating assets are $19.4 billion. With an estimated $2.93 billion of 2016 NOPAT (before synergies), ROTC is approximately 15.1%. Excess OpCo cash will represent approximately 3.5% of NewCo (pre-Adient), assuming a $46 stock price.

Adient will be levered 1.85x net debt to 2016 EBITDA post-$3 billion dividend to NewCo ($3.5 billion total debt and $500 million of retained cash).

Tyco Deal Structure

JCI. Current JCI shareholders have the option of choosing $34.88 in cash, some combination of cash & NewCo stock, or all NewCo stock. With JCI currently trading above $34.88 the choice is moot. Approximately 110.8 million JCI shares will be converted into the right to receive $34.88 in cash ($6.04 pro rata to all shareholders), thus retiring the shares and leaving 528.93 million of equivalent NewCo shares, for an approximate ownership of 56.51%.

Because the cash portion is not a simple dividend, it can get a bit muddled. JCI’s current market cap of $29,120 can be broken down as follows:

  • $29,120 Market Cap = 639.71 million shares x $45.52 stock price
  • $3,864 Cash = 110.8 million ‘cash shares’ x $34.88 per share cash consideration
  • $25,256 NewCo Stake = 528.93 million ‘NewCo shares’ x $47.75 implied NewCo (pre-Adient) stock price

As such, JCI’s current stock price is comprised of: $6.04 cash + $39.48 NewCo = $45.52.

(Important for later valuation calculations – 528.93 NewCo shares are 82.7% of total JCI shares out.)

TYC. Just prior to the merger TYC will effect a reverse stock split of .955 per current TYC share, leaving 407 million of equivalent NewCo shares, for an approximate ownership of 43.49%.

Using the $47.75 NewCo price as implied above, the ‘deal value’ for TYC shareholders is $45.60 (.955 x $47.75), versus Friday’s closing price of $45.32.

NewCo. Post-TYC transaction, NewCo will have approximately 935.93 million shares outstanding and can be broken down into the following parts:

  • OpCo = Legacy JCI Industrial + Legacy TYC Industrial
  • Excess Cash = 75% of pro forma cash on hand
  • Adient


Adient. Before looking at NewCo’s fair value and implied PE via JCI’s stock price, a quick fair value estimate for the Adient spin.

Per the S-4, Adient will generate $1.3 billion of EBIT in 2017. And assuming $3 billion of net debt at a 5% rate and a 25% tax rate, net income is $866 million, or $.92 per NewCo share. At an 8.33x fair value PE, Adient is worth approximately $7.70 per NewCo share.

NewCo. Using the three parts as outlined above, NewCo’s fair value is comprised of:

  • OpCo: $55.44
  • Excess Cash: $1.60
  • Adient: $7.70
  • Total: $64.74

Using management projections for JCI WholeCo, JCI RemainCo and Tyco, I use a DCF model to value the NewCo operating company (see JCI Analysis under the Documents section below). (The inputs and assumptions to the DCF can be debated ad nauseum; but as the last 18 months or so in the market have proven, any and every assumption to any and everyone’s analysis can be debated to the ‘nth’ degree…so do what works for you.) But IMO the real margin of safety lies in the very low expectations embedded within JCI’s current stock price.

JCI. As stated earlier, due to the ‘cash shares’ component of JCI’s current capitalization the NewCo calculations must be multiplied by 82.7% in order to convert into a per-current-JCI-share equivalent. With that in mind, NewCo OpCo’s implied 2017 PE based on JCI’s current stock price looks as follows:

  • JCI PPS: $45.52
  • (-) JCI Deal Cash: $6.04
  • (-) Excess Cash: $1.32
  • (-) Adient: $6.37
  • Implied NewCo OpCo PPS: $31.79

NewCo OpCo will generate 2017 EPS of approximately $3.03 before synergies. Multiplied by 82.7%, the JCI-equivalent EPS figure is $2.50 for an implied 2017 PE of 12.7x.  If Adient trades for 12.5x, the implied PE falls to 11.4x; and if it 5x, the implied PE rises to 13.7x.

Using the NewCo SOTP fair value, JCI’s current fair value is $57.


This is a rather boring, seemingly under-followed restructuring/event situation, which is why I believe it could surprise to the upside in the relatively near-term. Not huge upside, but decent nonetheless. The global macro economic backdrop is stable/improving enough to take economic-related operational downside off the table in the medium-term; revenue synergies are at minimum a free option; NewCo (ex. Adient) has material balance sheet capacity, IMO (3 to 3.5x leverage would be more appropriate given the revenue/cash flow profile); buybacks could surprise to the upside in the near-term; the Battery business could be divested or spun; Adient could be a sneaky home run; and who knows…NewCo could end up receiving a take-out offer.

The biggest risk is the tax authorities stepping in to block the ‘inversion’; but I believe investing via JCI as opposed to TYL largely takes this risk off the table. On a standalone basis JCI trades for less than 12x 2016 earnings and 8x EBITDA, versus 22x and 13.6x for TYC. Shorthand yes, but JCI is materially less expensive.

More to come…


17M JCI Analysis August 2016

Final S-4 7.6.16

Clinton Cash

17 Mile

Clinton Cash

August 6, 2016

Ya, ya – not supposed to talk about religion and politics. But how about corruption?

Outside of abortion – which I believe from a rational, humane standpoint can be considered nothing other than outright murder of a scientifically proven LIFE form (Hillary Clinton herself says: “The unborn person doesn’t have constitutional rights.”) – I am as politically neutral as they come:

  • Gay rights – 100% a religious issue. Any and all forms of gay rights oppression should be banned at the Federal level – once and for all. If you are religious and thus believe in ‘sin’, then you should be ashamed of yourself for hypocritically denying someone the same rights you possess based on a behavior you believe is ‘wrong’…when by definition you commit a different set of wrongs every single day.
  • Planned Parenthood – Again, a religious issue. Any and all involvement by Planned Parenthood in abortion should be shut off; but the more birth control to go around the better.
  • Healthcare – The normal market forces of supply & demand do not apply to the actual implementation of care (i.e. we do not deny care based on lack of funds); as such, the Government must be involved in some way shape or form. Republicans are out of their minds to think the entire HC system should be run by the private sector. But Democrats are equally out of their minds to think the Government can actually run the system itself.
  • Taxes/Spending – Republicans’ hyper focus on tax cuts, tax cuts, tax cuts is as asinine as Democrats hyper focus on redistribution. Simplify and flatten the tax code – particularly payroll taxes; and make government spending more transparent and highly targeted (i.e. high velocity infrastructure spending via PPIP, etc.).
  • Stimulus – One of the most embarrassing moments in Republican policy history was the full-throated opposition of the globally critical $900 (?) billion stimulus package in early 2009. As Mr. Buffett liked to say at the time – by definition, when the private sector is deleveraging, the only entity available to take the other side is fiat government. That stimulus package likely saved the global economy from a Great Depression 2.0.

With that as background, and with all possible neutrality I would like to present the “Clinton Cash” documentary. It is an hour and four minutes and fifty-seven seconds long. Do yourself a favor and take the time; and if short on time, skip to minute 50…


This is precisely why Trump is where he is. Bash him all you want – but the Putin ‘support’, flip-flopping, ‘lack’ of policy knowledge, and crazy behavior pales in comparison to the criminal enterprise that is the Clinton Foundation/Clinton family.

I am no Trump fan. But people have died protecting our right to vote; and I simply cannot sit idly by and vote for the continuation of one of the most egregious forms of corruption one could imagine. These criminals are hiding in plain sight, and I shutter to think of the long-term ramifications of a Hillary presidency.

HRC – see you next (election) Tuesday.

Generals: Apple TWX Analysis


Generals: TWX Analysis

May 29, 2016


  • Recent PPS: $100.35
  • Shares Out: 5599.8 million
  • Market Cap: $561,940
  • Net Cash: $20.95 per share


Thursday’s FT article that reported an AAPL executive proposed a bid for Time Warner (NYSE: TWX) is precisely the type of game-changing move AAPL needs to make from a long-term ‘moat’ perspective.

Forget the bullish prospect of AAPL becoming the Berkshire Hathaway of content – buying TWX would begin to solve a basic 2-part math problem for current AAPL shareholders: AAPL’s terminal fair value PE is likely limited to 10x in its current earnings power configuration + its net cash position is worth no more than ‘par’, if not at a discount if the market places a discount on overvalued stock buybacks.


The ‘Street’ estimates TWX will earn $7.56 billion of EBIT in 2016. Taxed at 25%, that’s $5.67 billion of NOPAT. In a recent Lex article, the FT estimates AAPL would need to pay $110 billion in total EV – $22B of which is debt – to acquire TWX, which is approximately 19.4 times 2016 NOPAT.

Not only is 19.4 times not expensive for a game-changing acquisition; when AAPL can issue 5% 30-year debt to fund the entire purchase and still have almost zero turns of net leverage + convert its net cash position into a durable, high multiple asset…19.4 times could be considered a bargain.

In a recent write-up, I estimated that AAPL’s current ‘normalized’ earnings power (NOPAT) was approximately $44.5 billion, or $7.95 per share. TWX’s $5.67 billion of NOPAT adds $1.01 per share, for PF earnings of $8.96 per share.

AAPL would see a slight valuation degradation on the surface, as the pro forma PE would rise from 9.98 to 11.2 times (assuming net cash goes to $0). But not only does 11.2 times not account for any operational/bargaining power synergies, IMO it undervalues the long-term ‘moat’ prospects of the pro forma entity…


The FT’s recent Lex column believes that distribution agreements are the cheaper, more financially sound avenue for AAPL to obtain access to content. I disagree.

(A) There is a reason Concast (NASDAQ: CMCSA) owns content and distribution. John Malone himself has used and continues to endorse the model. AAPL needs to leverage its enormous ecosystem into a giant distribution platform, and owning/developing content would only enhance the LT economics.

(B) Simply because AAPL does not have a core competency in developing content doesn’t mean buying TWX would be an unprofitable diversion. Using the Berkshire Hathaway model, AAPL could not only incubate TWX properties against short-term ‘Street’ pressures, but reinvest all TWX earnings (and then some) back into more content development.

Content – economically and commercially cyclical – is the perfect business for the long-term oriented BRK model…and with its historically long-term thinking and prodigious cash flows, AAPL is the perfect Berkshire prototype.

Shorts: Apple Terminal Value Analysis


Shorts: Terminal Value Analysis

May 22, 2016


  • Recent PPS: $95.22 (5/20/16 close)
  • FD Shares Out: 5599.8 million
  • Market Cap: $533,209
  • Net Cash: $117,318
  • Enterprise: $415,891
  • EVPS: $74.27
  • Normalized PE: 9.3 times
  • 2017 ‘Street’ PE: 8.3 times


(1) AAPL’s fundamentals appear to have peaked. In other words, the ‘direction of fundamentals’ is likely down, creating a (powerful?) headwind to the stock price.

(2) The iPhone franchise is simultaneously impressive and frightening.

  • Born in 2007, the iPhone has gone from $0 to $155 billion in sales in less than a decade – WOW!
  • But the iPhone currently represents approximately 83% of consolidated gross profits – YIKES!

(3) With strong cash generation, a net cash balance sheet, and an enormous ecosystem, AAPL has (massive?) operational upside optionality.

(4) Worryingly, however, in bowing to market pressure and ‘returning cash to shareholders’, AAPL is not only squandering precious resources that would allow it to make a game-changing business development move, but also demonstrating little in the way of long-term thinking at the board/management level.

(5) In order to re-rate its terminal PE from a ‘run-off drug multiple’ of 10-12x to a highly integrated, sticky, wide-moat, tech/content/connectivity company multiple of 15-20x…AAPL needs to – at bare minimum – demonstrate that it is committed to diverting its iPhone cash flows into more durable, long-term, high-multiple assets that solidify its large-scale ecosystem.

(6) Unfortunately for AAPL bulls…until a game-changing business development announcement arrives, the direction of fundamentals will likely reign supreme, rendering AAPL a perennially ‘cheap’ stock.

(7) At its recent close, AAPL trades at an implied terminal PE of 9-13 times, depending on the scenario. To build in any semblance of a margin of safety against the highly unpredictable nature of long-term iPhone economics, somewhere between 5 and 7 times would be a more appropriate implied terminal PE to get excited about the stock on the long side.

  • Under a very generous baseline scenario that assumes terminal iPhone sales and GPM of $144.4 billion and 45% (versus $155 and 50% currently), AAPL currently trades at an implied terminal PE of 9.1 times.
  • Under a more realistic downside scenario that assumes terminal iPhone sales and GPM of $116.6 billion and 42.5% (versus $155 and 50% currently), AAPL currently trades at an implied terminal PE of 13.2 times.

(8) While the market is highly efficient in immediately reflecting ‘new’ information, it is very inefficient in appropriately pricing that new information. As such – even if AAPL’s stock pops on a big business development announcement, the market will dramatically underprice the long-term prospects of such a change in strategy, allowing profitable long-term positions to be initiated.

(9) Without a game-changing announcement however, a more appropriate entry point is below of $80, as at that level the implied terminal PE more appropriately reflects the highly uncertain future of the iPhone franchise.


In order to build out my short selling ability, I started a ‘paper’ short strategy in late October 2015. I hate paper trading, as it is tough to mimic the psychological side of managing real capital; but I am restricted from short selling due to my day job, so it is the best I can do for now. I will write about it more at length this summer.

Regarding AAPL, it has been a core short since late October 2015 inception, but is beginning to enter ‘coverable’, if not long initiation, range (big emphasis on beginning). While the decline has not been significant – particularly for an AAPL ‘long’ who believes in something along the lines of Carl/Brett Icahn’s analysis from October 2014 – it is in line with what I look for in a short that is: safe (i.e. limited risk of take-out) and well-behaved (i.e. limited risk of waking up to a 25%+ move).

As I have written about in various capacities, one of the bigger lessons of the last 12 months is the importance of the ‘direction of fundamentals’ (DOF). The friend who drilled the lesson into me likes to say: “You can press fundamentals – long and short – but not valuation.” At an optically cheap 8.3 times 2017 earnings, clearly an AAPL short thesis must be centered on the DOF.

But, without a game-changing diversion of cash flow away from ‘returning cash to shareholders’ and into more durable, high-multiple earnings streams, I believe AAPL’s fundamental business value has a serious terminal value issue – the focus of this write-up – which represents a powerful tailwind to the DOF thesis.

For now, I will leave the DOF side of the short thesis to an excellent recent post by my friend Matt Brice of The Sova Group.

* * * * * * * * * * * *

The DOF concept is a bit more ‘art’ than ‘science’. At the very highest level it is probably best described as a Company that is growing YOY. McDonalds (NYSE: MCD) from 2006 thru 2011, then 2011 thru 2014 is a decent clean example of importance of the DOF.

Post-activist involvement in the mid-2000’s MCD stepped on the operational/financial engineering gas, unloading company-owned stores to franchisees, boosting margins, and repurchasing stock, all in a virtuous cycle backed by an impressive streak of strong same-store-sales (SSS) growth across its system due to weak global economic conditions. The stock price followed suit…before hitting a wall as soon as 2012 opened for trading. The stock went nowhere from 2012 thru 2014, as MCD digested its newfound market share, and competitors began to catch on to MCD’s remodeling strategy (i.e. 3G taking over Burger King) leading to flat to negative SSS growth for MCD and calls for an operational turnaround (an astonishing display of short-termism, after 5 years of highly impressive operational and financial performance). MCD’s stock began to turn around in mid-2015 alongside improvement in SSS growth.

Sounds simple in hindsight – obviously it’s not. Just an example.

AAPL has followed a similar operational DOF/stock price path. Yes, there was a ‘dog pile’ into the stock in 2012 leading up to a 40%+ decline into mid-2013…but the decline coincided with an inflection in iPhone sales (2013 growth was ‘only’ 16% v. 71% in 2012). And yes, sentiment/positioning turned very negative in mid-2013 leading up to a 100%+ return into mid-2015…but the rally coincided with an inflection in iPhone sales (2015 growth 52%) led by sales into China.

At a high level, the current direction of AAPL’s fundamentals are best represented by current ‘Street’ estimates for AAPL’s sales:

  • FY 2015A: $233.7 billion
  • FY 2016E: $216.2 billion
  • FY 2017E: $226.6 billion

With the current sales base elevated by a large step-up in sales to ‘Greater China’ – $27B (2013) to $58.7B (2015); competition heating up; emphasis on ‘returning cash to shareholders’ over making a game-changing acquisition/partnership; and a very weak broad market backdrop on top…from current levels, the risk/reward is skewed to the downside, IMO.


Value investors are fond of taking pride in eschewing DCF and thus terminal value analysis. This value investing tenet is based largely on several wobbly (read: out of context) quotes by Buffett and Munger over the years. For example, this exchange regarding the use of DCF analysis at the 1996 BRK annual meeting:

“Warren talks about these discounted cash flows. I’ve never seen him do one.” “It’s true,” replied Buffett. “If the value of a company doesn’t just scream out at you, it’s too close.”

The critical context missing from the above quote is that Buffett is highly disciplined about investing within his ‘circle of competence’. Within that circle of competence are dilly bars, branded sugar water, car insurance, and railroads – all of which have A) been around for decades, B) change very little, and thus C) are able to be valued with a high degree of certainty on near-term earnings. If an experienced investor requires a DCF model to value a steady-state stream of Coca-Cola (KO) or KO-like cash flows, they are doing it wrong…let alone Buffett, who is quite literally a human calculator.

* * * * * * * * * * * *

AAPL’s economics – while hugely impressive – are a touch less predictable than dilly bars, branded sugar water, car insurance, and railroads. Setting new product development and/or entering an ancillary business line via acquisition aside, valuing AAPL based on near-term earnings power implicitly assumes VERY long-term stability in the iPhone franchise. Like, in perpetuity.

As such – I believe it is critical to, at minimum, consider what the current valuation implies from a terminal multiple/value perspective after making some long-term iPhone/non-iPhone segment assumptions.


Segments. I simplify AAPL’s product segments into iPhone and Core/Legacy. In the two forecast/valuation scenarios, I assume the Core/Legacy segment grows 3% p.a. and maintains flat gross profit margins.

iPhone. The iPhone franchise generated sales of $155 billion in FY 2015, or 66% of consolidated sales; and assuming a 50% gross profit margin, 83% of consolidated gross profit.

Using ‘Street’ projections for consolidated sales in 2016 and 2017, I back into implied iPhone sales of $135.2 and $143.1 billion. For 2018-2021, in the baseline scenario I assume flat sales at the 2015-2017 average; while in the downside scenario, I assume a 5% decline p.a. thru 2021.

In the baseline scenario, I assume the iPhone GPM declines from 50% in 2015 to 45% in 2021; and in the downside scenario, I assume the GPM declines to 42.5% in 2021.

Baseline Scenario. From 2015 thru 2021, consolidated sales and net income grow .33% and -3.5% per annum, and terminal iPhone sales are $144.4 billion (versus $155 in 2015).

The current stock price implies a terminal PE of approximately 9.09 times in the baseline scenario. Given this scenario is largely muddle thru, without investment in alternative earnings streams the market is highly unlikely to re-rate AAPL much beyond 9 or 10 times, IMO.

At an implied terminal PE of 5 times, AAPL would trade for approximately $76.

Downside Scenario. From 2015 thru 2021, consolidated sales and net income grow -1.7% and -8.4% per annum, and terminal iPhone sales are $116.6 billion (versus $155 in 2015).

The current stock price implies a terminal PE of approximately 13.2 times in the downside scenario.

At an implied terminal PE of 5 times, AAPL would trade for approximately $67.


17M AAPL Analysis May 2016

Capital Structure

Cap Structure

  • Net Cash = Cash – Debt – Deferred Revenue – Deferred Taxes = $117.3B = $21 per share

Normalized Earnings Power

Earnings Power

  • Baseline Revenue = Average (2014A, 2015A, 2016E)
  • Normalized EPS = $7.95

Segment Analysis


  • AAPL’s product segments are simplified down into two: iPhone and Core/Legacy
  • Core/Legacy includes: iPad, Mac, Services and Other
  • Very rough estimate of iPhone GPM is 50%, which implies 20.5% for the Core/Legacy segment
  • At the estimated 50% GPM, iPhone comprised approximately 83% of consolidated gross profit in FY15
  • Note, Core/Legacy sales are flat to down from 2013 thru 2015 – a trend to keep in mind when making bullish projections for ‘services’ and ‘sell thru’ rates…

Baseline DCF


  • Core/Legacy revenue grows 3% p.a. from 2015-2021
  • iPhone GPM declines from 50% in 2015 to 45% in 2021
  • iPhone revenue flat at $144.4 billion from 2018-2021 (versus $155 billion in 2015)
  • 2015-2021 consolidated revenue CAGR: .33% p.a.
  • 2015-2021 net income CAGR: -3.5% p.a.
  • 2021 iPhone % of consolidated GP: 77%

Downside DCF


  • Core/Legacy revenue grows 3% p.a. from 2015-2021
  • iPhone GPM declines from 50% in 2015 to 42.5% in 2021
  • iPhone revenue declines 5% p.a. from 2018 thru 2021 to $116.6 billion (versus $155 billion in 2015)
  • 2015-2021 consolidated revenue CAGR: -1.7% p.a.
  • 2015-2021 net income CAGR: -8.4% p.a.
  • 2021 iPhone % consolidated GP: 72%

Terminal Value

Baseline DCF:

  • Terminal PE implied at current PPS: 9.09 times
  • FVPS at terminal PE of 15 times: $123
  • PPS at implied terminal PE of 5 times: $76

Downside DCF:

  • Terminal PE implied at current PPS: 13.2 times
  • FVPS at terminal PE of 15 times: $101
  • PPS at implied terminal PE of 5 times: $67


While I would more than likely cover between $67 and $76, without a game-changing change in strategic direction I personally believe the stock is uninvestable even in that price range. The downside scenario of $116.6 billion in sales and a 42.5% GPM in perpetuity for the iPhone franchise is a very, very difficult set of assumptions to handicap.

Critically, however, with robust cash flow generation, a squeaky-clean balance sheet, and an enormous ecosystem, AAPL has (massive?) long-term optionality. Unfortunately however (for longs), it appears Tim Cook is not in much of a hurry. Perhaps he’s sly/crazy/tactical like a fox and is waiting for his time to strike…but prioritizing buybacks in response to activist involvement over building up a war chest to enter the ‘connectivity’ and ‘content’ arenas is a bit troubling.

* * * * * * * * * * * *

The ideal scenario from a portfolio management perspective would be a decline to below $70 followed soon after by a game-changing ‘business development’ announcement allowing me to flip long.

Worst case scenario is likely a game-changing announcement somewhere between the current price and the 52-week high of approximately $133.

IMO, it is highly unlikely the stock ‘runs away’ to the upside on an operational inflection point with the current business mix.