Even With Negative FCF, Apple Still Undervalued

Jul. 9.13 | About: Apple Inc. (AAPL)

For the entire first half of 2013 investors have been scratching their heads as to how low the share price of Apple (NASDAQ:AAPL) could go. We are all aware of the negative sentiment surrounding this company, and unfortunately this appears to be keeping the stock at depressed levels. Interestingly enough, if you covered up the Apple name and logo on the company's SEC filings and looked strictly at the financial statements, it is likely nine out of ten investors would begin acquiring shares. So how can a company which is on pace to spend over $4 billion in R&D this year be thought of as a losing technology play?

My personal opinion is that fear is keeping would be investors from diving into this stock. The worry that all those talking heads on television saying Apple is doomed may actually be right is causing our behavior to look past one of the most appealing value stocks in the market today. But what if all those Apple bears are right? What would the stock look like if the company began to exhibit negative growth for the next few years? Throughout this article I will run though a few scenarios to forecast possible share prices given some bearish forecasts.

Free Cash Flow Model

The discounted free cash flow model is appealing to use with Apple for a variety of reasons. The company's financial statements are fairly simplistic and do not utilize many account tricks. Additionally the company tends to hold most of its cash rather than pay it out as dividends. If the dividend payout ratio were to increase a dividend discount model may be more applicable. The basic calculations of a FCF model are somewhat simplistic, however the assumptions and discount rates utilized can provide drastically different results. For this reason I recommend investors utilize other investment valuation models in addition to the discounted free cash flow model.

There are various ways to calculate free cash flow, the basic concept is operating cash flows minus fixed capital investments. Looking at Apple's statement of cash flows I consider fixed capital investments to be comprised of three reported line items; payments made in connection with business acquisitions (net of cash), payments for acquisition of PPE (property, plant and equipment), and payments for acquisition of intangible assets. All three of these investing cash flows are crucial to support Apple's future growth and thus should be included in a FCF calculation. The table below lists out prior fiscal year and FY Q2 2013 free cash flow utilizing my modified calculations. The growth rate of the historical results have been staggering, however given the increased completion resulting in margin compression, it is highly unlikely growth rates like these will continue.

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Source: Apple SEC Filings and my modified calculation

You can see that just two quarters into the current fiscal year and Apple is already on pace to produce another record year of free cash flow. When earnings are released on July 23rd we will have a better picture of how FQ3 looked for the company. But let's assume that the Apple bears are correct and free cash flow is going to begin deteriorating as a result of increased competition. In each of my assumptions below I assume that free cash flow is going to decrease by either 1%, 2%, or 3% per year for the next four years before stabilizing and growing at 1% in perpetuity (call my crazy but I would assume that $4+ billion per year in research and development spending is going to pay off eventually). As you can see in the table below, using a discount rate of 9% and negative one percent free cash flow growth rate, shares would be worth roughly $510 today (25% below current levels). Assuming a worst case scenario of negative three percent free cash flow growth and a higher discount rate (assuming Apple carries more risk in the future), shares would be worth roughly $423 today (current valuation levels).

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Source: Apple SEC Filings and DCF valuation model

Again, these assumptions are heavily weighted on the discount rates and growth rates utilized. Even small changes to the model can produce different valuations for each share price. However given the current year to date trend of cash flow generation, my estimates appear somewhat conservative in nature.

Other Points to Consider

I would point investors towards two recent announcements which I believe play a large part in analyzing the company. The first is the capital return program which Apple more than doubled last April. The Board of directors announced that it will utilize $60 billion of cash to repurchase shares by the end of calendar year 2015. As you can see in my calculation above, I use the diluted share count as of the recent quarter end (946,000,000) to find a per share value. Assuming the company completes its share repurchase program and has an average repurchase price of $500 per share (above current market levels), we would see the diluted share count drop by 120,000,000 shares. Re-running a FCF calculation would point towards a significantly higher share price.

From an investment standpoint the timing of a share repurchase program seems extremely attractive. As you can see in the chart below, the quarterly trailing twelve month price-to-sales (left hand scale), price-to-earnings (right hand scale), and price-to-book value (left hand scale) ratios are all trading near historic lows. I think it is safe to assume that investors prefer management to repurchase shares when value is apparent (i.e. today).

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Source: Apple SEC Filings

A second observation worth noting took place on May 3rd when Apple issued $17 billion in debt at some of the most attractive interest rates this company is likely to ever see. What is even more impressive is that the company was able to borrow at what appears to be the bottom of the market. Below is a chart of the ten year treasury note yield, and although we did reach lower levels back in August of 2012, the date Apple issued its debt was not too far from those levels. Over the next few weeks yields jumped over 100 basis points making Apple management look like sheer genius.

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Source: Yahoo! Finance

Conclusion

The question I have to ask myself repeatedly is how can a company which appears undervalued at today's price levels assuming negative growth scenarios, which is currently undertaking a robust share repurchase program, and recently tapped the debt markets at the lowest possible rates be trading so cheap? Why wouldn't investors be willing to load up on this stock and drive the price higher? My answer is to remind investors that sometimes our behavior is irrational and I believe this is clearly revealed in the case of Apple.

If Apple were to move higher, I have a feeling conversations in the future may look somewhat like this:

Investor: "Why didn't we load up on Apple shares at $400?"

Me: "I don't really know, the market just didn't like them and this Korean company was rumored to be taking over the mobile device world. Risk was just too high at those levels."

Investor: "But shares were trading under 10x earnings and free cash flow was tremendous?!"

Me: "Well yeah, but they had too much cash on the balance sheet back then."

Investor: "Why is that a bad thing?"

Me: "I'm not sure, but at the time it all made sense…"

Consider your investment goals and objectives before initiating a position in Apple and please remember that the value of investments in equity securities, like AAPL, will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. In my opinion the risk/reward scenario is skewed drastically towards the reward side in this stock.

*Note: All data reported and graphed is pulled directly from Apples SEC filings and press releases.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.