Finance (BUSA 5099) MBA P/T (2009-2011 intake) Individual Assignment 1

Apples Computers Financial Performance Economic Value Added (EVA)

Kirill A. Oussov (Student No. 397580)

Word Count: 1,100 Submission Date: April 26, 2010

Table of Contents
Table of Contents ......................................................................................................................................... 2 1. Introduction to EVA (Economic Value Added) ..................................................................................... 3 1.1. 1.2. 2. General Overview ......................................................................................................................... 3 EVA and the Drives of the Value Creation .................................................................................... 3

Apples Computers Financial Performance and Value Creation ............................................................. 5 2.1. 2.2. Apples Economic Value Added and NOPAT ............................................................................... 6 Apples EVA and Capital Management ......................................................................................... 7

3.

List of References ................................................................................................................................. 9

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1. Introduction to EVA (Economic Value Added)

1.1. General Overview
Financial measuring tools are many and varied. Traditionally, analysts focus on financial accounting metrics such as sales and sales growth, margin, operating profit and operating profit growth, bottom-line earnings and earnings per share (EPS), market value, return on equity, and return on assets or cash flow. Each of these metrics is flawed. Neither sales nor operating profit accounts for the financial requirements necessary to achieve them, in terms of either annual expenses or capital invested. Bottom-line profits and EPS take no account of the fact that equity has a cost. Market value ignores the capital employed to create it - invest more, and of course market value rises, without necessarily creating value. EVA however is a performance metric that calculates the creation of shareholder value, but it distinguishes itself from traditional financial performance metrics. EVA is the calculation of what profits remain after the costs of a company's capital - both debt and equity - are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital (McClure, 2010).

1.2. EVA and the Drives of the Value Creation

In general terms, EVA is defined by the following formula (Stern, Shiely, Ross, 2001):

EVA = NOPAT - WACC x Capital Employed NOPAT is the net operating profit after taxes; WACC is the weighted average cost of capital.

Thus, in order to create value, i.e. generate positive Return on Invested Capital (ROIC), an organization must improve its EVA. Based on arithmetical rules, these may be achieved in several ways, including: increasing NOPAT, lowering the WACC, and reducing invested capital. Conducting further analysis to establish dependency between economic value creation and its main drives, one can use deductive method (similarly to the DuPont analysis (Ross, Westerfield, Jordan, Firer, 2008)). Picture below illustrates these dependencies:

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Sales less Cost of Sale (Variable), % less Overheads (Fixed Costs)

Increase sales Improve GP margin Decrease overheads

NOPAT less

EVA

Cost of Debt Cost of Equity Gearing ratio Reduce Percieved Risk Reduce Percieved Risk Use Debt rather than Equity (Debt is cheaper than Equity)

WACC multiply

CAPEX Capital Employed plus

optimise CAPEX utilisation Cash less Debtors Reduce Debtors age Reduce Inventories Increase Creditors age Reduce Cash

Working Capital

less I nventories plus Creditors

Picture 1-1. Key drives of EVA

Therefore, more detailed recommendations can be made: First, operating performance with respect to operating profit margins or asset turnover ratios could be improved to generate more revenue without using more capital. Second, the capital invested in the business might be reduced by selling under-utilized assets or choosing off-balance sheet financing of the assets; this strategy will simultaneously improve operating performance through a higher asset turnover ratio, as well as a reduced capital charge against those earnings because of a reduced debt or equity capital investment. Third, redeploy the capital invested to projects and activities that have higher operating performance than the current projects or investments are exhibiting. And fourth, if the business is not highly leveraged, change the capital structure by substituting lower cost debt for higher cost equity. Although this last strategy will decrease net income because of the higher interest cost, it will improve the EVA of the business because the total cost of debt and equity is reduced, and EVA measures the value created after all costs of capital (debt and equity) have been taken into account.

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2. Apples Computers Financial Performance and Value Creation

Equipped with the EVA methodology, one can analyze Apples financial performance over the last 25 years through value creation according to EVA principles as well as to understand the major contributing factors in this process. As it is shown on Picture 2-1, Apple went through 4 major cycles of destruction-creation of economic value. The first one falls on the period between 1982 and 1985; the second occurred between 1985 and 1997, where the third can be attributed to 1998 to 2001-2002 and the forth on has started in 2002 and is on uprising phase. All three complete cycles can be characterized by the initial growth of EVA followed by its downfall into negative values. Every consecutive cycle had shown fluctuation with increasing magnitude.

4,000 3,000 2,000 1,000 0 -1,000 -2,000 Economic profit (EVA) Figures $m Economic profit (EVA), $m Value Creation / Destruction Year on Year Dynamics 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 0 0 0 0 0 0 0 0 0 1993 1994 0 0 1995 0 1996 0 1997 1998 1999 2000 0 0 0 0 2001 2002 2003 2004 0 0 0 0 2005 0 2006 0 2007 0

30.0

35.0 -5.0 -3.0 107.0 163.0 309.0 282.0 330.0 153.0 388.0 -145.0 39.0 78.0 -1,106.0 -1,202.0 220.0 507.0 625.0 -186.0 -3.0 13.0 261.0 1,284.0 1,790.0 3,135.0

Picture 2-1. EVA Cycles

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2.1. Apples Economic Value Added and NOPAT

In terms of value creation and economic value add, Apple has built very interesting business model, which since 1997 almost completely excludes cost of both Working Capital & CAPEX out of the EVA equation (explained in Section 2.2) and leaves NOPAT to be a major driver of economic value added (with coefficient of correlation of 0.99). As per the scheme on Picture 1-1, NOPAT is determined by 3 factors: SALES, GP margin and Fixed Costs. Thus, through understanding of trends in this 3 factors, one could understand the underlying reasons for Economic Value creation or distruction.

EVA vs. NOPAT

3,500.0 3,000.0 2,500.0 2,000.0 1,500.0 1,000.0 500.0 0.0 -500.0 -1,000.0 -1,500.0

Ec. Value destruction 1

Economic Value created 2

Economic Value destruction 2

Ec. Value created 3

Ec. Value destruction 3

Economic Value created 4

Economic profit (EVA), $m

EBIAT (NOPAT), $m

1982 Economic profit (EVA), $m Value Creation / Destruction Year on Year Dynamics Sales Year on Year Dynamics Gross margin Year on Year Dynamics Overheads (Fixed Costs) Year on Year Dynamics

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1993 1994

1995

1996 9,833 9.8% 2,262

1997 1998 1999 2000

2001 2002 2003 2004

2005

2006

2007

30.0

35.0 -5.0 -3.0 107.0 163.0 309.0 282.0 330.0 153.0 388.0 -145.0 39.0 78.0 -1,106.0 -1,202.0 220.0 507.0 625.0 -186.0 -3.0 13.0 261.0 1,284.0 1,790.0 3,135.0

583

983 1,516 1,918 1,902 2,661 4,071 5,284 5,558 6,309 7,087 7,977 9,189 11,062

7,081 5,941 6,134 7,983 5,363 5,742 6,207 8,279 13,931 19,315 24,006 19.3% 24.9% 27.6% 27.1% 23.0% 27.9% 27.5% 27.3% 29.0% 29.0% 34.0% 2,422 1,188 1,116 1,261 1,486 1,619 1,695 1,937 2,410 3,187 3,793

50.6% 48.5% 42.0% 41.8% 53.1% 53.1% 51.1% 49.0% 53.1% 47.5% 43.7% 43.2% 25.5% 25.8% 193 347 546 702 736 1,042 1,460 1,955 2,239 2,550 2,242 3,365 1,846 2,232

Picture 2-2.Correlation between EVA and NOPAT

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Cycle 1. The first time Apple had achieved negative EVA was in 1984-1985 when despite growth in sales and consistently high GP margin could not compensate for excessive growth in overheads (partly contributed by increasing R&D cost in Apple III, which never took off), which has doubled over 2 years from 1983 to 1985. Cycle 2. Apple successful launched of Macs range in 1986-1990 and Powerbook range in 1990-1992, and had secured sustainable growth in revenues which was covering shrinking GP and increasing fixed cost and continued creating value of the company. Falling to recognize the early symptoms of the forthcoming problems as exurban fixed cost and shrinking GP started affecting EVA in 1991-1993, by 1994 Apple had found itself in a position of losing its competitive edge. As the management chose the strategy of lowing GP from 45% to 25% in 1995 to the lowest-ever 9.8% in 1996, Apple found itself in the position of economic value destruction of over $1.1bn a year. The desperate attempts to boost the dropping sales and drastic job cuts had a little effect on EVA. Cycle 3. Jobs is back to Apple. The successful launch of iMac boosts sales in 1998-2000 and improves GP margin; massive job and R&D cuts, which reduce fixed cost by half, pushes EVA into the black in 1998-2000, but failes to secure sustainability. In 2001 EVA drops to -$186.0m again. Cycle 4. The company changes its distribution strategy and opens the chain of its own retail outlets and starts to sale online. Successful launch of iPod and iTune bost the sales, which reach $13bn in 2005; the GP margin is improved to stable 27%-29% and despite increasing spend on R&D, which doubled from 2001 to 2006, Apple has reached cumulative EVA of $6.4bn over period of 2004-2007 with ever-highest $3.1bn in 2007.

2.2. Apples EVA and Capital Management

As it was mentioned in the previous paragraph, after drastic increase in cost of capital in 1992-1996, where cost of capital rose from $100.0m to $300.0m, having negative impact on EVA. Since 1996, the company had started aiming on operational optimization to improve Capital assets utilization and improve a position of working capital the main contributor of the costly capital growth. Thus, through implementation of off-balance sheet capital financing and sale of unused CAPEX, Apple had reported positive capital spending over 1998-2001, while improvement of stock management and extension of the debtors age had positively affected working capital (See Picture 2-3).

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Creditors, $m
6,000 22.0%

Gearing
60% 4,000 2,000 0 50% 40% 30% 20% 10%

- (WACC * Capital Employed)

100.0 50.0 0.0 -50.0 -100.0 -150.0 -200.0 -250.0 -300.0 -350.0 Ave. Annual Cost of Capital, $m

20.0% 18.0% 16.0% 14.0% 12.0% 10.0%

Debtors, $m
3,000 2,000

WACC

0%

2,500 2,000 1,500 1,000 500 0 -500 -1,000 4,000 3,000 2,000 1,000 0 -1,000 -2,000 -3,000

Woking capital, $m

1,000 0

Inventories, $m
2,000

1,000

Ave capital employed

Picture 2-3. Cost of the Employed Capital

The drastic improvement in capital requirements in 1996-1999 from $2.0bn to -$0.5bn in combination with improving the Apples gearing over the same period had brought cost of capital (i.e. the WACC * Capital Employed factor) to 0 in 2001 and furthermore turned it into sustainably positive factor in 2004. See Picture 2-4 for more details.
1982 Economic profit (EVA), $m Value Creation / Destruction Year on Year Dynamics WACC Year on Year Dynamics Ave capital employed Year on Year Dynamics Ave. Annual Cost of Capital, $m Year on Year Dynamics 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 13.9% 2,081 -290.0 1997 1998 1999 2000 2001 2002 2003 2004 2005 11.8% -592 70.0 2006 12.4% -461 57.0 2007 12.2% -490 60.0

30.0

35.0

-5.0

-3.0 107.0 163.0 309.0 282.0 330.0 153.0 388.0 -145.0

39.0

78.0 -1,106.0 -1,202.0 220.0 507.0 625.0 -186.0

-3.0

13.0 261.0 1,284.0 1,790.0 3,135.0

20.9%

18.5% 19.8% 18.1% 15.1% 15.9% 16.4% 15.9% 16.1% 15.4% 14.5% 13.4% 14.6% 14.1% 173 -32.0 293 -58.0 282 -51.0 166 -25.0 195 -31.0 428 660 654 798 979 1,446 1,840 2,218

13.9% 12.6% 13.1% 13.6% 12.8% 16.0% 11.4% 11.7% 1,083 -150.0 507 -64.0 237 -31.0 279 -38.0 141 -18.0 -13 2.0 18 -2.0 -214 25.0

110

-23.0

-70.0 -105.0 -105.0 -123.0 -142.0 -194.0 -269.0 -312.0

Picture 2-4. Dynamics in Cost of the Employed Capital

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3. List of References
McClure, B. (2010, 03/12/2003) All About EVA, last accessed 25/April, 2010, from URL http://www.investopedia.com/articles/fundamental/03/031203.asp. Stern, J. and Shiely, J. and Ross, I. (2001) The EVA Challenge: Implementing Value-Added Change in an Organization, Wiley, New York. Firer, C. and Ross, S. and Westerfield, R. and Jordan, B. (2008) Fundamental of Corporate Finance, 4th SA ed., McGraw-Hill Education, New York.

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