Note: This blog post was originally written on December 30, 2012 when the stock was trading for $510, prior to a two day run up in the stock. While the stock is not as inexpensive at the moment, the thesis still holds true.
We all know the legend of Steve Jobs and Apple’s history of revolutionary products over the past decade. I have a Toshiba laptop, an HTC smartphone, and an Asus tablet. The only thing Apple-related I use is iTunes, and I have downloaded at most 15 songs on it. Regardless, I personally think Apple is a great company that makes great products. After the stock dropped about 30% from its recent September high, I thought there might be an opportunity to get in, so I finally dove into Apple’s 10-K for the first time.
My analysis revealed two things that I have not seen discussed anywhere else, which surprised me greatly. The first is that, like an insurance company, Apple (AAPL) has float, which is a tremendously wonderful asset to have and reduces Apple’s cost of capital. Second, an investment in Apple at these prices ($510/share on 12/30/12) represents a free option on whatever Apple rolls out next. I will discuss each of these items individually.
Many readers might be confused by the term “float”, especially when applied to a non-insurance company. An insurance company collects premiums up-front from policy holders. Over time, that cash collected by the insurance company will be used to pay claims as they are incurred. A lot of time can pass in the mean time, and during that time, the premiums collected up-front but not yet paid out is referred to as “float.” Many insurance companies lose money on the actual insurance underwriting but make up for it by investing the float and realizing a solid return.
Float is generally a term only applied to insurance companies. However, the concept can be applied to other industries. Conceptually, a non-insurance company can collect cash from its customers before it pays its vendors. This situation is very rare for any non-insurance company since the cost to deliver product or services is usually paid before the cash from the sale of those products or services is received. A company that can force customers to pay quickly and can force vendors to wait for payment has tremendous bargaining power with both parties. As you might imagine, this type of company would be very difficult to compete with since cash is king. So when I find a non-insurance company with float, I know that there is a very good chance the company has a durable competitive advantage that will allow it to realize outsize returns for quite some time.
There are two indicators for determining if a company has float, one direct and the other indirect. The direct indicator involves simply calculating non-cash working capital in conjunction with free cash flow. If the company’s current operating liabilities exceed current operating non-cash assets and the company is generating a healthy amount of operating cash flow net of capital expenditures, then the company‘s operations are in essence being financed by the company’s suppliers.
The indirect indicator verifies the existence of float and involves the cash conversion cycle. The cash conversion cycle is a measure of how quickly a company converts a product or service into cash. Without getting into the math, it adds the time to sell a product after it is added to inventory to the time to collect the cash from the customer after the product is sold and subtracts the amount of times it takes to pay the supplier after the liability is first incurred. Using simple numbers, say a company takes 30 days to sell a new product and another 30 days to collect cash from the customer after the sale but pays its suppliers 20 days after first purchasing the product to re-sell. In this example, this hypothetical company has a cash conversion cycle of 40 days (30+30-20). It can get more complex if you factor in interest, but that is the gist of it. A company with a cash conversion cycle below zero collects its cash from the sale before it pays suppliers and verifies the existence of float.
So how does Apple measure up using these two indicators? The simple answer is that Apple’s float is the strongest I have ever seen for a non-insurance company. As of September 29th, 2012, the company had, by my calculations, $20B in float and, per Morningstar, a cash conversion cycle of negative 52. How does that cash conversion cycle measure up to other very well-known and enormous cash cows, such as Google, Microsoft, and Wal-Mart? The answer might surprise you. Below is the cash conversion cycle for each company going back to 2003 per Morningstar (Google’s 2012 is for the trailing twelve months ended in September 2012).
What is the significance of having float other than an indication of strong bargaining power? In short, this situation is tremendous and rare. It means that Apple’s suppliers are financing its operations and likely at very low, if any, implicit interest cost. It is very difficult to compete with a company that is financed by its own suppliers. It further results in lower cost of capital. I would argue that the implicit financing cost by the suppliers is approaching zero. Meanwhile, Apple invests that float and earns about 1% per annum. Apple has no interest-bearing debt. As a result, Apple’s cost of debt is actually negative. Further, the ability to force your suppliers to finance your operations also creates an economic benefit that I think actually reduces the cost of equity because it greatly lowers the risk inherent in the company’s operations. Total cost of capital is, of course, a weighted average of the cost of debt and the cost of equity. Treating the float as debt with a negative cost and reducing the cost of equity for the strong business model yields a relatively lost total cost of capital. I would argue that Apple’s total cost of capital is around 8-9%, though I use a slightly higher discount rate for my valuation in the interest of conservatism.
Analyst revenue and earnings estimates are far higher than mine yet my valuation of the company indicates the company is currently undervalued. The implication is that the market is using a far higher discount rate than I am. I think this is clearly a mistake that will be corrected in time.
Apple Stock = a Free Option
This may throw some people for a loop, but I actually see Apple at these prices as a free option on whatever product category they roll out next (looking at you, Apple TV). I say that because I think unrealistically low expectations or an unrealistically high discount rate is currently priced into the stock, thereby protecting the downside (i.e., the risk of the stock permanently declining from these prices is very low). Using a higher discount rate of 10% and assuming company revenue and margins decline going forward, the stock is fairly valued right now. Using more reasonable but still moderate growth assumptions and assuming no new product category is introduced, the company is undervalued. In other words, one could invest in Apple right now at these prices (currently selling for roughly $510/share) and expect to realize capital gains due to the success of just the product categories they currently have. A new product category would just be gravy – a new product would likely have a significant impact on company performance and the stock price. Therefore, not only is Apple a free option on future product categories at these prices, it is an option that you are compensated for holding via capital gains and dividends resulting from performance in just the product categories the company is already in. Further, this option does not ever expire, so you can avoid entirely the time decay factor that makes option investing so difficult.
Disclosure: Long Apple (AAPL)