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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Wednesday, July 30, 2008

Apple Inc (AAPL): Are Investors Overlooking Cash Earnings?

Apple Inc (nasd:AAPL) $157.08: I believe investors have become overly fixated on Apple’s expected accounting income, while ignoring Apple’s impressive free cash flow generating ability. Free cash flow, not earnings reported in the accounting statements, determines the true value of a firm. AAPL’s high margins coupled with minimal capital investment needs, enables it to produce robust free cash flow. Another issue is the iPhone accounting treatment, which conceals the true magnitude of its cash generation. According to my estimations, the 3G model’s cash flow per unit is higher than its predecessor. In addition, Apple receives these cash flows much sooner compared to the old model. Not only will Apple sell many more 3G models, the per-unit impact on cash earnings will be much greater. Therefore, when shifting focus to cash earnings, as opposed to accounting earnings, AAPL looks attractive at current levels.

Earnings Expectations:
At the Q3 earnings call, Apple guided well below expectations for Q4, and gave a weak gross margin forecast for FY09. Shares took a hit and prompted Wall Street analysts to reduce their 4Q08 and FY09 estimates. Consensus estimates for FY08 & FY09 are $5.20 & $6.05, respectively. Early this year, the FY09 estimate was ~$6.50, then drifted lower to ~ $6.35 where it hovered for several months. Since Apple announced its margin guidance, the consensus FY09 EPS estimate has plunged to $6.05.

Apple shares currently trade @ 27x FY09 EPS, with expected annual growth of 16%. A 27x multiple for 16% growth isn’t exactly cheap. However, evaluating Apple on an EPS-multiple basis is misleading due to Apple’s iPhone accounting treatment. Considering Apple’s cash flow/share, the stock looks attractive.

Wall Street estimates are for accounting income- what Apple is expected to report, not what Apple will actually earn. Cash flow is the true metric that matters, not accounting earnings. Accounting earnings are a product of a firm’s finance department, and cash earnings are a product of customer behavior. Thus, one shouldn’t place too much emphasis on accounting income and quarterly estimates.

The amount of cash flow available for distribution to owners determines intrinsic value. Accounting income and cash flow are not the same, and often accounting income is a poor proxy for distributable income, hence intrinsic equity value.

Evolution of Market Expectations:
The 3G iPhone developments- new markets, new revenue model, lower price points, and new features, etc didn’t seem to affect AAPL shares much. However, concerns over Steve Jobs’s health and guidance have pressured shares. iPhone demand has been relentless since the launch as stores struggle to keep supplied. Analysts have raised their forecasts for unit sales, yet earnings estimates have only changed slightly (before CC).

Earlier this year, investors and analysts were questioning whether Apple would achieve its stated sales goal of 10 million units in CY08. Some began to think the iPhone was going to turn out to be a disappointment, and that expectations were certainly excessive. However, iPhone sales projections rose significantly with the June announcement. Many analysts raised estimates to more than 20 million for 2009. Yet, there was then the question of reduced profitability due to the reduced price points. Originally, the thinking was that volume could certainly expand but the effect on the bottom line would be subdued due to shrinking margins. Yet, it was soon agreed that margins won’t be significantly impacted due to the larger-that-originally expected subsidy payment. Instead of receiving a cut of monthly carrier payments over 24 months, Apple will receive an upfront lump-sum payment that is likely equivalent.

So, we have a massive increase for iPhone sales expectations with profitability remaining somewhat intact, yet AAPL shares react moderately and analysts only revise estimates slightly higher. Ostensibly, earnings estimates didn’t change significantly due to the iPhone accounting treatment that spreads revenue over 24 months. Thus, iPhone sales won’t really impact the income statement until a much higher run-rate persists for many quarters so that revenue recognition has had time to catch-up.

Shares reacted little to the June announcement, until somebody pointed out that Jobs looked unhealthy causing the stock to tank. Shares later recovered only to get slammed again after the Q3 earnings call when management refused to elaborate on Job’s health condition. Panic over Job’s health has abated, but concerns regarding Apple’s gross margin guidance and susceptibility to a weakened consumer still linger.

3G Produces More Cash Flow & Sooner:
The transition from shared payments from carriers to an upfront subsidy payment increases Apple’s intrinsic value.

Apple’s cash flow will increase from receiving an upfront, one-time payment opposed to recurring monthly payments. Originally, when an iPhone was sold, Apple only received cash associated with the handset sale, revenue which probably averaged around $430-$440. Apple then would receive $15/mo (guesstimate) for the next 24 months, $360 in total payments, or PV of $319 @ 12% discount rate. Present value of total CF is ~$750/unit, However, this isn’t a very realistic assumption to model. Actual revenue/unit is significantly less due to several reasons.

First, not all units receive full 24 months of payments due to iPhones being lost, stolen, broken, etc. Monthly payments are then attributed to the replacement unit and the original device no longer generates monthly revenue payments. AT&T shares revenue per iPhone customer (activated device), not for each device sold. Thus, Apple has sold two handsets yet only collects $15/mo, or theoretically $7.50 per device.

Second, not all iPhones sold were activated with a participating carrier (unlocked), so a significant percentage of legacy iPhones (maybe 40%-50%) don’t receive carrier payments. Unlocking has actually been beneficial because is has allowed Apple to sell units that it would have never sold, and it has generated product exposure in foreign markets. Yet, for the sake of modeling, and for cash flow comparison between the former and current revenue models, we can’t assume that the average monthly payment is $15 across all units.

Third, many units will be replaced with 3G iPhones before the full 24 months elapses. 2.5G iPhone owners that upgrade to the subsidized 3G model contribute maybe 12 months (or less) worth of payments. Piper Jaffray’s survey on launch day found 38% of 3G buyers were current iPhone owners.
Just for the sake of illustration, assume 50% of iPhones are unlocked (or lost/broken), and one-half of the other 50% upgrade to the 3G model after 12 months. This leaves 25% with 24 months of revenue payments At $15/month shared carrier payment, the average unit revenue/month is $5.63, or $135 over 24 months. Assuming ASP of $430, total revenue/unit is $565 (not accounting for time value of money). Therefore, it’s unrealistic to assume that the legacy iPhone revenue model was bringing in $790/unit ($430 + $15 x 24m)

With the subsidy payment model, there isn’t any uncertainty as to what the actual realized revenue/unit will be, since all payments occur on the front-end. Sales thus far have been skewed towards the 16GB model, which AT&T is offering for $299 with a 24-month contract, or $699 for no commitment. Similar arrangements exist in foreign markets, and the pricing works out to be roughly equivalent on a currency translation basis. So, AAPL could be capturing over $600/unit, a more conservative figure would be $550 or $500. Thus, Apple is likely receiving revenue per unit commensurate to the 2.5G iPhone.

A major point that I feel is overlooked relates to the timing of cash flows. For example, consider the following illustrative assumptions. Apple receives $600 upfront on the 3G opposed to $450 upfront and $150 in total cash payments spread over 24 months for the 2.5G. The accounting will look the same for both models since total revenue/unit is equivalent, and in both cases is recognized over 24 months resulting in revenue of $75 per quarter. Even though both scenarios appear to be similar from an accounting standpoint, the cash flows are different. All cash flow from the 3G hits at the time of the sale, where as just a portion of 2.5G cash flow occurs on the front-end.

To summarize my points:
1) 3G iPhone realized revenue/unit is higher- not every 2.5G iPhone generates shared carrier revenue, and not all units that have attached payments will survive the full 24 months.
2) Time Value of Money- Apple receives 3G iPhone revenue upfront, whereas the previous model entailed deferred revenue payments. Not only is there the opportunity cost of forgone investment alternatives, the cash payments are uncertain.
3) 3G model’s production cost is estimated to be about $55 less that the original model.
4) Demand, demand, demand. More markets, more features, cheaper price. The first iPhone took more than two months to sell 1 million units, which the 3G iPhone surpassed its first weekend.

The new 3G iPhone and revenue model will dramatically boost Apple’s cash flow that should result in a higher valuation. Not only is demand substantially stronger for the 3G model, but the actual revenue/unit realized will be higher, and the cash flow will occur sooner.

iPhone Impact:
If Apple sells 20 million iPhones next year assuming: $500 ASP, 50% gross margin. 30% tax rate, it will generate incremental cash flow of $3.90/share. Assuming that Apple sells 5 million in each quarter, the accounting treatment would only recognize $1.23/share for 2009. Cash earnings are more than 3x higher than reported earnings. Using more aggressive assumptions: $600 ASP, $250 COGS, the iPhone would produce $5.50 CF/share. Subscription accounting would only report $1.72/share.

The assumptions I am modeling for FY09: 20 million units, $350 subsidy, 65% 16GB ($299) & 35% 8GB ($199) = $614 ASP, $233 production cost, 30% tax rate. This calculates out to 5.32B in after-tax cash flow, or $5.92/share.

Apple’s FCF/share (ttm) is roughly $6.84, a price multiple of 23x. In contrast, Apple trades 31x EPS (ttm). I estimate that $1.10 of the $6.84 CF/share is iPhone related, thus FCF/share associated with all other segments is $5.74. With a 25% growth rate, non-iPhone CF increases to $7.18/share in FY09, and adding $5.92 from iPhone, CF for FY09 totals $13.10/share. This figure equates to a price multiple of 12x, and as mentioned previously, Apple is trading 27x FY09 EPS estimate of $6.05.

This is more or less a “back of the envelope” exercise, but the purpose is to illustrate the vast difference between Apple’s cash flow and accounting EPS due to iPhone revenue recognition.

Apple’s Free Cash Flow-
Apple is an impressive free cash flow generator. The primary components of free cash flow are 1) NOPAT- net operating profit after-tax 2) Working-capital requirements 3) Investment in fixed assets (capex).

Apple’s has negative working-capital requirements due to rapid inventory turns. AAPL turns its inventory about every 7 days, or 50x a year. Apple’s collection period for outstanding receivables is slightly more than 20 days, yet it doesn’t pay its suppliers for roughly 90 days. Thus, Apple doesn’t need to sink additional cash into working capital as sales increase since it’s funded through trade credit. This would allow more cash to be distributed to shareholders since it doesn’t need to be retained to fund operations.

Apple’s capital investment needs are quite modest. FY07 capex was $735 million and $893 million for the last 4 quarters. This equates to roughly 3% of revenues, and when depreciation is taken out, net investment is approximately 1.7% of total sales. A sizable portion of Apple’s capital investment relates to retail store growth. Apple’s stores produce extremely high revenue per square foot, as well as attracting consumers unfamiliar with the Apple brand. Retail stores perform a marking function for Apple due their appeal that generates substantial foot traffic. The stores are also ideal for cross-selling Macs to consumers who have come to purchase an iPhone or iPod. Thus, Apple’s retail store strategy has proven to be a very worthwhile investment.

Much of Apple’s assets are intangible, thus not reported on the balance sheet. Intellectual capital and brand equity are just two examples. Relatively speaking, Apple doesn’t have to spend heavily on developing these assets. Apple’s marking spend is 2% of revenue as it enjoys doses of free advertising from the media and word-of-mouth from satisfied users. Apple’s research and development expense is just slightly more that 3% of sales. In comparison, R&D for Yahoo ~16%, Google ~13%, and Amazon ~ 6%.

In summary, EPS (ttm) is $5.11 or 15% net margin, and free cash flow as a percentage of revenue is 20%. As iPhone sales increase, these two metrics will diverge further, yet the focus should be on cash flow. It’s widely accepted that the iPhone has a much higher gross margin than the overall Apple business, yet due to subscription accounting, the iPhone’s impact on overall gross margin is very minimal. Thus, panic over the gross margin forecasts is misguided because on a cash basis, gross margins would be much higher. Investors should then place less weight on Wall Street earnings estimates. Therefore, when evaluating Apple on its prospective cash flows, shares look attractive under $160.

Disclosure: None


Anonymous said...

Do you still feel the same about AAPL? When I look at its Free Cash Flow I get -11 million dollars. I took '07s net income plus amortization and depreciation, minus changes in working capital and capital expenditures and that's how I arrived at that number.

Turley M Muller said...

I get about 8.5 billion for FY08 FCF, which is ~9.43 a share, so on a trailing multiple basis Apple is trading 10x, or so, pretty cheap.

BizBlogged1 said...
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