Should You Buy Apple, Foxconn, Or Both?
IntroductionOur model portfolios include positions in Apple (NASDAQ:AAPL) but not Foxconn (2354.TW) (TPE.2354) (HHPD.IL) primarily because we, like most U.S.-based analysts, tend to focus on U.S. and Canadian stocks. But since we have recently expanded our coverage of analysis to include 36 countries and more than 15,000 stocks (so far), we decided that we should also expand the universe of stock that we consider for our model portfolios.Our analysis focuses heavily on free cash flow.
From our analysis, we can identify companies that consistently allocate capital efficiently and have significantly higher potential for future growth and appreciation. Also, cash does not lie.What is Free Cash Flow?It is important to understand the difference between CF (operating cash flow) and FCF (free cash flow). CF is all the cash generated from operations before the company uses any of it for things like buying back shares of the company stock, paying dividends, capital investments to maintain the company assets and debt retirement (paying the principal).
A company can have positive CF, but at the same time have negative FCF. To make up the difference, it will either need to issue more shares, diluting existing shareholders, or issue more debt (borrow either from financial institutions or by issuing bonds).FCF is what is left over after the company has already reinvested in its property, plant and equipment to maintain and grow the business.
This is the big difference between CF and FCF. A company with a very capital intensive business, like a utility, must continuously use its cash flow to maintain the earnings potential of its assets. Many companies must raise cash (issue shares or debt) every year in order to meet the needs of the business model because the business does not generate enough cash to cover operations, dividends and capital expenditures.
Fortunately, neither Apple nor Foxconn is faced with such problems. Both generate healthy FCF to fund continued growth and rising dividends.Why We Prefer Free Cash Flow AnalysisEPS (earnings per share) can be manipulated and is by many U.
S.
companies.
The gap between GAAP earnings and "adjusted" (or headline reported) earnings has expanded fairly consistently since the financial crisis, as more and more companies reclassify certain expenses as non-operational to make their respective numbers. The GAAP EPS for the S&P 500 in 2016 was below the level it was in 2011. Five years with no "real" growth in EPS! But adjusted EPS is doing great.
It makes me wonder when company executives will run out of ways to engineer more EPS growth.Executive stock option compensation is not included in adjusted EPS; neither are asset impairments or restructuring costs. When management pays too much for an acquisition, it can reclassify its mistakes and still hit consensus EPS estimates by excluding those costs.
After all, that does not affect current operations, does it? It is a non-cash accounting entry, not a cost of doing business. Right. And we are supposed to believe that when they paid for the acquisition, they did not use cash or dilute existing shareholders.Return of shareholder equity is becoming less useful as well since companies have been buying back shares at record levels again.
The last time companies were buying back so much stock was back in 2007. Some companies now have negative shareholders' equity because the amount paid for the stock bought back by the company is more than all of the retained earnings ever created by the company since it was formed. The smaller the equity number becomes the better the return on equity becomes.
P/E (price to earnings) ratio analysis (the simplest form of valuing stocks) is also becoming less relevant because of both the buybacks that increase the P/E even when earnings are flat and because of the manipulation of reported earnings.But they cannot fudge cash (at least not yet) and that is why we focus on what is real and does not change over time.So how do Apple and Foxconn stack up when we compare them? We will take a look at the more familiar company, Apple, first and then look at Foxconn, pointing out what we like and what could be better.
Apple by the NumbersOne thing that we like about Apple is that the company always reports GAAP EPS. It does not use smoke and mirrors to make its results look better. It does not need to. Another house thing we like about the company is that it consistently (that is a very important word to us) produces huge amounts of free cash flow.
Momentum investors want a new blockbuster product offered every year. Investors just want to know that the company allocates its capital efficiently enough to increase sales and earnings over time. We are patient. Investing for the long term requires that of us.
Below is a table for Apple of relevant ratios that we produce on each stock we cover (we call it a datafile):What we would like readers to notice first is that our estimated fair value (Main Street Price) is higher than the current market price (Wall Street Price). Unfortunately, the market price is no longer below the bargain price that we target for entering a new position. Our Main Street Price is updated every quarter based upon the most recent TTM (trailing twelve months) of results reported by each company.
We update the ratios every month to show changes due to fluctuations in the market price.Next, I want you to see the Super Six boxes Score at the top of the datafile. Apple ranks as a five out of a possible six.
The only category where it falls short is because the market price is above the bargain price. That means that the company is still performing very well.Now, move on down the right side of the table (second column from the right margin) to find the FROIC ratio.
FROIC (free cash flow return on invested capital) currently stands at 21 percent. Anything above 20 is excellent in this category and very few stocks can hit this level consistently. FROIC measures how much free cash flow a company produces from each $1 it invests in the business.
So, for every $1 Apple invests in its business, it produces 21 cents of future free cash flow. That is awesome!Now, look at the next row down; cap flow ratio. This ratio measures how much of each dollar of cash flow the company must use to maintain its business and continue to grow.
Anything below 33 percent is excellent as it means that the company can grow without devoting an excessive amount of its cash to maintaining its existing assets. The lower this number is the more cash that can be available for new product development or acquisitions to foster additional growth.The next row is what we call Badwill. This is really a measure of boxes the value of goodwill and intangible assets carried on the books relative to total assets.
When this number is over 33 percent, we tend to consider looking elsewhere. There are exceptions to this rule for me, but it requires additional analysis to determine whether or not management is allocating capital efficiently and not overpaying for acquisitions. Anything under that 33 percent level is fine.
The Friedrich Cash Machine is merely a measure of how much free cash flow is generated from each dollar of revenue. We like companies that consistently produce a ratio above 15 percent. Below that level is okay but generally is not as apt to lead to future outperformance.
Here, again, consistency over time is the key. Once again, Apple is consistently excellent in this category.The Friedrich Equalizer simply tells us at a glance whether the company is increasing revenue or not.
If it is higher than the Friedrich Cash Machine, the company has its total revenue growing. Earnings can go up while revenue is going down. We are looking for companies that are growing, not just cutting costs or buying back stock.
Apple is not blowing the doors off in this area and even had a slightly down year in 2016, but we think it will return to form again in 2017.At this point, I should explain the color coding: green is excellent, gold is good, yellow is average and red is bad. A little red in a spot or two occasionally is nothing to worry about as long as it is not in one of the six categories above.
Even when the Friedrich Equalizer goes red for one year, we do not necessarily fret. Two consecutive years requires us to dig deeper to find out if something is going wrong.If there is nothing red in the Bankruptcy or Fraud Centers, we then skip down to the other very important row called Price to Bernhard/Buffett ratio, or price to FCF.
This is named after two legendary investors we both admire: Arnold Bernhard (founder of Value Line Investment Survey) and Warren Buffett, the Oracle of Omaha. Both of them use the price to FCF ratio extensively in their respective analysis. So do we. This ratio tells us how well the company is performing relative to the market price.
When this ratio gets below 15, all other things considered, it is a bargain. At nearly 19, Apple is not currently a bargain (by our standards) but neither is it expensive.Foxconn by the NumbersThat is the highlights of how to assess the datafiles our algorithm creates.
Now we will continue on to take a look at Foxconn. Please note that our data provider for foreign stocks only goes back for five years rather than the 10 we generally have available for U.S. stocks, so this next datafile will look a little different.
FROIC for Foxconn is lower than for Apple but consistently putting up good results. This is the only one of the Super Six Score categories on which the company falls short. In the two years during which this ratio fell below 10 (which is still a good score, just not excellent) it was just barely below that level.
The company also scores consistently very well in the other five primary categories except in the Friedrich Equalizer. This ratio suffers from the cyclical nature of its business with new models of the iPhone not released in every year. But it should be noted that management is still able to consistently manage the cost structure to produce good free cash flow from the business.
That is impressive.
The Bankruptcy Center looks clean, but there is one blip in the Fraud Center under the Beneish Score. This measures potential manipulation but does not raise a red flag unless it is a frequent violator. Foxconn does not score poorly here except in one year.
A score above -.
222 signals "potential" manipulation and tells us to look deeper into the cause if it is recurring.Finally, we want to check the Price to Bernhard/Buffett ratio to see if the stock is priced at a bargain. Low and behold, we find Foxconn has a score of only 5.
47! Remember that we mentioned above that the lower the score the better and that anything below 15 is a bargain? At the current price, this company is truly a bargain with plenty of potential to grow.The Buffett factorWe would be remiss if we did not mention that Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) recently increased its stake in Apple by nearly tripling its holdings in recent months.
That is a strong vote of confidence by an investor that knows the value of free cash flow. Here is a link to the news about the Berkshire increasing its investment in Apple to $19.2 billion.ChartsFinally, we want to show our charts for the two companies together to see how a quick glance can show when a stock becomes a bargain in price.
Note that the three lines on the charts represent: white = Wall Street Price (market price); yellow = Main Street Price (estimated value); green = Bargain Price (buy); and red = Sell Price (extremely overvalued).The Wall Street Price for Apple is now above its Bargain Price but below the Main Street Price so we rate it as a strong Hold. The Wall Street Price for Foxconn is below both the Main Street Price and the Bargain Price so we rate this one as a Buy.
Apple pays a dividend yielding 1.
65 percent.
Foxconn paid a cash dividend last year yielding 5.2 percent along with an additional stock dividend of about 1.3 percent. You can find a table of dividend history for Foxconn here.
Do not be fooled by the company name of Hon Hai in Chinese. It is Foxconn Technologies.How to Invest in Foreign Stocks at Reasonable CostI generally use Interactive Brokers as my online broker as it enables investing activity on exchanges in 20 countries. For Foxconn, which is listed in its native Taiwan, the only way I could find to trade its stock is through GDRs (global depository receipts) on the LSE (London Stock Exchange).
This link takes you to a quote for the Foxconn GDR on the LSE.Below is a table showing the commission rates charged by Interactive Brokers for trading in the United Kingdom. The third row from the top would be applicable for Foxconn since it is quoted in US$:This seems very reasonable to me.
To check out commissions for other countries, follow this link and scroll down for listing in North America, Europe and Asia/Pacific regions.It seems that Seeking Alpha is beginning to establish a more global footprint, so we thought we would help a little by including some global analysis.As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can.
The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge. Don't forget to hit the "FOLLOW" button at the top of the article next to my name to keep up to date on my next moves and full accounting of results for the strategy.For those who would like to learn more about my investment philosophy, please consider reading "How I Created My Own Portfolio Over a Lifetime.
"Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.
Disclosure: I am/we are 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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please
From our analysis, we can identify companies that consistently allocate capital efficiently and have significantly higher potential for future growth and appreciation. Also, cash does not lie.What is Free Cash Flow?It is important to understand the difference between CF (operating cash flow) and FCF (free cash flow). CF is all the cash generated from operations before the company uses any of it for things like buying back shares of the company stock, paying dividends, capital investments to maintain the company assets and debt retirement (paying the principal).
A company can have positive CF, but at the same time have negative FCF. To make up the difference, it will either need to issue more shares, diluting existing shareholders, or issue more debt (borrow either from financial institutions or by issuing bonds).FCF is what is left over after the company has already reinvested in its property, plant and equipment to maintain and grow the business.
This is the big difference between CF and FCF. A company with a very capital intensive business, like a utility, must continuously use its cash flow to maintain the earnings potential of its assets. Many companies must raise cash (issue shares or debt) every year in order to meet the needs of the business model because the business does not generate enough cash to cover operations, dividends and capital expenditures.
Fortunately, neither Apple nor Foxconn is faced with such problems. Both generate healthy FCF to fund continued growth and rising dividends.Why We Prefer Free Cash Flow AnalysisEPS (earnings per share) can be manipulated and is by many U.
S.
companies.
The gap between GAAP earnings and "adjusted" (or headline reported) earnings has expanded fairly consistently since the financial crisis, as more and more companies reclassify certain expenses as non-operational to make their respective numbers. The GAAP EPS for the S&P 500 in 2016 was below the level it was in 2011. Five years with no "real" growth in EPS! But adjusted EPS is doing great.
It makes me wonder when company executives will run out of ways to engineer more EPS growth.Executive stock option compensation is not included in adjusted EPS; neither are asset impairments or restructuring costs. When management pays too much for an acquisition, it can reclassify its mistakes and still hit consensus EPS estimates by excluding those costs.
After all, that does not affect current operations, does it? It is a non-cash accounting entry, not a cost of doing business. Right. And we are supposed to believe that when they paid for the acquisition, they did not use cash or dilute existing shareholders.Return of shareholder equity is becoming less useful as well since companies have been buying back shares at record levels again.
The last time companies were buying back so much stock was back in 2007. Some companies now have negative shareholders' equity because the amount paid for the stock bought back by the company is more than all of the retained earnings ever created by the company since it was formed. The smaller the equity number becomes the better the return on equity becomes.
P/E (price to earnings) ratio analysis (the simplest form of valuing stocks) is also becoming less relevant because of both the buybacks that increase the P/E even when earnings are flat and because of the manipulation of reported earnings.But they cannot fudge cash (at least not yet) and that is why we focus on what is real and does not change over time.So how do Apple and Foxconn stack up when we compare them? We will take a look at the more familiar company, Apple, first and then look at Foxconn, pointing out what we like and what could be better.
Apple by the NumbersOne thing that we like about Apple is that the company always reports GAAP EPS. It does not use smoke and mirrors to make its results look better. It does not need to. Another house thing we like about the company is that it consistently (that is a very important word to us) produces huge amounts of free cash flow.
Momentum investors want a new blockbuster product offered every year. Investors just want to know that the company allocates its capital efficiently enough to increase sales and earnings over time. We are patient. Investing for the long term requires that of us.
Below is a table for Apple of relevant ratios that we produce on each stock we cover (we call it a datafile):What we would like readers to notice first is that our estimated fair value (Main Street Price) is higher than the current market price (Wall Street Price). Unfortunately, the market price is no longer below the bargain price that we target for entering a new position. Our Main Street Price is updated every quarter based upon the most recent TTM (trailing twelve months) of results reported by each company.
We update the ratios every month to show changes due to fluctuations in the market price.Next, I want you to see the Super Six boxes Score at the top of the datafile. Apple ranks as a five out of a possible six.
The only category where it falls short is because the market price is above the bargain price. That means that the company is still performing very well.Now, move on down the right side of the table (second column from the right margin) to find the FROIC ratio.
FROIC (free cash flow return on invested capital) currently stands at 21 percent. Anything above 20 is excellent in this category and very few stocks can hit this level consistently. FROIC measures how much free cash flow a company produces from each $1 it invests in the business.
So, for every $1 Apple invests in its business, it produces 21 cents of future free cash flow. That is awesome!Now, look at the next row down; cap flow ratio. This ratio measures how much of each dollar of cash flow the company must use to maintain its business and continue to grow.
Anything below 33 percent is excellent as it means that the company can grow without devoting an excessive amount of its cash to maintaining its existing assets. The lower this number is the more cash that can be available for new product development or acquisitions to foster additional growth.The next row is what we call Badwill. This is really a measure of boxes the value of goodwill and intangible assets carried on the books relative to total assets.
When this number is over 33 percent, we tend to consider looking elsewhere. There are exceptions to this rule for me, but it requires additional analysis to determine whether or not management is allocating capital efficiently and not overpaying for acquisitions. Anything under that 33 percent level is fine.
The Friedrich Cash Machine is merely a measure of how much free cash flow is generated from each dollar of revenue. We like companies that consistently produce a ratio above 15 percent. Below that level is okay but generally is not as apt to lead to future outperformance.
Here, again, consistency over time is the key. Once again, Apple is consistently excellent in this category.The Friedrich Equalizer simply tells us at a glance whether the company is increasing revenue or not.
If it is higher than the Friedrich Cash Machine, the company has its total revenue growing. Earnings can go up while revenue is going down. We are looking for companies that are growing, not just cutting costs or buying back stock.
Apple is not blowing the doors off in this area and even had a slightly down year in 2016, but we think it will return to form again in 2017.At this point, I should explain the color coding: green is excellent, gold is good, yellow is average and red is bad. A little red in a spot or two occasionally is nothing to worry about as long as it is not in one of the six categories above.
Even when the Friedrich Equalizer goes red for one year, we do not necessarily fret. Two consecutive years requires us to dig deeper to find out if something is going wrong.If there is nothing red in the Bankruptcy or Fraud Centers, we then skip down to the other very important row called Price to Bernhard/Buffett ratio, or price to FCF.
This is named after two legendary investors we both admire: Arnold Bernhard (founder of Value Line Investment Survey) and Warren Buffett, the Oracle of Omaha. Both of them use the price to FCF ratio extensively in their respective analysis. So do we. This ratio tells us how well the company is performing relative to the market price.
When this ratio gets below 15, all other things considered, it is a bargain. At nearly 19, Apple is not currently a bargain (by our standards) but neither is it expensive.Foxconn by the NumbersThat is the highlights of how to assess the datafiles our algorithm creates.
Now we will continue on to take a look at Foxconn. Please note that our data provider for foreign stocks only goes back for five years rather than the 10 we generally have available for U.S. stocks, so this next datafile will look a little different.
FROIC for Foxconn is lower than for Apple but consistently putting up good results. This is the only one of the Super Six Score categories on which the company falls short. In the two years during which this ratio fell below 10 (which is still a good score, just not excellent) it was just barely below that level.
The company also scores consistently very well in the other five primary categories except in the Friedrich Equalizer. This ratio suffers from the cyclical nature of its business with new models of the iPhone not released in every year. But it should be noted that management is still able to consistently manage the cost structure to produce good free cash flow from the business.
That is impressive.
The Bankruptcy Center looks clean, but there is one blip in the Fraud Center under the Beneish Score. This measures potential manipulation but does not raise a red flag unless it is a frequent violator. Foxconn does not score poorly here except in one year.
A score above -.
222 signals "potential" manipulation and tells us to look deeper into the cause if it is recurring.Finally, we want to check the Price to Bernhard/Buffett ratio to see if the stock is priced at a bargain. Low and behold, we find Foxconn has a score of only 5.
47! Remember that we mentioned above that the lower the score the better and that anything below 15 is a bargain? At the current price, this company is truly a bargain with plenty of potential to grow.The Buffett factorWe would be remiss if we did not mention that Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) recently increased its stake in Apple by nearly tripling its holdings in recent months.
That is a strong vote of confidence by an investor that knows the value of free cash flow. Here is a link to the news about the Berkshire increasing its investment in Apple to $19.2 billion.ChartsFinally, we want to show our charts for the two companies together to see how a quick glance can show when a stock becomes a bargain in price.
Note that the three lines on the charts represent: white = Wall Street Price (market price); yellow = Main Street Price (estimated value); green = Bargain Price (buy); and red = Sell Price (extremely overvalued).The Wall Street Price for Apple is now above its Bargain Price but below the Main Street Price so we rate it as a strong Hold. The Wall Street Price for Foxconn is below both the Main Street Price and the Bargain Price so we rate this one as a Buy.
Apple pays a dividend yielding 1.
65 percent.
Foxconn paid a cash dividend last year yielding 5.2 percent along with an additional stock dividend of about 1.3 percent. You can find a table of dividend history for Foxconn here.
Do not be fooled by the company name of Hon Hai in Chinese. It is Foxconn Technologies.How to Invest in Foreign Stocks at Reasonable CostI generally use Interactive Brokers as my online broker as it enables investing activity on exchanges in 20 countries. For Foxconn, which is listed in its native Taiwan, the only way I could find to trade its stock is through GDRs (global depository receipts) on the LSE (London Stock Exchange).
This link takes you to a quote for the Foxconn GDR on the LSE.Below is a table showing the commission rates charged by Interactive Brokers for trading in the United Kingdom. The third row from the top would be applicable for Foxconn since it is quoted in US$:This seems very reasonable to me.
To check out commissions for other countries, follow this link and scroll down for listing in North America, Europe and Asia/Pacific regions.It seems that Seeking Alpha is beginning to establish a more global footprint, so we thought we would help a little by including some global analysis.As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can.
The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge. Don't forget to hit the "FOLLOW" button at the top of the article next to my name to keep up to date on my next moves and full accounting of results for the strategy.For those who would like to learn more about my investment philosophy, please consider reading "How I Created My Own Portfolio Over a Lifetime.
"Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.
Disclosure: I am/we are 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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please
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