Let’s talk about one of the biggest public companies by market cap ($805 billion) in the world. Apple (AAPL) designs, manufactures and markets products ranging from iPhones to MacBooks and provides services and support for these products. Over the years, Apple has proven to be a solid investment because of its incredible cash generation and aggressive stock repurchase programs. However, the stock as recently received a $200 billion haircut after dropping iPhone sales in China.
It is easy to see why the bears are out, after looking at figure 1 (data from 10K-2018). The largest generator of revenue, by a wide margin, is the iPhone (63%), coupled with the fact that 20% of the revenue is generated in China. Hence, a slowdown of the Chinese economy might put a dent is Apple’s cash flow generation. However, the company has a rapidly growing services industry, which is growing with a rate of 19% in Q1-19. This combined with high iPhone sales in Europe and the US, should dampen the impact of the slowing Chinese economy. Now let’s consider that quantifiable factors of the company.
Apple is known for its bulletproof balance sheet (figure 2). First, we consider the short term by looking at the current ratio, that is defined as the current assets (cash and other assets that are expected to be converted to cash within a year) divided by the current liabilities (amounts due to be paid to creditors within twelve months). We require an investment to be able to cover its short term liabilities (current ratio higher than one). In this case, the current ratio is equal to 1.12. Hence, Apple is able to meet its short term liabilities without any issues. Next, we will take a look at the financial leverage, which is defined as the total assets divided by the total equity. In this case the leverage is equal to 3.4. This seems to be on the high end. However, considering the companies ridiculous $240 billion holding in fixed income securities (mostly U.S. Treasury and Corporates), Apple should easily be able to cover its debt is case of an emergency.
Apple produces high quality products and sells high margin services which is apparent when taking a glance at the income statement (figure 3). The gross margin (dividing gross margin by net sales) is 0.38. Hence, for every dollar of product sold, Apple receives 38 cents. The net margin is given by dividing net income over net sales. This is equal to 0.22, or for every dollar of sales, Apple’s net profit is 22 cents. Both gross and net margin are at the highest end of the industry (technology, consumer products). R&D is an important channel for growth. For every dollar in gross profit, Apple spends 14 cents in R&D. This average in the industrie. However, considering the $266 billion in revenue, the company should be able to stay on top.
STATEMENTS OF CASH FLOWS
Now things are getting interesting. Cash is king and Apple is the king at making it rain. In 2018, Apple generated an astronomical free cash flow of $64 billion dollars (figure 4), an amount that might even leave Rockefeller flabbergasted. The company returned $86 billion dollars to shareholders in the form of dividends and share buybacks in 2018 (higher than normal because of the new US tax act). The most important thing to take out off stament of cash flow is whether Apple actually turned net income into cash, we are not doing this to lose money after all. Apple’s free cash flow is generally higher than the reported net income, as seen in figure 5.
CASH FLOWS VERSUS BALANCE SHEET
Before turning to the standard FCF model, we introduce equation 1, that is inspired by the DuPont System.
in which (millions):
- FCF = operational cash flow – capital expenditures = 77434 – 13313 = 64121
- FCFBT = FCF + cash paid for income taxes = 64121 + 10417 = 74538
- FCFBIT = FCFBT + cash paid for interest = 74538 + 3022 = 77560
- employed assets = current assets – current liabilities + non-current assets (not including marketable securities) = 131339 – 116866 + 234386 – 170799 = 78060
- equity = 107147
The first term in the right hand side of equation 1 is referred to as the tax burden. This is equal to 0.86. The company might be preforming some tax evasion magic (as we all know), since that number is exceptionally high. Apple retains 86 cents in cash for every dollar of free cash flow before paying taxes. The second term is called the interest burden, that is equal to 0.96. Again this number is very high, the company has a trivial debt holdings in relation to FCF. In other words, the company has to be in extreme stress for it to be troubled by interest payments. The third term is called the return on capital (ROC). The ROC is equal to 0.99. Hence, Apple generates roughly 1 dollar per dollar of employed assets. Let that sink in for a bit.
Imagine owning a garage shop. Business is good and you have $300000 on the bank. However, the garage across the street is on sale for $200000, and you think of making a bid. After all what is money in the bank going to do you for. After some due diligence and cigar box accounting you find out you could turn out $200000 dollar in profits after 1 year off service. This is Apple’s situation, not many companies can say the same.
Let’s return the equation. The final term is the net financial leverage. This is different from the regular leverage because it does not include current liabilities (make sure the current ration is above 1) and does not account for the non-current marketable securities. The net financial leverage is equal to 0.73, which says a lot more the leverage computed in the balance statement section. Apple should easily be able to cover its long term debt when losses are incurred.
Finally we compute the ROE by either dividing FCF by equity or multiplying all of the terms above. Either way, we get an ROE of 0.6, which is very high. However, it does not tell us anything on how the return relates to the purchase price.
Only one thing left. After seeing how amazing Apple is on every level we analysed, without making too many guesses, it’s time for a bit of Fingerspitzengefühl. The FCF model computes the net present value of the free cash flows over a period of 10 years. We will make the following assumptions:
- first five years, growth rate equal to 13% and discount rate equal to 2.6% (10Y US yield),
- second five years, growth rate equal to 10% and discount rate equal to 3.5% (assumption)
The result of the FCF model is presented in figure 6 and 7. Our conclusion is that today market price of $172 represents a healthy 41% discount.
Apple is a company that makes everything work. Across the board, the company is first in its class and selling at a healthy discount. For all the reasons that where mentioned above, Apple is a long position in the Bona Fide I portfolio.