Milking the Apple cash cow

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  Horace Dediu

  analyst and founder, Asymco.com, Boston

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  Aleem Israel

  CEO and portfolio manager, AFINA Capital Management, Toronto

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  Whitney George

  chairman, Sprott U.S. Holdings Inc., Darien, Conn.

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  Michael Scanlon

  managing director and senior investment analyst, Manulife Asset Management, Boston

Apple, currently the world’s most valuable firm by market cap, is a case study of a cash-rich company. Skeptics, associating it with iPhone sales, say Apple is a one-product company that’s making a slow, rustbelt-esque decline. They largely value the company based on its robust balance sheet that, as of December 31, included $246 billion in gross cash. Proponents, however, have pointed to its price-to-earnings ratio, which at the time of its Q1 release was less than 15 times earnings. That’s low for a Fortune 500 company.

“The company’s valued not on a PE basis, but on a PX-cash basis,” explains Horace Dediu, industry analyst and founder of Asymco.com, who says Apple’s been undervalued. The cash in the ratio, he says, is reflected in its financial statements. The “PX,” on the other hand, is “everybody’s beliefs,” Dediu says. That Apple would trade as a “rustbelt” company, or one that’s going out of business, “is one of the most shocking observations you can make,” he says.

For this lesson on how to read, we take a look at tables from Apple’s quarterly statement for the three-month period ending December 31, 2016 (Apple’s fiscal Q1 2017, released January 31).

Whitney George, a value investor who runs a fund with Apple as one of its biggest holdings, says the iPhone maker’s valuation, as of Q1, was half that of similarly mature technology companies going through transformations, like Microsoft or IBM. “I only buy companies with very strong balance sheets,” says George, who describes Apple’s as “fortress-like.”

Apple’s bulls don’t simply see a cash horse. They point to the company’s investments and research into self-driving cars, medical technology and augmented reality. Aleem Israel, a portfolio manager for AFINA Capital Management who holds Apple, sees big potential in the Apple operating system iOS, saying it could be used in applications as diverse as cars and medical devices. “When I think about Apple, it’s more about the operating system as opposed to the devices, per se,” Israel says.

Bulls point out that Steve Jobs, Apple’s late founder, used to say the company was like Babe Ruth: it only hit home runs. That’s made it a great company for consumers and fans, but a difficult one for investors to love.

Let’s look at the relevant sections in detail.

Net sales

The period ending December 31 captured Apple’s “holiday quarter,” reflecting strong sales of $78.35 billion and a gain of 4% from the same period a year earlier. The company’s complete quarterly statement shows iPhone sales were up 5%, with the iPhone bringing in average sales revenue of $695 per phone.

Operating income

This is what operations brought in after expenses like cost of goods sold, wages, and depreciation, and it’s a good measure for comparing earnings across industries. For George, it indicates health. “Operating income, to me, is more important because it gets to pre-tax, pre-interest expense. It gets to the core business,” he says. Critics have pointed out Apple’s operating income has been flat for about three years, and here it’s declined YOY. George doesn’t assume operating income will pick up but, for reasons explained on the balance sheet (see Table 2), it was still a good investment at the time.

Diluted EPS

Earnings per share has remained strong over the year, rising slightly from $3.28 to $3.36. From EPS, you can calculate Apple’s P/E ratio. Divide current share price by current EPS, and then do the same for its share price and EPS a year ago to see the change. You’ll find the company’s PE ratio rose from about $11 to more than $14 at the time of the quarterly release. That indicates investors have been warming to Apple, willing to put more in—$14, to be precise—for every $1 returned. Even at $140 per share, the stock still undervalued, Dediu says: “Generally, one share at $140 spits out a $10 bill, every year. What is the average PE ratio for a Fortune 500 company? It’s like twice Apple’s.”

R&D

Research and development came in at $2.87 billion in the quarter, up slightly from a year earlier. The company’s historical R&D has been strong, in the range of 3% to 4% of revenues, and Apple is holding in the high end, Israel says. The investment is a good sign for Apple bulls, with R&D representing its growth engine. “A lot of people were expecting them to slow down their spend on R&D, because the revenue growth rate has slowed down,” Israel says. “They’ve got a lot of different things under development that aren’t necessarily in the market, as yet.”

Return on equity

This traditional profitability measure is calculated using annual numbers to avoid seasonal swings. Add up net income for the past four quarters to get an annual figure and divide it by total shareholder’s equity, found on the balance sheet. Israel, who likes ROE as an indicator, notes Apple’s was about 35% at the end of the quarter on December 31, 2016. “It just shows they continue to have the ability to place their dollars and spending in areas that are generating strong return on equity for shareholders,” he says. “Tim Cook has been doing an excellent job of allocating the capital.”

Diluted shares

Use diluted shares—representing total shares if the company exercised all convertible securities—for your calculations. For years, activist investors had demanded Apple use its cash to reward shareholders with buybacks and dividends. In recent years, the company has been consistently repurchasing shares. Over the last five years, “there’s a pretty good decline in shares outstanding,” George notes. “Even though the business hasn’t been growing very much, your share of that business has increased if you were a constant shareholder.”

Again, let’s look at the relevant sections in detail.

Cash per share

Divide gross cash ($246.09 billion) by the total number of diluted shares (5.33 billion), found on the statement of operations. The calculation reveals cash per share makes up a huge portion, $46 worth, of the share price ($121 at time of the quarterly release). “This is shocking to anyone who thinks about this,” Dediu says. “You have a business, which is a black box, and [almost] half of it is cash in terms of what the market thinks it’s worth.”

Gross cash

Add cash and cash equivalents ($16.37 billion), short-term marketable securities ($44.08 billion) and long-term marketable securities ($185.64 billion) to calculate gross cash, here a staggering $246.09 billion. “Some mega-companies are in the fortunate position that they’re cash-rich. They’re so dominant that, unless they fall asleep at the wheel, if some emerging technology comes up, they always have the option of buying it versus building it,” George says. Analysts are also watching to see whether Apple, which holds most of its cash overseas, will repatriate the funds with tax amnesty from the Trump administration.

Net cash

Subtract total debt ($87.55 billion) from gross cash ($246.09 billion) to calculate net cash ($158.54 billion). “Even though they paid out $14 billion to shareholders in buybacks and dividends, their net cash balance still grew year over year and quarter over quarter,” Scanlon says.

Total debt

Tally commercial paper ($10.50 billion), current portion of long-term debt ($3.50 billion) and long-term debt ($73.56 billion) for total debt, which here amounts to $87.55 billion.

And let’s look at each relevant section in detail.

Cash from operating activities

Pulling in $27.06 billion in operating cash, in a single quarter, is a “mountain of money” that exceeds many company’s revenues, let alone cash flows, notes Dediu.

Free cash flow

Free cash flow is the cash generated after capital expenditures. Take cash generated by operating activities ($27.06 billion) and subtract payments for acquisition of property, plant and equipment ($3.33 billion). You’ll arrive at free cash flow of about $24 billion. Apple’s free cash flow for the quarter, Scanlon points out, is more than 130% of net income. How? The company amortizes iPhone revenues over the life of contracts for subsidized devices, making free cash flow a more accurate reflection of money coming in than earnings. “As people always say, ‘Earnings are an opinion; cash flow is a fact,’” Scanlon says. “Apple is a free cash flow horse.” The $24 billion of free cash flow, he adds, is left over after buying back about $35 billion worth of stock per year.

Free cash flow yield

Calculate this by dividing annual free cash flow over the past four quarters ($52.5 billion) by the total market capitalization ($636.67 billion on January 31), which generates a free cash flow yield of 8.2%. “Generally, if something has a free cash flow yield of 8% and over, that tends to be a pretty good measure of your [valuation] batting average,” Israel says.

Dividends and share buybacks

The stock repurchase indicates the value bought back in the quarter ($10.85 billion). The dividends paid, in the line above, are $3.13 billion. The company’s annual stock repurchases represent about 6% of market cap, and its dividends about 2%, Scanlon points out. “If they do that every year, you’re getting about 8% return just from reducing the share count and [from] the 2% dividend,” he says. The dividends—for which Israel estimates Apple will spend about $3.1 billion per quarter—are nice rewards for investors.