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Henry Blodget writes in Silicon Investor http://www.alleyinsider.com/2008/11/apple-s-stock-aapl-cheap... that Apple is cheap on a free cash flow basis. I agree, but also think he double-counts.

Henry's comments and my response:


"Apple (AAPL) is nearing the low it hit for a few minutes in early October: the mid-$80s. We're going to say again now the same thing we said then: At this level, Apple is CHEAP.

"Excluding the value of its cash, Apple is trading at about 13X trailing EPS. That's cheap for a company with this growth potential. But look at the stock relative to free cash flow instead of earnings (which is appropriate because of the deferred revenue accounting for iPhone sales), and it's really cheap.

"Specifically:

"Apple generated $8.5 billion of free cash flow in fiscal 2008 (through September). Apple's enterprise value at $88 a share is about $56 billion. That's 7X trailing free cash flow.

"7X!

Did you think you'd ever be able to buy Apple for 7X free cash flow? We certainly didn't.

"Could Apple get even cheaper? Of course. Stocks can always get cheaper. But at 7X free cash flow, Apple's stock should have significant valuation support.

"At this level, the market is assuming that Apple will be hammered in 2009--an assumption that is not yet reflected in analysts estimates. Over the next few months, as analysts realize that Apple will, in fact, be hurt by the economy, their estimates will likely come down, and the stock will have a hard time sustaining a rally until they do.

"However: Unless Apple's business collapses and the long-term story changes, we have a hard time believing Apple will trade at 7X free cash flow forever. So we say again: At $88, Apple is cheap, cheap, cheap.


My response:

Henry -

Nice column. I agree Apple (AAPL) looks cheap.

Two minor points:

1) If we subtract $25B in cash from the numerator to get an EV of $56B, then we must exclude the $620M of interest income from the denominator FCF. Otherwise, we double-count.

Here's the analogy: If you buy Apple at its current market value and then put the $25B of cash and securities into your personal checking account, then AAPL loses this nonoperating source of income.

Thus, when using EF/FCF multiples, exclude interest income from FCF. Also adjust taxes to reflect the lower earnings rate.

2) Apple enjoyed a negative investment in working capital of $4.1B in the year just-ended, in part due to the deferred revenue from phone sales, as you point out. Given the size of this source of cash -- about the same as its NOPAT, less interest income -- we need to use some caution here. If phone sales slow at some later date, this source of cash will dry up. Several years ago Dell (DELL) enjoyed robust FCF, in part because it too enjoyed a negative investment in working capital. At the peak in fiscal 2005, Dell's FCF included $2.6B of working capital profit, the result of getting paid first before making the laptop. But last year, Dell's WC profit was just $177M.

Returning to Apple, if you include its $4.1B of WC profit in your FCF definition, keep in mind this source of cash may wither over time, as happened to Dell.


Hewitt Heiserman
Author, It's Earnings That Count (McGraw-Hill, 2004)
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