Apple Is Fairly Priced

| About: Apple Inc. (AAPL)

Summary

Apple's capital return program, along with over 90% of its cash being overseas, will lead to the company consistently issuing large quantities of debt.

When looking at U.S. cash and debt, Apple has net debt.

I conducted a DCF analysis and found that shares of Apple are fairly valued at their current price.

I recently read a Seeking Alpha article by Erik Bergseng about Apple (NASDAQ:AAPL) being grossly mispriced. After conducting some research, I concluded Apple is fairly valued at its current price.

I disagree with Bergseng's contention that,

No matter which way you cut it, Apple is grossly mispriced. Even if we assume the worst and revenues stagnate or even slightly decline ...

Last April, I wrote The Drawbacks Of Apple's Cash Hoard Are Starting To Show, where I showed that the overwhelming majority of the cash Apple has is stuck overseas, U.S. cash was decreasing and to fund capital returns Apple had to issue debt. Over the last year, all of these items have gotten worse. I believe they will lead to Apple's share price stalling out, barring a miracle repatriation tax deal in congress.

Foreign Versus U.S. Cash

I constructed the following chart with data [see cash data table below] from Apple earnings transcripts and SEC filings. It shows that the percentage of cash held offshore has been steadily increasing over the last three years and is at an all-time high. Conversely, U.S. cash as a percentage of total cash is at its lowest level in three years. For Apple, it is not a case of both foreign and U.S. cash increasing, with foreign cash increasing more than U.S. cash. In fact, in actuality, U.S. cash is not just at a percentage low, but also an absolute low.

Click to enlarge

Click to enlarge

Cash Data Table

Q1 2013

Q2 2013

Q3 2013

Q4 2013

Q1 2014

Q2 2014

Q3 2014

Q4 2014

Q1 2015

Q2 2015

Q3 2015

Q4 2015

Q1 2016

Total Cash

137.1

144.7

146.6

146.8

158.8

150.6

164.5

155.2

178

193.5

202.8

205.7

215.7

Foreign Cash

94

102

106

111.3

124.4

132.2

137.7

137.1

157.8

171

181

187

200

U.S. Cash

43.1

42.7

40.6

35.5

34.4

18.4

26.8

18.1

20.2

22.5

21.8

18.7

15.7

Foreign Cash as % of Total Cash

68.56%

70.49%

72.31%

75.82%

78.34%

87.78%

83.71%

88.34%

88.65%

88.37%

89.25%

90.91%

92.72%

Click to enlarge

*Data in billions

The following quote from Luca Maestri on Apple's fiscal 2015 Q2 earnings conference call shows that Apple has two options to continue funding its capital return programs, given that foreign cash makes up such a large percentage of total cash:

As we've done in the past, we expect to fund our capital return program with U.S. cash, future U.S. cash flow generation, and borrowing from both domestic and international debt markets.

Apple Capital Return Program

With U.S. cash being at the lowest level in three years, the two options Apple has to continue to support its capital return program is to divert ever-increasing capital return funds from free cash flows and/or issue large quantities of debt. This is what Apple has done so far because low interest rates make borrowing debt to buy back stock attractive. The following quote from Apple's most recent earnings conference call backs up the view that Apple will continue to take on large quantities of debt:

We also plan to be very active in the U.S. and international debt markets in 2016, in order to fund our capital return activities.

Given the large scale of its capital return program, Apple must continue issuing debt or its capital return program will fall apart.

Debt Repayments

Starting this year Apple will have to divert more resources to paying principal payments on debt that will be coming due. As the table below from the most recent 10-K shows, Apple has $2.5 billion due this year, $3.5 billion next year and $6 billion in 2018 and so on. These are principal payments Apple has not had to make before because it just started issuing debt not even three years ago. For example, in 2016, to pay the $2.5 billion principal payment the company has three options: use U.S. cash, which lowers its cash balance, issue new debt to cover the principal payment or use part of its free cash flows. With U.S. cash at multi-year lows, I believe the most likely option of those three is that Apple will issue more debt to cover the principal payments.

Click to enlarge

With the possibility of issuing debt to cover principal payments, combined with all the debt Apple has to issue to maintain or possibly grow its capital return program, I believe Apple could have nearly $100 billion in debt by the end of 2017.

Net Cash

One item I have noticed following Apple is that everyone always touted Apple has "X" billions in cash. However, more recently I have noticed that Apple has "net cash" being used instead, thereby accounting for the large amount of debt issued by Apple. Barring a miracle repatriation tax deal, I see no reason why investors should count foreign cash when calculating net cash. If you look through each transcript for Apple since the beginning of 2013, it spells out where it issues its debt. When adding up total debt issued inside the United States, it amounts to $43.5 billion and outside the U.S. totals $11.6 billion. When you consider that Apple only has $15.7 billion in U.S. cash [see cash data table above], Apple in fact has a negative net cash [net debt] balance of $27.8 billion when looking purely at U.S. cash and U.S. debt only. Therefore, until a point where repatriation occurs or is likely to occur, there is no reason to count foreign cash because it cannot be brought back and used for capital returns. I believe investors should look past the nearly $150 billion in net cash that is always quoted and realize that in fact Apple has net debt when only counting U.S. cash and U.S. debt, which is what really matters most for Apple's capital return program.

Apple Valuation

When valuing Apple everyone always uses total free cash flows, however I believe this is potentially flawed because the majority of sales and profits now come from international sources. Apple breaks down sales by region, however I had to dig through the 10-K to find out how the proportion of earnings that come from international sources.

On page 57 of its most recent 10-K Apple states:

The foreign provision for income taxes is based on foreign pre-tax earnings of $47.6 billion, $33.6 billion and $30.5 billion in 2015, 2014 and 2013, respectively.

By going back and looking at the 2014 and 2013 10-Ks I was able to construct a data table showing foreign vs. U.S. earnings for the last five years. With that data, I was able to estimate how much U.S. free cash flow Apple has for the purposes of conducting a DCF analysis.

Total Pre-Tax Earn.

Foreign Pre-Tax Earn.

U.S. Pre-Tax Earn.

% of Earnings from Foreign

2011

34,205

24,000

10,205

70.17%

2012

55,763

36,800

18,963

65.99%

2013

50,155

30,500

19,655

60.81%

2014

53,483

33,600

19,883

62.82%

2015

72,515

47,600

24,915

65.64%

U.S. Pre-Tax Earn. Growth Rate

25.00%

Average % Foreign Earn.

65.09%

% Earnings from U.S.

34.91%

TTM FCF

62778

U.S. FCF Estimate

21917.62

Click to enlarge

Source: Apple 10-Ks referenced above and Gurufocus

To determine the upside opportunity for Apple, I conducted a discounted cash flow analysis (table below) and found that shares are fairly valued at current levels.

I propose a new formula on what value of free cash flows to use when running Apple through a DCF analysis. This formula accounts for the likelihood or unlikelihood of repatriation occurring. If repatriation is possible, then a portion of foreign FCF can be used when determining the level of FCF as an input for a DCF analysis. Given the political gridlock in Washington and the uncertainty around the election, I would give a 0% chance of repatriation occurring within the next year. The formula could also be adapted in determining net cash referenced above by simply substituting U.S. and foreign FCF for U.S. and foreign cash.

True FCF = U.S. FCF + (Probability of Repatriation within 1yr x Foreign FCF)

I used the above formula for my estimate of Apple free cash flows, the growth rate from the above table and to determine the discount rate & terminal growth rate, I used the following calculators.

Discount rate calculator

Terminal Growth calculator

  • FCF/Share: $21917.62/5594.1 shares = $3.92 FCF/share
  • Proj. Long-term growth rate: 25%
  • Terminal growth rate: 3.46%
  • Discount rate: 8.32%

Fair Value Calculator Assumptions

  • EPS grows for next 5 years.
  • After that, growth levels off to the terminal rate for 15 years.

AAPL

DCF Calculations

CF/Share

PV

Year 1

1

4.90

$4.52

Year 2

2

6.12

$5.22

Year 3

3

7.65

$6.02

Year 4

4

9.57

$6.95

Year 5

5

11.96

$8.02

Year 6

6

12.37

$7.66

Year 7

7

12.80

$7.31

Year 8

8

13.24

$6.99

Year 9

9

13.70

$6.67

Year 10

10

14.18

$6.37

Year 11

11

14.67

$6.09

Year 12

12

15.17

$5.81

Year 13

13

15.70

$5.55

Year 14

14

16.24

$5.30

Year 15

15

16.81

$5.07

Year 16

16

17.39

$4.84

Year 17

17

17.99

$4.62

Year 18

18

18.61

$4.41

Year 19

19

19.26

$4.22

Year 20

20

19.92

$4.03

Fair Value

$115.66

Current Price

$111.44

Upside/Downside

3.78%

Click to enlarge

Closing Thoughts

With Apple, having ever increasing needs for its capital return program, the company must continue issuing large quantities of debt to sustain the program because its U.S. cash balance is the lowest in three years and the majority of its free cash flow comes from international sources. By adjusting free cash flows to account for the probability of repatriation I believe a more accurate measure of value can be achieved. The reason behind that is that foreign free cash flows used to generate international sales do not add a huge benefit to Apple since it is unable to bring back or use those funds within the United States directly. All of this could become irrelevant if tax reform were to occur and Apple could have access to its foreign cash.

Disclaimer: See here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.