Return on invested capital, commonly known as ROIC, is a valuable financial metric, which can help investors identify very high quality stocks.
ROIC is the ratio of the after-tax operating profit of a company to the sum of its cost of debt and equity capital. ROIC is useful when compared to the weighted average cost of capital of the company, which is commonly known as WACC.
The wider the difference between ROIC and WACC the more efficient the company is in its allocation of capital.
As high-ROIC stocks allocate the capital of their shareholders in a highly profitable way, they are among the highest-quality stocks in the investing universe.
Here we discuss the prospects of three high-ROIC stocks, namely Apple (AAPL) , HP Inc. (HPQ) and Starbucks (SBUX) .
Apple (AAPL)
Apple is the largest company in the stock market, with a market capitalization of $2.4 trillion. It revolutionized personal technology with the introduction of Macintosh in 1984 and now generates 49% of its sales from iPhones while it also sells iPads, Apple Watch and Apple TV.
Apple has a premium brand, which is admired around the globe. Apple and Samsung earn essentially all the profits in the top end smartphone market. In addition, Apple's Services, which include music, applications and subscriptions, generate a growing stream of recurring revenues.
Moreover, Apple has proved resilient to recessions.
During the Great Recession, in 2008-2009, the tech giant grew its earnings, though the company was in its hyper-growth phase back then. In the fierce recession caused by the pandemic in 2020, Apple proved resilient once again and grew its earnings per share 10%, to a new all-time high. Nevertheless, that recession proved short-lived thanks to the unprecedented fiscal stimulus packages offered by most governments in response to the pandemic.
Since Apple is highly dependent on sales of relatively high-cost smartphones, a major economic crisis is likely to hurt its profits. This is an important risk factor to consider, given the increasing risk of an imminent recession due to the aggressive interest rate hikes of the Fed. Apple recently announced that it would reduce the production of iPhones due to the poor global economic outlook.
On the other hand, Apple has exhibited an impressive growth record. During the last decade, the company has grown its EPS by 15.1% per year on average. This growth rate is much lower than the gigantic growth rate of Apple in the previous decade but it is only natural that the company is facing growth limitations due to its gigantic size. Nevertheless, Apple still has many growth drivers in place.
The primary growth driver is the release of a new iPhone year after year. In the long run, Apple should be able to grow its iPhone sales, albeit in an irregular fashion. Moreover, in emerging countries, in which consumers have rising disposable incomes, Apple should be able to grow its sales of smartphones, as more people will be able to afford them.
In addition, Apple's Services division, which consists of iTunes, Apple Music, the App Store, iCloud, Apple Pay, etc., has grown its revenue significantly in recent years. Services revenues grow at a fast rate and produce high-margin, recurring revenues.
HP Inc. (HPQ)
In late 2015, Hewlett-Packard spun off Hewlett Packard Enterprise Company (HPE) , which was its enterprise technology infrastructure, software and services business, and changed its name to HP Inc. Nowadays, HP Inc. has centered its business activities around two main segments: its product portfolio of printers and its personal systems, which include computers and mobile devices.
HP is a leader in its two legacy businesses and hence it enjoys significant competitive advantages. The long-term viability of these markets is unknown to some extent due to the breathtaking pace of technological advances, but HP is thriving right now.
It is also important to note that HP could be a major beneficiary of consolidation in the industry. Thanks to its strong balance sheet and its excessive free cash flows, it could easily acquire smaller competitors. Due to the fast-changing business landscape in the tech sector, it makes sense for HP to have ample funds to buy its way into the next trend if there is a strategic fit.
HP has a short history as a standalone company, as it was created in late 2015. Nevertheless, the company has grown immensely during this short period, as evidenced by the growth of EPS from $1.53 in 2016 to $3.79 in 2021. More importantly, growth has been consistent every year, with the exception of only 2017, when the bottom line dipped 3%.
HP is a leader in the printing and personal computing markets, but these areas face secular threats, as consumers continue to shift to mobile devices. In addition, most companies are doing their best to shift from a traditional business model, with numerous folders of printed material, to a new era business model, which is as paperless as possible. The adoption of 3D printing could help HP somewhat offset these secular headwinds, but so far the majority of profits are generated by traditional printers and printing products.
The long-term threats facing HP are clearly reflected in the valuation of the stock, which has traded at single-digit price-to-earnings ratios most of the time. The stock is currently trading at a P/E ratio of 5.8, which is a historically low level. On the one hand, the cheap valuation can be partly justified by the aforementioned secular threats, which result in great uncertainty over future earnings, and the increasing risk of an upcoming global recession. On the other hand, despite its risks, the stock seems undervalued from a long-term perspective right now.
Starbucks (SBUX)
Starbucks began with a single store in Seattle in 1971 and now has more than 34,000 stores worldwide. It operates under the namesake Starbucks brand, but also holds the Seattle's Best Coffee, Teavana, Evolution Fresh, and Ethos Water brands in its portfolio.
Starbucks is highly popular in the investing community for its outstanding performance record and its easy-to-understand business model. The company has grown its EPS by 15.3% per year on average over the last decade. The impressive performance has resulted from a nearly 100% increase in the store count of the company and an expansion of net profit margin from 5% to 13%. Even better, the performance of Starbucks has been consistent, with meaningful growth of earnings every single year, apart from 2020 due to the pandemic. The company recovered fully from the pandemic in 2021, with record EPS in that year.
Starbucks is currently facing some headwinds and hence it is poised to incur a 5%-10% decrease in its EPS this year. First of all, due to the surge of inflation to a 40-year high, its costs have greatly increased. To provide a perspective, in the most recent quarter, the gross margin of the company shrank from 19.9% to 15.9% due to cost inflation and the impact of the extended lockdowns imposed in China during the quarter.
Moreover, Howard Schultz, its legendary CEO, who should be praised for the exceptional growth trajectory of the company, is about to step down. This is a significant risk factor to consider, though the effect of the retirement of the CEO may prove less substantial than feared. Furthermore, the employees of Starbucks are trying to form a labor union. As they are likely to succeed in their efforts, they are likely to significantly increase the labor cost of the coffee chain.
On the other hand, despite all these headwinds, Starbucks still has exciting growth prospects in the long run. It sells an addictive product combined with a well-respected brand. As a result, it has the power to sell its coffee at premium prices and generate recurring sales from its customers.
The company can also continue opening new stores at a fast pace for several years. To provide a perspective, Starbucks recently opened its 6000th store in China and expects to reach a store count of 9,000 in the country by 2025. Overall, the iconic coffee chain is likely to return to double-digit growth of EPS in the upcoming years.
Final Thoughts
Apple, HP and Starbucks are high-ROIC stocks, which have offered excessive returns to their shareholders in recent years.
Apple has an unparalleled business model with long-term growth prospects.
HP faces some secular challenges but it seems undervalued at its current price.
Starbucks is now facing some short-term headwinds but it has an exceptional growth record and is likely to return to strong growth mode in 2023 or 2024. Given also its reasonable valuation, the stock is likely to highly reward investors in the upcoming years.
All three have strong returns on invested capital, as well as safe dividends and long-term dividend growth potential.
