Financial Alchemist

Apple to Surpass its iPhone Sales Goal of 10M in CY08

2008-10-06T04:03:00.007-05:00

This article was a collaborative effort with:

Andy Zaky from Bullish Cross

Based on the tremendous efforts by members at Mac Observer’s AFB and Investor Village's AAPL Sanity Board member howlongtoretire to track IMEI iPhone numbers, Apple has drastically surpassed analyst’ Q4 iPhone sales estimates, and reached its goal of selling 10 million iPhones in 2008. The consensus estimates for iPhone sales figures for Apple’s Q4 (calendar Q3) were calling for approximately 4 million units. It now appears that Apple has sold at least 7 to 7.5 million iPhones in Q4—that’s nearly 80% above consensus. Apple has far surpassed even Gene Munster’s bullish estimates of 5 million iPhone sales in Q4 according to the data.

At MacWorld 2007, when Apple was trading at the same price it is today, Steve Jobs and Apple set a bold goal of selling 10 million iPhones in 2008. Despite Apple’s consistent reassurances of meeting its goal, bearish analysts repeatedly raised irrational concerns about whether Apple could reach such lofty sales figures. In January, Bernstein Research analyst Toni Sacconaghi, an analyst who rarely comments on Apple, started the “missing iPhones controversy” which led to a herd of naive analysts to reduce their iPhone sales estimates to numbers that fell well below Apple’s 10 million iPhone goal for 2008. Sacconaghi forecasted that Apple would only sell 7.9 million iPhones in the period. This obviously put considerable pricing pressure on shares of Apple in February.

Kathryn Huberty of Morgan Stanley, arguably one of the worst analysts covering Apple, estimated that Apple would only sell 9.3 million iPhones for the year. Apple now appears to be on track to sell nearly double that number. Yet, Huberty and Sacconaghi aren’t the only ones. Keith Bachman of BMO Capital also jumped on the bashing Apple bandwagon in February when he estimated that Apple would only sell 8.5 million iPhones in 2008. Scott Craig of Bank of America also maintained bearish iPhone estimates in February with an 8 million iPhone sales target. Several other analysts followed suit and were obviously dead wrong. One would think these analysts would have learned from their mistakes, yet to no avail we see similar behavior from many of these very same analysts today.

IMEI Number Tracking by Mac Observer’s AFB

An IMEI number or an International Mobile Equipment Identity number is a unique 15 digit code assigned to each individual iPhone found on the back of the box in which an iPhone is packaged. Within this 15 digit code are two 6-digit numerical sequences crucial to determining the number of iPhones being produced. One 6 digit number, known as the TAC, or Type Allocation Code, signifies a particular build or set of iPhones being manufactured. The second 6 digit number is unique to each individual iPhone produced in that particular series—so that 1 million iPhones can be registered to a specific TAC. In other words, one six digit code, known as the TAC, signifies a set of iPhones being produced whereas the other six digit code signifies each individual iPhone within the TAC set.

Members at the Apple Finance Board at Mac Observer have been collecting IMEI numbers from new 3G iPhones sold during the period, and have been maintaining a spreadsheet of iPhone IMEI data points along with the purchase date, model, and production week. By early September, Apple was on its 8^th TAC, meaning that 8 million 3G iPhones had already been manufactured. The actual number of handsets sold versus manufactured depends on a variety of factors including the amount of inventory Apple carries in its retail chain, defects that were destroyed, defects that were sold and then exchanged, display models etc.

However, the latest IMEI data point collected by AFB was 9,190,680—an 8GB Black iPhone recorded as manufactured on September 29 and sold on October 5. This suggests that even if a whopping 1.5 million iPhones of the total IMEI registered devices are unsold as of today, an unlikely assumption, it would still put 3G iPhone sales at 7.6 million units and 2008 iPhone sales at over 10 million units. Coming into the quarter, Apple had already sold 2.42 million iPhones. Thus, 7.6 million 3G iPhones sold puts Apple above 10 million units for the year.

Net Applications OS Market Share:

The Net App OS share measurements based on web usage data lends further support to the IMEI tracking conclusions. In the weeks leading up to the 3G launch, iPhone OS share was rather consistent hovering at 16 bps. During this period, the population of iPhones remained static at 6 million units because inventory dried up weeks before. The share readings began to rise sharply subsequent to the 3G introduction. Due to the volatility and noise present in the data over the quarter, it’s not possible to make granular assessments. However, for the last few weeks of the September quarter, iPhone OS was averaging 34 bps. This suggests iPhone units increased by 6.75M. A small portion of legacy iPhones were replaced by 3G models resulting in those sales having no effect OS market share readings. Sales into the channel are not represented in the Net Applications measurement since the device is yet to reach the end-consumer. This data together with the IMEI Number Tracking by the AFB highly suggests that Apple more than likely sold at least 7 million iPhones in Q4 and that Apple has surpassed its 10 million iPhone target.

See my previous commentary: iPhone Q4 Sales Estimates

Disclosure: Both Authors are Long Apple

Q4 Sales Estimates for Apple's 3G iPhone

2008-09-11T17:12:00.006-05:00

Apple Inc. (nasd:AAPL) $152.65- Apple introduced the new 3G iPhone model on July 11, and sales thus far look to be impressive. Using the OS market share data from Net Applications and the IMEI tracking data from the Mac Observer’s Apple Finance Board, iPhone sales appear to have approached 6 million units since launch. By the end of this quarter (Q4), I predict iPhone sales will reach 7-8 million. Most estimates on the Street are calling for unit sales to come in under 5 million units. Perhaps the most important aspect is the effect on cash earnings. Since Apple spreads iPhone revenue over 8 quarters, reported EPS will see little effect. However, cash earnings should increase more than $2.00.

SUMMARY:

I estimate Apple has sold roughly 6 million 3G iPhones with 3 weeks still left in the quarter. Q4 sales could hit 7 million, or more, with the aid of a couple factors.

1) July 11th, Apple introduced new model at 189 Apple stores and 2,000+ AT&T locations in the US, and internationally in more than 20 countries.

2) August 22nd, another twenty-plus countries launched.

3) September 7th, iPhone went on sale at Nearly 1,000 BestBuy stores.

Supply dried up at all points of sale after the first weekend. Apple stores received the bulk of new shipments as AT&T and foreign providers were strained for several weeks. About mid-August, the production ramp and demand levels showed signs of equalizing. It wasn’t until late August that AT&T stores began to have on-hand inventory since running out on the initial launch. Apple records iPhone sales when shipped to carriers opposed to Apple retail stores, which are recorded when sold to the end-user. As demand is starting to normalize along with Apple’s retail store inventory stabilizing, focus will shift to supplying the channel. This comprises of AT&T stores, foreign carriers from both the July and August launches, and BestBuy. With 6 million likely sold thus far, sales should surpass 7 million by the end of the quarter from replenishing the channel and consumer sales.

NET APPLICATIONS OS MARKET SHARE MODEL:

Net Applications estimates OS market share from internet usage data. Since the 2G iPhone supply dried up in May and June, the installed base essentially remained static at 6.12 million units during that time. As measured by Net Applications, iPhone OS share remained steady at around 16.5 bps for those two months. That equates to roughly 370 units per basis point of market share. Using the share data since the 3G launch, unit sales of the new iPhone model can be estimated.

There appears to be some aberrations in the Net Application survey data as the huge spike in mid-August would suggest. The spike causes the sales estimates to accelerate rapidly and then flatten. If the share data were more normalized, weekly sales estimates would be smoother. Thus, the weekly estimates are volatile, and likely not accurate. Yet, the data probably does give a decent estimation of cumulative sales since the launch.

Here are a several thoughts regarding the spike in web usage seen the week beginning August 8:

1) Certainly the weekly run rate has slowed, as with any new product launch, but definitely not to the degree that the OS share data depicts. Larger proportion of early sales (1st 30 days) versus late sales (2nd 30-days) whereby internet usage is highest right after purchase and fades. Thus, early iPhone purchases caused pronounced acceleration and when usage faded, late iPhones with heavy usage don’t offset the early decline since it’s a smaller portion.

2) There is cannibalization of 2.5G iPhones from upgrades. Original iPhones that become inactive from new 3G purchases won’t increase market share measurements. Of course, some legacy iPhones are sold or passed on.

3) Up until early August, supply was sporadic at Apple retail outlets, and virtually non-existant at AT&T and international carriers. A good number of orders were placed at AT&T outlets, but customers had to wait for their shipments to arrive. It’s possible than many customers who placed orders in July received them at the beginning of August when supply firmed, leading to higher web usage.

AFB IMEI NUMBER TRACKING MODEL:

Members at the AFB board have been collecting IMEI numbers and recording those in a Google spreadsheet. The theory is that the IMEI numbers follow a consecutive sequence, and tracking them can reveal the number of units produced so far. The highest IMEI number submitted so far points to 5.604 million from a iPhone purchased on August 30. Fortune’s Elmer-DeWitt wrote about this approach September 1st. This model corroborates the Net Application data and my calculations, suggesting unit sales have approached 6 million.

STREET Q4 ESTIMATES:

These are the latest estimates that I have been able to find, however they may have been revised since.

Piper Jaffray- 4.5M

Credit Suisse- 4.2M

Pacific Crest- 3.5M

Financial Alchemist- 7-8M

CONCLUSION:

Apple’s 3G iPhone appears to be selling ahead of Street estimates which may provide an opportunity for upside surprise when Apple reports Q4 results in October. Even though demand has cooled from launch day, Apple has to supply the channel which suffered an inventory drought for over a month after the 3G model was released. Domestically, iPhone shipments will go being going to over 2000 AT&T outlets and nearly 1000 BestBuy locations. Abroad, some 50 countries will have their inventories replenished. This should give a boost to iPhone sales as the quarter comes to a close.

Looking at the OS market share data, the focus should be on cumulative units, as opposed to weekly change. I believe that some aberrations in the measurement may have lead to that abnormal spike seen at the beginning of August. This causes the subsequent weekly changes to show a pronounced slowdown which is likely exaggerated. We also must remember that some 3G models replace legacy iPhones which will not increase market share numbers, thus won’t account for new 3G unit sales.

The number to watch will be cash flow when Apple reports. The iPhone has the potential to significantly boost cash earnings. I discussed this implication back at the end of July- Apple’s Cash Earnings. On a cash earnings basis, Apple is very cheap at current levels.

Disclosure: none

Understanding Valuation Multiples with Respect to Cash

2008-08-25T18:01:00.007-05:00

A common mistake I see people make refers to how a firm’s cash stockpile is treated in the valuation process. Specifically, Investors err when they subtract cash from market value before calculating an earnings multiple that includes interest income. P/E multiples are calculated using EPS, or net income per share. This figure includes interest income that is generated from a firm’s cash investments. It’s incorrect to make assertions regarding P/E ratios based on cash/share values. For instance, $100 share price & $5 EPS, and has $20 cash/share, the firm’s P/E is 20x. End of story. No adjustments are to be made, nor should the $20 cash/share have any bearing/relevancy in that scenario. It’s true and only P/E multiple is 20x. The common mistake is to adjust the share price by the cash/share and then divide earnings. Hence: 100-20= 80/5 = 16x. If the $20 cash/share earns 5%, then it contributes $1 to EPS. If cash were eliminated from the calculation, it needs to be done on both sides. EPS would then be $4 not $5, and $80/$4 is 20x. Multiple doesn’t change because the value of the cash was captured in the share price as well as the EPS. Therefore, cash/share doesn’t have any effect on P/E multiples and shouldn’t be part of P/E analysis.

EQUITY VALUE MULTIPLES:

Let’s take Apple (nasd:AAPL) for example: Price = $172.55, Cash/Share = $23.45, FY09 EPS Estimate = $6.06. The forward P/E is 28.5x. The incorrect computation is to subtract cash from the share price before dividing by expected EPS: $172.55 - $23.45= $149.10 / $6.06 = 24.6x. The rationale people give for making this mistake is that one share of Apple represents $23.45 of cash and a business that generates $6.06 in EPS, thus an investor can purchase the earnings stream for $149.10.

Here’s the issue- the cash balance contributes to earnings in the way of interest income. Without the cash stockpile, EPS would be lower. One must not assume that Apple’s FY09 EPS will be $6.06 without interest income, thus a higher multiple should not be assigned on the basis of its high cash/share. In FY07, Apple earned $647 million in interest from its cash holdings, which totaled $15.4 billion at year-end. In per-share terms, interest income contributed roughly 51 cents to Apple’s reported FY07 EPS of $3.93. Apple’s P/E multiple based on FY07 EPS is 43.9x. Without interest income, EPS falls from $3.93 to $3.42, and subtracting cash from share price, Apple’s historical P/E is 43.6x. That’s roughly the same as the multiple calculated with cash included in both price and EPS. The common mistake is not subtracting out interest income from EPS while taking cash out of the share price. Therefore, it’s incorrect to subtract cash from one figure without taking it out from the other figure as well.

Since P/E ratios represent income that includes interest income, the conversation of cash/share is inappropriate, as it has no bearing on value, nor multiples in that regard. It’s incorrect to assert that a firm’s P/E multiple is actually lower because it has a relatively high cash/share, and that one should consider cash/share in tandem with P/E ratio. The cash/share is accounted for in the P/E ratio because it’s a part of the “E” or earnings, which includes interest income. The cash balance is the present value of future interest income, thus the two are the same.

ENTERPRISE VALUE MULTIPLES:

In instances where EBIT or EBITDA figure (Earnings before Interest, Taxes, Depreciation, Amortization) is used in a price multiple, then cash holdings should be considered since interest income (expense) is not captured. Thus, a P/EBITDA multiple makes an incorrect comparison since cash & debt aren’t included in the value of the denominator but are in the share price, or market value of the equity. To properly compare EBITDA, one should use enterprise value, or EV, in place of share price, or P. EV is the market value of the equity plus value of debt minus cash. Therefore, the multiple becomes EV/EBITDA. Cash holdings are excluded from the value figure, numerator, as well as excluded from earnings stream, EBITDA, in the denominator.

CONCLUSION:

To calculate multiples correctly, one shouldn’t include components in the numerator without also including in the denominator. If one is computing P/E multiple, then cash/debt needs to be ignored because those values are captured in the EPS. If one is computing EBITDA based multiples, then EV instead of P, is the correct input for the numerator. Since EBITDA doesn’t account for interest income/expense, then it would be much higher for a debt-laden firm. If share price, P, were used instead of EV, then the numerator would be too low resulting in too low of a multiple. Adding debt to arrive at EV, increases the numerator to coincide with the exclusion of interest expense increasing the denominator as well.

Apple vs Google: Detailed Comparison

2008-08-19T06:32:00.006-05:00

I have been coming across many comparisons between Apple (nasd: AAPL) and Google (nasd: GOOG) lately, especially given that Apple’s market cap surpassed Google’s last week. A recent example is Felix Salmon, who doesn’t think Apple should be worth more than Google as he argues in “Apple vs Google.” Mark Krieger compares Apple to Google and concludes Apple’s valuation is lofty and due for a pullback. The authors do make some great, valid points, yet their conclusion is ultimately flawed due to the failure of comparing on a free cash flow basis. Cash flow, not accounting earnings, determines an asset’s value. For the matter of an Apple-Google comparison, there are significant differences in free cash flow production, hence return on invested capital (ROIC).

I present the following analysis of the similarities/differences between the two firms.

The primary issue I take, is the common fallacy of valuation comparisons using price-earnings multiples. Last month, I wrote a rather detailed analysis about the disconnect between Apple’s reported earnings and its cash flow (Investors Overlooking Cash Earnings). This gap will widen as iPhone sales accelerate. The iPhone accounting treatment calls for its revenue to be recognized over 8 quarters, yet Apple receives cash in the full sale amount when they occur. A very astute Apple analyst, Andy Zaky, whom I highly respect, echoed my viewpoint in his recent commentary- “Apple Should Be Valued on a P/FCF Basis.” Zaky reported that many are making the mistake of comparing Apple to Google based on reported earnings multiples, which he states is inappropriate. Zaky couldn’t be more correct in that assertion. Andy Zaky and myself are not alone in thinking that the P/E as a value metric for Apple is misguided. Stephen Coleman of Daedalus Capital wrote “The price earnings multiple (P/E) is an increasingly useless metric when valuing Apple’s stock price. The reason why is that Apple now uses subscription accounting”

In summary, Apple and Google can’t be compared on a P/E basis because of the differences of accounting treatment and capital spending levels that affect free cash flow. Reported income doesn’t accurately present either firms real story. To better assess and compare Apple and Google, one must examine each firm’s cash earnings, thus P/FCF is a much more suitable metric for comparison.

Price Multiple Comparisons- Apple vs Google:

The first table illustrates the differences between P/E and P/FCF based comparisons. First, let’s compare the cash flow multiples. According to Morningstar, Apple is trading at 25.6x trailing free cash flow compared to Google’s P/FCF of 38.6x. Google’s P/FCF ratio is more than 50% higher than Apple’s, and that’s on a trailing basis. Consider that Apple will probably sell close to as many iPhones in this quarter, as it did in the past year in total. Also, factor in dozens of new countries that the iPhone will soon be offered, as well as increased exposure through Best Buy outlets. iPhone sales are certain to increase free cash flow relative to reported EPS due to the 24 month revenue deferral. As I mentioned in my July analysis, I wouldn't be surprised is Apple could generate more that $10 FCF/shr next fiscal year. Hence, Apple’s free cash flow is poised to increase dramatically. In contrast, Google’s free cash flow growth will likely match EPS growth, if even that. Google’s has high capital spending needs, and even much higher if considering cash spent on acquisitions. A more detailed analysis on the matter will be presented later.

Evaluating P/E multiples: Apple trades at a higher forward P/E- 28.9x vs 20.6x based on expected FY09 EPS. On the surface, this appears to be backwards, since Googles earnings are expected to increase 23% versus Apple’s 16%, it would seem Google should be afforded the higher P/E multiple. Thus, GOOG would appear to be of better value superficially. However, a closer examination reveals that Apple’s multiple isn’t unreasonable, rather uninformative. There are several justifications for Apple’s higher P/E multiple.

First, Apple’s FY09 estimates are most likely too low. Apple has significantly exceeded the consensus estimates for many quarters going back. 16% EPS growth is not inline with Mac sales growth which has been north of 40%. This spills over into hardware and software sales growth which has been growing roughly 30-40% Yr/Yr in recent periods. Music sales has been north of 30%. More iPhones will continue to support that growth. iPod sales have been one area of concern, yet FY08 iPod revenue growth has been stronger than FY07, and with the expected introduction of new iPod models, iPod growth should not significantly falter.

The key issue has been the reduced margin guidance. I believe there are two possibilities: 1) Management is being overly conservative 2) Apple is undertaking a more aggressive strategy. Neither of the two are unfavorable. According to Andy Zaky’s research at Bullish Cross, Apple has a long history of sandbagging on its margin guidance which has enabled Apple to consistently beat EPS numbers. Generally, Apple only exceeds revenue estimates by a slight to moderate margin, yet its EPS continues to come in by a much higher amount. Therefore, it’s very possible that management is being overly conservative. The other possibility is that Apple is actually being candid, but not necessarily a cause for concern. Management alluded to a “new product transition” and I also detected a latent overtone of possibly more competitive pricing. Apple wouldn’t sacrifice margin unless it were to more than offset the ensuing profit reduction with increased sales volume. Why would it? Apple doesn’t have to shrink its margins voluntarily. Historically, it hasn't had to defend market share with price promotion. Thus, Apple may be looking to measurably expand its share with more completive pricing. In short, I don’t expect the lowered margin guidance to negatively impact earnings growth.

Second, FY09 EPS would be significantly higher if Apple didn’t account for iPhone sales using subscription guidelines. This is a key issue many others are missing or just choosing to ignore. Most analysts expect Apple to sell more than 20 million iPhones next year, which may amount to 10 billion in revenue, yet it will be reported over a 2-year period even though resulting cash flow will be received on the front-end. At minimum, under traditional accounting methods, Apple’s FY09 EPS would be at least $1 higher than current estimates. I stress “at least.” That would push Apple’s FY09 growth back above 30%.

Google’s Revenue Demand Outlook:

Google’s main source of revenues is online advertising, notably paid-search. Google dominates as it garners an overwhelming share of search traffic and paid-search ad dollars. Google’s sales growth rate has been decelerating for a couple reasons. First, the “Law of Large Numbers” is beginning to take affect. It’s much easier to increase sales 50% from a revenue base of 1 billion than it is from $10 billion. No growth stock is immune from this inevitable constraint. Second, more importantly, Google is exhausting its growth avenues in paid-search.

The three paths for a firm to increase sales are 1) Market Growth- non-users become new users 2) Increase Market Share- steal current users from competitors. 3) Up-Sell Own Customers- entice current customers to purchase more or pay higher prices.

Google’s rapid growth has originated from the online advertising industry growth, coupled with market share gains within that industry. Generally, as the industry life cycle evolves, firms initially focus on capturing growth as the market expands and attempt to avoid clashing with other industry participants. When industry growth ebbs, firms then look to take share from weak competitors for sustaining sales growth. When low-hanging fruit has been harvested, a firm may attempt to raise prices if it has monopoly power (differentiated product) which assuages customer defection.

What has been Google’s major focus recently? Raising prices. Customers bid on key search terms providing price formation as PPC, or price per click, the amount an advertiser is charged each time a consumer clicks on the sponsored search result. Google has been working on improving quality, hence relevancy of its paid search ads displayed. The goal is to reduce the “bounce rate” which is when a user clicks an advertised link and subsequently navigates off the destination web page without navigating any deeper on the landing site. The advertiser still incurs charges for the traffic sent to its site, however it didn’t produce any value. In theory, the higher number of clicks leading to a sale should be more valuable, thus command higher prices. If Google’s major effort is enhancing ad search value, what does that imply about its other avenues for growth? It basically confirms what is logically apparent. Internet advertising market growth is decelerating as it traverses the path towards saturation. Google’s market share growth has also been decelerating. Both areas are still growing, albeit, at slower rates. The outlook for market share growth is limited. Google already commands an overwhelming majority giving it less room to expand. It has taken so much of the market there is not much more left to take. There will always be room for niche players that provide value by offering an alternative to Google. Yahoo is moving in that direction as it continues to lose share, joining the likes of Ask, MSN, etc. but will be off limits to Google for anti-trust reasons.

This new focus provides clear evidence that Google can’t solely rely on industry growth and share gains to support continued sales growth. Google also needs to find new growth sources aside from online advertising. This is a primary focus as evidenced by the heavy capital spending, research & development, hiring, and new acquisitions. It’s quite nebulous as to how this will all take shape, yet there’s a very good chance that Google will be the pioneer in new market spaces once they evolve.

There is no question that Google will continue to turnout impressive growth, as it’s the leader in a space that should continue to demonstrate above-average growth. And, there are all the other growth opportunities that Google faces. Given its technological leadership and market position, Google has the advantage going into emerging product spaces. The key question in my mind continues to be “Google’s growth- At what cost?” How much of this capital spending and R&D will pay off? How about acquisitions? Can Google get those to add value, specifically YouTube and DoubleClick? Or, will Google destroy shareholder value from investing in areas that fail to produce desired returns? For me, these are the most pressing issues.

Many say that Google is a one-trick pony, and a pony not getting younger at that. Another characterization is Google is Janus-faced: part cash cow,a piggy-bank that will continue to get fatter, coupled with the side that milks the cash cow in efforts to add to its cattle herd. In order for Google’s stock price to move higher, investors will need to see evidence that Google’s spending and investing activities are worthwhile. I published an analysis of Google on March 18, 2008 when shares were trading below $440. I concluded from my analysis and valuation modeling that Google’s fair value was $537. I think that fair value estimate roughly still remains intact today, yet I haven’t done the needed in-depth analysis to ascribe a high degree of confidence to it. My thinking is I would be a buyer under $500 and a seller above $550, absent of any new developments.

Apple’s Revenue Demand Outlook:

Apple’s Mac computers only account for single digit share of the PC market. That share has been increasing at breakneck speed, and there hasn’t been any indications that the trend won’t continue. With the capability of running Windows OS on Mac hardware, the transition barrier has been drastically reduced. Apple’s small market share provides vast room for sales growth. Same could be said about the iPhone. The iPod business may be approaching a saturation point, as I recently evaluated. , however Apple is likely to introduce new models that may lift growth. There is no telling what new products Apple will come up with. They will likely be natural extensions or complements to existing offerings which will allow Apple to leverage its installed base. This is essentially what we have been witnessing as the “halo” effect.

Apple has also not appeared to be as economically sensitive as Google. Mobile phones and computers have become daily needs, whereas online advertising is not. When the economy weakens, consumers will not spend as much or as often on phones and computers, yet the first item axed from corporate budgets is advertising spend.

Apple’s demand outlook is strong, and it generates strong free cash flow due to low capital investment needs and working capital. My view is that Apple’s cash flow prospects are not entirely reflected in its share price causing the stock to be undervalued. Considering how little incremental investment is required to support sales growth, Apple is great company. Assets such as brand equity and human capital aren't reflected on the balance sheet, yet those are critical value-generating assets. With the additional cash flow I expect the iPhone to deliver next year, I believe AAPL will surpass $250 in 2009.

Profit Margins:

Another difference many point out is profit margins. Google has higher net margins than Apple 25% vs 15% (ttm), yet there is a major caveat that shouldn’t be ignored. Net income reported is not the amount of cash that is available to shareholders. Free cash flow is, since it’s net of capital expenditures and other investments using internal cash. The FCF margin (FCF/Sales) is roughly identical for both firms, about 20% in the trailing 12 months. Google’s capex as a percentage of sales is much higher than Apple’s. Additionally, Google has spent large sums of cash on acquisitions recently which I didn't include in the FCF margin calculation reported above. In the last 12 months, Google spent over $4 billion acquiring businesses, or 20.5% of total sales. In FY06, cash acquisitions were 3.8% of sales, and 5.5% for FY07. Therefore, Google may have a higher net margin, yet it must spend heavily on capital assets and acquisitions which results in less remaining cash that could be distributed to shareholders.

Another notable fact: Apple’s net margin has risen from 10.3% FY06, to 14.6% FY07, and is 14.9% in the last four quarters. Google’s net margin has declined, 29% FY06 to 25.3% FY07, and to 24.6% in the trailing four periods.

Capital Investment Requirements:

Apple’s capital expenditures were 2.9% of revenues for the last 12 months according to Morningstar. This has been drifting lower as capex/revenues was 3.4% in FY06, and 3.1% in FY07. Google’s capex requirements are significantly higher as it has averaged north of 14% of revenues for the past year. As mentioned previously, Google has also used cash to acquire businesses which pushes cash investments as percentage of sales above 20%, to be exact 35% for the preceding 12 months. This illuminates the stark difference between Apple and Google many fail to consider.

Operating Expenditures:

Google spends heavily on research and development as evidenced by 12.9% of sales in last 12 months. This has ticked up from 12.8% in FY07 and 11.6% in FY06. Apple’s R&D is much more modest, 3.3% TTM, 3.3% FY07, 3.7% FY06. Google spends nearly 4x as % revenues than Apple, and Google’s R&D has been increasing while Apple’s R&D has been falling/stabilizing

Apple’s selling,general, and administrative expense (SG&A), the technical word for overhead, has been falling as a percentage of overall sales. In contrast, Google’s SG&A expense is higher (%sales) and has been trending in the opposite direction, up. This can partially be attributed to the massive increase in Google’s head count as well as additions to its sales function. The idea behind an internet company is that there are economies of scale, incremental revenue dollars incur lower costs, not higher costs, as sales are spread over fixed cost base. This hasn’t proved to be the case with Google, nor Amazon for that matter. Yet, the caveat is that these two have experienced rapid growth, and are spending in attempts to generate more.

Since Apple’s product categories/markets are more defined, it’s able to spend at a more measured pace to support growth. Being of a more traditional business model, Apple is able to spread overhead expense over higher sales volumes, in effect leveraging its cost structure to boost margins.

Conclusion:

Google spends heavily on capex, acquisitions, R&D, and new hires in attempts to sustain its robust growth. Google’s paid-search business probably won’t be able to sustain above 30% revenue growth for too much longer. It’s likely that growth will gradually fall into the upper to mid-teens where it will stabilize. Google is positioned to capitalize on an immense number of growth opportunities as they are presented. It’s in the driver seat, yet there is some risk Google may spend frivolously on efforts that never come to fruition. Yet, there’s also the potential of huge rewards that cold result from Google’s heavy investing translating into a market leader in new spaces. Google’s new sources or growth are not entirely clear at the moment, opposed to Apple’s growth sources being more defined.

Apple has plenty of room for growth due to its low share of PC and mobile handset market. Apple has built substantial momentum in capturing more share in both markets. Apple has low R&D and capital spending requirements, Margins have been improving, as the desired effects of scale and operating leverage come into play.

Google’s margins are falling as expenses increase, the opposite effects of leverage. This implies that there is an increasing incremental cost of generating an additional dollar of revenue. Thus, in my mind, this suggest Google is hitting headwinds as it has picked the low-hanging fruit.

Apple and Google can’t be compared on a P/E basis because of the differences of accounting treatment and capital spending which affects free cash flow. Reported income doesn’t accurately present either firms real story. To better assess and compare Apple and Google, one must examine each firm’s cash earnings, thus P/FCF is a much more suitable metric for comparison.

Disclosure: None

Apple Inc (AAPL): Are Investors Overlooking Cash Earnings?

2008-07-30T10:27:00.005-05:00

Apple Inc (nasd:AAPL) $157.08: I believe investors have become overly fixated on Apple’s expected accounting income, while ignoring Apple’s impressive free cash flow generating ability. Free cash flow, not earnings reported in the accounting statements, determines the true value of a firm. AAPL’s high margins coupled with minimal capital investment needs, enables it to produce robust free cash flow. Another issue is the iPhone accounting treatment, which conceals the true magnitude of its cash generation. According to my estimations, the 3G model’s cash flow per unit is higher than its predecessor. In addition, Apple receives these cash flows much sooner compared to the old model. Not only will Apple sell many more 3G models, the per-unit impact on cash earnings will be much greater. Therefore, when shifting focus to cash earnings, as opposed to accounting earnings, AAPL looks attractive at current levels.

Earnings Expectations:
At the Q3 earnings call, Apple guided well below expectations for Q4, and gave a weak gross margin forecast for FY09. Shares took a hit and prompted Wall Street analysts to reduce their 4Q08 and FY09 estimates. Consensus estimates for FY08 & FY09 are $5.20 & $6.05, respectively. Early this year, the FY09 estimate was ~$6.50, then drifted lower to ~ $6.35 where it hovered for several months. Since Apple announced its margin guidance, the consensus FY09 EPS estimate has plunged to $6.05.

Apple shares currently trade @ 27x FY09 EPS, with expected annual growth of 16%. A 27x multiple for 16% growth isn’t exactly cheap. However, evaluating Apple on an EPS-multiple basis is misleading due to Apple’s iPhone accounting treatment. Considering Apple’s cash flow/share, the stock looks attractive.

Wall Street estimates are for accounting income- what Apple is expected to report, not what Apple will actually earn. Cash flow is the true metric that matters, not accounting earnings. Accounting earnings are a product of a firm’s finance department, and cash earnings are a product of customer behavior. Thus, one shouldn’t place too much emphasis on accounting income and quarterly estimates.

The amount of cash flow available for distribution to owners determines intrinsic value. Accounting income and cash flow are not the same, and often accounting income is a poor proxy for distributable income, hence intrinsic equity value.

Evolution of Market Expectations:
The 3G iPhone developments- new markets, new revenue model, lower price points, and new features, etc didn’t seem to affect AAPL shares much. However, concerns over Steve Jobs’s health and guidance have pressured shares. iPhone demand has been relentless since the launch as stores struggle to keep supplied. Analysts have raised their forecasts for unit sales, yet earnings estimates have only changed slightly (before CC).

Earlier this year, investors and analysts were questioning whether Apple would achieve its stated sales goal of 10 million units in CY08. Some began to think the iPhone was going to turn out to be a disappointment, and that expectations were certainly excessive. However, iPhone sales projections rose significantly with the June announcement. Many analysts raised estimates to more than 20 million for 2009. Yet, there was then the question of reduced profitability due to the reduced price points. Originally, the thinking was that volume could certainly expand but the effect on the bottom line would be subdued due to shrinking margins. Yet, it was soon agreed that margins won’t be significantly impacted due to the larger-that-originally expected subsidy payment. Instead of receiving a cut of monthly carrier payments over 24 months, Apple will receive an upfront lump-sum payment that is likely equivalent.

So, we have a massive increase for iPhone sales expectations with profitability remaining somewhat intact, yet AAPL shares react moderately and analysts only revise estimates slightly higher. Ostensibly, earnings estimates didn’t change significantly due to the iPhone accounting treatment that spreads revenue over 24 months. Thus, iPhone sales won’t really impact the income statement until a much higher run-rate persists for many quarters so that revenue recognition has had time to catch-up.

Shares reacted little to the June announcement, until somebody pointed out that Jobs looked unhealthy causing the stock to tank. Shares later recovered only to get slammed again after the Q3 earnings call when management refused to elaborate on Job’s health condition. Panic over Job’s health has abated, but concerns regarding Apple’s gross margin guidance and susceptibility to a weakened consumer still linger.

3G Produces More Cash Flow & Sooner:
The transition from shared payments from carriers to an upfront subsidy payment increases Apple’s intrinsic value.

Apple’s cash flow will increase from receiving an upfront, one-time payment opposed to recurring monthly payments. Originally, when an iPhone was sold, Apple only received cash associated with the handset sale, revenue which probably averaged around $430-$440. Apple then would receive $15/mo (guesstimate) for the next 24 months, $360 in total payments, or PV of $319 @ 12% discount rate. Present value of total CF is ~$750/unit, However, this isn’t a very realistic assumption to model. Actual revenue/unit is significantly less due to several reasons.

First, not all units receive full 24 months of payments due to iPhones being lost, stolen, broken, etc. Monthly payments are then attributed to the replacement unit and the original device no longer generates monthly revenue payments. AT&T shares revenue per iPhone customer (activated device), not for each device sold. Thus, Apple has sold two handsets yet only collects $15/mo, or theoretically $7.50 per device.

Second, not all iPhones sold were activated with a participating carrier (unlocked), so a significant percentage of legacy iPhones (maybe 40%-50%) don’t receive carrier payments. Unlocking has actually been beneficial because is has allowed Apple to sell units that it would have never sold, and it has generated product exposure in foreign markets. Yet, for the sake of modeling, and for cash flow comparison between the former and current revenue models, we can’t assume that the average monthly payment is $15 across all units.

Third, many units will be replaced with 3G iPhones before the full 24 months elapses. 2.5G iPhone owners that upgrade to the subsidized 3G model contribute maybe 12 months (or less) worth of payments. Piper Jaffray’s survey on launch day found 38% of 3G buyers were current iPhone owners.
Just for the sake of illustration, assume 50% of iPhones are unlocked (or lost/broken), and one-half of the other 50% upgrade to the 3G model after 12 months. This leaves 25% with 24 months of revenue payments At $15/month shared carrier payment, the average unit revenue/month is $5.63, or $135 over 24 months. Assuming ASP of $430, total revenue/unit is $565 (not accounting for time value of money). Therefore, it’s unrealistic to assume that the legacy iPhone revenue model was bringing in $790/unit ($430 + $15 x 24m)

With the subsidy payment model, there isn’t any uncertainty as to what the actual realized revenue/unit will be, since all payments occur on the front-end. Sales thus far have been skewed towards the 16GB model, which AT&T is offering for $299 with a 24-month contract, or $699 for no commitment. Similar arrangements exist in foreign markets, and the pricing works out to be roughly equivalent on a currency translation basis. So, AAPL could be capturing over $600/unit, a more conservative figure would be $550 or $500. Thus, Apple is likely receiving revenue per unit commensurate to the 2.5G iPhone.

A major point that I feel is overlooked relates to the timing of cash flows. For example, consider the following illustrative assumptions. Apple receives $600 upfront on the 3G opposed to $450 upfront and $150 in total cash payments spread over 24 months for the 2.5G. The accounting will look the same for both models since total revenue/unit is equivalent, and in both cases is recognized over 24 months resulting in revenue of $75 per quarter. Even though both scenarios appear to be similar from an accounting standpoint, the cash flows are different. All cash flow from the 3G hits at the time of the sale, where as just a portion of 2.5G cash flow occurs on the front-end.

To summarize my points:
1) 3G iPhone realized revenue/unit is higher- not every 2.5G iPhone generates shared carrier revenue, and not all units that have attached payments will survive the full 24 months.
2) Time Value of Money- Apple receives 3G iPhone revenue upfront, whereas the previous model entailed deferred revenue payments. Not only is there the opportunity cost of forgone investment alternatives, the cash payments are uncertain.
3) 3G model’s production cost is estimated to be about $55 less that the original model.
4) Demand, demand, demand. More markets, more features, cheaper price. The first iPhone took more than two months to sell 1 million units, which the 3G iPhone surpassed its first weekend.

The new 3G iPhone and revenue model will dramatically boost Apple’s cash flow that should result in a higher valuation. Not only is demand substantially stronger for the 3G model, but the actual revenue/unit realized will be higher, and the cash flow will occur sooner.

iPhone Impact:
If Apple sells 20 million iPhones next year assuming: $500 ASP, 50% gross margin. 30% tax rate, it will generate incremental cash flow of $3.90/share. Assuming that Apple sells 5 million in each quarter, the accounting treatment would only recognize $1.23/share for 2009. Cash earnings are more than 3x higher than reported earnings. Using more aggressive assumptions: $600 ASP, $250 COGS, the iPhone would produce $5.50 CF/share. Subscription accounting would only report $1.72/share.

The assumptions I am modeling for FY09: 20 million units, $350 subsidy, 65% 16GB ($299) & 35% 8GB ($199) = $614 ASP, $233 production cost, 30% tax rate. This calculates out to 5.32B in after-tax cash flow, or $5.92/share.

Apple’s FCF/share (ttm) is roughly $6.84, a price multiple of 23x. In contrast, Apple trades 31x EPS (ttm). I estimate that $1.10 of the $6.84 CF/share is iPhone related, thus FCF/share associated with all other segments is $5.74. With a 25% growth rate, non-iPhone CF increases to $7.18/share in FY09, and adding $5.92 from iPhone, CF for FY09 totals $13.10/share. This figure equates to a price multiple of 12x, and as mentioned previously, Apple is trading 27x FY09 EPS estimate of $6.05.

This is more or less a “back of the envelope” exercise, but the purpose is to illustrate the vast difference between Apple’s cash flow and accounting EPS due to iPhone revenue recognition.

Apple’s Free Cash Flow-
Apple is an impressive free cash flow generator. The primary components of free cash flow are 1) NOPAT- net operating profit after-tax 2) Working-capital requirements 3) Investment in fixed assets (capex).

Apple’s has negative working-capital requirements due to rapid inventory turns. AAPL turns its inventory about every 7 days, or 50x a year. Apple’s collection period for outstanding receivables is slightly more than 20 days, yet it doesn’t pay its suppliers for roughly 90 days. Thus, Apple doesn’t need to sink additional cash into working capital as sales increase since it’s funded through trade credit. This would allow more cash to be distributed to shareholders since it doesn’t need to be retained to fund operations.

Apple’s capital investment needs are quite modest. FY07 capex was $735 million and $893 million for the last 4 quarters. This equates to roughly 3% of revenues, and when depreciation is taken out, net investment is approximately 1.7% of total sales. A sizable portion of Apple’s capital investment relates to retail store growth. Apple’s stores produce extremely high revenue per square foot, as well as attracting consumers unfamiliar with the Apple brand. Retail stores perform a marking function for Apple due their appeal that generates substantial foot traffic. The stores are also ideal for cross-selling Macs to consumers who have come to purchase an iPhone or iPod. Thus, Apple’s retail store strategy has proven to be a very worthwhile investment.

Much of Apple’s assets are intangible, thus not reported on the balance sheet. Intellectual capital and brand equity are just two examples. Relatively speaking, Apple doesn’t have to spend heavily on developing these assets. Apple’s marking spend is 2% of revenue as it enjoys doses of free advertising from the media and word-of-mouth from satisfied users. Apple’s research and development expense is just slightly more that 3% of sales. In comparison, R&D for Yahoo ~16%, Google ~13%, and Amazon ~ 6%.

Conclusion:
In summary, EPS (ttm) is $5.11 or 15% net margin, and free cash flow as a percentage of revenue is 20%. As iPhone sales increase, these two metrics will diverge further, yet the focus should be on cash flow. It’s widely accepted that the iPhone has a much higher gross margin than the overall Apple business, yet due to subscription accounting, the iPhone’s impact on overall gross margin is very minimal. Thus, panic over the gross margin forecasts is misguided because on a cash basis, gross margins would be much higher. Investors should then place less weight on Wall Street earnings estimates. Therefore, when evaluating Apple on its prospective cash flows, shares look attractive under $160.

Disclosure: None

Authentidate (ADAT): Exploding Demand for Shares

2008-07-27T18:11:00.004-05:00

Authentidate Holding Corp. (Nasdaq: ADAT) $0.78- Authentidate has been on a tear recently with shares up 189% from an all-time low of $0.27 reached on July 7. In May, I wrote about ADAT when it was trading at $0.43 and recommended the stock since I believed it was undervalued. Since its trading low, daily volume has averaged 108k for the subsequent 14 trading sessions. For the 14 sessions prior to its low, ADAT’s average daily volume was 17k. Hence, there has been strong demand for ADAT shares. This trend bodes well for continued share price appreciation.

I think there are a couple factors responsible for the recent rally. First, ADAT is a good value with $0.53 cash/share and is expected to reach cash flow breakeven in the next 2-3 quarters. Second, ADAT recently announced a new joint venture with EncounterCare Solutions, Inc. (OTC PK: ECSL that represents its entry into a new market vertical. This new segment offers a significant opportunity for revenue growth and profitability.

ExpressMD Joint Venture Press Release (June 10, 2008):

The joint venture called ExpressMD^TM Solutions will provide in-home patient vital signs monitoring systems and services to improve care for patients with chronic illnesses and reduce cost of care by delivering results to their health care providers via the Internet. ExpressMD Solutions will combine EncounterCare's Electronic House Call^TM patient vital signs monitoring appliances with a specially designed web-based management and monitoring software module based on Authentidate's Inscrybe^TM Healthcare platform. ExpressMD Solutions will enable unattended measurement of patients' vital signs and related health information. Patients' data will then be securely sent electronically to each patient's health care provider for review. ExpressMD Solutions will be designed to aid wellness and preventative care, and deliver better continuity of care to specific patient segments such as the elderly, special needs or pediatric patients with chronic illnesses who require regular monitoring of serious medical conditions.

According to a January 2008 research study conducted at the State University of New York at Fredonia, the demand for patient monitoring systems in the primary healthcare sector in the United States is forecast to increase 5.9 percent per year to an estimated $12 billion market by 2012 based on expected contributions to positive therapeutic outcomes and efficiencies. Additionally, the study indicates that the market for self-monitoring activities will also expand as treatment for chronic care patients, especially patients with asthma, diabetes and heart disorders focuses on preventative care.

Using ExpressMD Solution's offerings health care providers will be able to easily view their specific patient's vital statistics and make adjustments to the patient's care plans via the Internet. ExpressMD Solution's easy to use patient monitoring system is intended to provide patients with increased peace of mind and improved condition outcomes through a combination of care plan schedule reminders and comprehensive disease management education on their in-home communication unit. The service will provide intelligent routing to alert on-duty caregivers whenever a patient's vital signs are outside of the practitioner's pre-set ranges.

Health care providers and health insurers also are expected to benefit by having additional tools to improve patient care, and reduce overall in-person and emergency room patient visits.  "EncounterCare's expertise with in-home patient monitoring technologies and Authentidate's expertise in online healthcare systems and securely managing patients' documents has allowed us to shorten the development cycle and ready this solution for delivery in record time," said Ron Mills, CEO of EncounterCare Solutions, Inc.  "The ExpressMD Solutions joint venture will allow Authentidate and EncounterCare to leverage existing portions of our respective healthcare products as well as existing healthcare industry relationships from both companies," said Ben Benjamin, President of Authentidate Holding Corp. "The telemedicine market is a large market that we believe will benefit from our document management capabilities. By entering this market through a joint venture, we will be able to strongly penetrate an emerging market, while expanding the use of our platform within the health care community.

ExpressMD Signs First Contract with Cyntrist:

On July 8^th, it was announced that Authentidate and EncounterCare had signed their first user contract with Cyntrist, for use in remote monitoring of Diabetes patients located through out the Southeastern U.S. The opportunity in the Diabetes space is colossal. In a recent study, the CDC reported that 24 million Americans (8% of population) are afflicted by Diabetes, a number which has increased by more than 3 million in just two years. The ExpressMD solution provides physicians with the ability to remotely monitor patients’ glucose levels, weight, etc. on a daily basis and adjust treatment as needed. Not only does this enhance the quality of patient care, it reduces the need for regular office visits, thus reducing the cost of medical care. The advantages are compelling, and with such a large addressable market, ADAT may benefit substantially.

Conclusion:

The recent news comes after Authentidate management had stated that they believed cash flow break-even could be attained by CQ1 2009. The implication was that existing business was likely sufficient to attain that goal, for it was an issue of customers ramping up implementation. Now, with these recent developments regarding the ExpressMD joint venture, Authentidate’s prospects have become even brighter.

A Look at the 3G iPhone's Profitability

2008-07-15T18:19:00.003-05:00

Apple’s 3G iPhone appears to be quite profitable. The fully subsidized price from AT&T is $199/$299 for the 8GB/16GB models, respectively- requiring a 2-year contract. If a current AT&T customer has recently purchased a discounted phone, then the price may increase up to $399/$499, depending how much subsidy AT&T needs to recover on the old phone. Without a 2-year contract from AT&T, the iPhone will cost $599/699.

The actual amount Apple receives per iPhone is uncertain. Wall Street analysts estimate AT&T is paying a $300-$350 subsidy. The AT&T pricing scheme suggests the subsidy may be as high as $400 per unit.

Even though $200 is the industry standard for smart phone subsidies, there are many reasons that support the higher estimates.

1) AT&T is increasing data plan by $10/mo and no longer offering 200 free text messages. Most iPhone plans will increase by $15/mo. This equates to a $360 increase over the life of the contract.
2) AT&T’s average revenue per user (ARPU) is roughly $50/mo, where the iPhone ARPU is north of $90/mo. Thus, iPhone users generate $960 more per 24-month contract.

Therefore, a $350 subsidy is quite reasonable and perhaps conservative. Using this assumption, Apple receives $550/$650 from AT&T.

A recent estimate by iSuppli puts the production cost at $173 for the 8GB unit. The 16GB model adds only $16 more to cost; yet it sells for $100 more than the 8GB device. Gross profit for the 8GB model is $376 at a selling price of $550. The 16GB model has a gross profit of $460 selling at $650. The gross margins calculate to 68% and 71% for the 8GB/16GB, respectively.
The 16GB adds $84 in incremental gross profit, or nearly a $1/share per 10 million units. Thus, the model mix can significantly impact the income statement.

Initial data suggests that consumers are favoring the 16GB model. This is very positive since the $16GB produces $100 more in revenue and has a higher gross margin.

According to the retail store availability information on Apple’s website, the 16GB model has been dramatically outselling the 8GB model. However, one problem is the supply of 8GB versus 16GB is unclear. Early Saturday, Apple’s website reported 20 stores sold-out of 8GB, versus 28 stores sold-out of 16GB-white and 53 for the 16GB-black. This indicates significantly higher demand for the 16GB models.

It’s also likely that Apple had a larger stock of 16GB devices due to higher demand for larger capacity historically. In addition, it’s less advantageous to carry to little stock of the higher-priced model since running out of the 8GB may persuade a consumer to trade up to the 16GB. Conversely, higher supply of 16GB models prevents losing potential sales of the higher-priced model when a stock-out forces one to purchase the cheaper model.

A survey by Piper Jaffray of 283 line waiters this weekend reported that 66% planned to purchase the 16GB model. This ratio of 2:1 would support the data gleaned from Apple’s website regarding iPhone availability.

Regions Financial (RF): Due for a Bounce?

2008-06-18T23:36:00.005-05:00

Regions Financial (nyse:RF) has plummeted to $11.40 from its July 2007 levels of $32. For most of 2008, RF traded in the $18-22 range, but since May, RF has been on a pronounced downtrend. It’s also important to note, that the regional banking group as a whole, has been extremely weak for the past several weeks. Regions fell 7.4% on Tuesday, June 17th, and then fell 10.4% on Wednesday. In the last 30 days, RF has plummeted 45%. Also under pressure are Suntrust (STI), Key Corp (KEY), Fifth Third (FITB), BB&T (BBT), and Wachovia (WB). Looking at the table, most of the 3 & 6 month cumulative losses occurred just in the last month.

The obvious question- is the selling overdone? Regions may be due for a bounce. The two key possibilities that must be examined are 1) Has indiscriminate selling of the regional bank industry unfairly punished RF shares? 2) Does the market know that disappointing news from RF is imminent- or consensus EPS estimate revisions?

Regarding the first possibility- if shares have been unfairly crushed, then answer is simple: RF should be bought. In order to ascertain if RF’s situation differs from the rest of its peers, the second possibility needs to be examined.

It’s tough to predict negative news announcements and earnings misses. However, it’s rather apparent that investors have been pricing in these events. Thus, the balance of risks appears favorable. If earnings come in below the consensus, or if the dividend is cut etc., it’s likely that much, if not all, are already reflected in the share price. Therefore, disappointing news wouldn’t adversely affect RF’s stock price. If news turns out to be better than expected, then RF should rally. Hence, the potential upside exceeds the risk to the downside; this creates a favorable risk-return tradeoff

Asset Quality:
Regions Financial doesn’t have any sub-prime exposure. It did have a sub-prime origination business- EquiFirst, but those mortgages were sold servicing-released and not retained on the books. Regions sold EquiFirst to Barclays back in 2007. In addition, Regions isn’t exposed to non-traditional mortgages such as option ARMs or loans with teaser rates. Regions primary concern is its $11.5 billion construction loan portfolio with $447 million in non-performing loans. Regions hasn’t had to take any major write-downs, and earnings have held up in the past several quarters relative to peers.

Earnings Expectations:
Analysts are forecasting EPS of 48 cents for the June quarter, which is down from 54 cents 90 days ago. For FY08, the consensus estimate is $1.95, down from $2.14 three months ago, but has been steady for the past month. Regions is trading 5.8x this year’s EPS estimate. This is quite low given RF’s 12.8x 5-year average and industry average of 13.5x. This might suggest that investors expect Regions to earn half of the current consensus, or 97 cents for FY08.

The trailing 12m dividend is $1.50, a yield of 13.2%. The stock price definitely reflects a cut or elimination. A 5% dividend yield at the current share price would be 57 cents. Assuming a 60% payout ratio, EPS would need to total at least 95 cents over the next 4 quarters.

It appears that analysts haven’t revised RF estimates down to reflect current market expectations. Why do investors think estimates are too high? It’s likely concerns center on Regions construction lending portfolio as it has been deteriorating. 3.5B of the 6.2B residential homebuilder segment consists of vacant lot and land, which could experience high losses. Regions management states that they are moving aggressively to manage losses in this portfolio.

Regions recorded a loan loss provision of 181 million for 1Q08, down from 358 million in 4Q07. It’s likely that Q2’s provision will have to return to at least 400 million. Even so, RF has been reducing costs through last year’s merger with AmSouth. In the march quarter, merger cost saves totaled 127 million, and management expects total cost saves of 700 million by year-end 2008. In addition, Regions Financial also owns Morgan Keegan, a strong brokerage firm, which will help diversify revenue streams during this downturn.

Short Interest:
RF’s short interest surged 13.1 million shares (27%) during the last period reported (May 15-30). This represents about 9% of the outstanding share float with cover ratio of 6.3 days. Since the last report, short interest has likely increased further given the declining share price. Short interest represents future share demand as shorts must buy shares to cover their positions.

Option investors are betting on further share declines in RF shares. On Wednesday, trading in Regions Financial's options surges to eight times the normal daily volume, as investors bought 48,000 puts and 8,000 calls. Activity was heavy in the July $10 puts, trading at 95 cents and will be in the money if RF slides below $9.05 before July 18.

It’s quite evident that investors are negative on RF. This positive aspect is that weak sellers are folding there hands and negative expectations are being priced-in. With so many investors negative, the supply of sellers begins to dry up, as the supply of future buyers increases. If future developments are not a dire as expected, then RF should see a nice bounce as short-sellers scramble to cover positions.

Conclusion:
Capital ratios are decent- Tier 1 capital ratio is 7.3% and Total capital ratio is 11.1%. These are well above the minimum requirements of 4% and 8%. Regions book value / share is $28.82 resulting in a P/BV of 0.4x.

Thus, the selling of RF shares has been warranted, but has it been overdone? Or, is there more selling to come? Regions revenue streams are diversified with its banking, brokerage, and insurance businesses. Regions is also aggressively improving its cost structure through its merger cost reduction plan. The combination of these factors should help offset, to a degree, future write-downs and loan losses. RF has adequate capital ratios, thus I don’t foresee a major equity capital raising.

I believe current share prices can withstand a 50% reduction to earnings and the dividend, as these possibilities are priced-in. Thus, I think, with a considerable amount of negative news already discounted, there is significant upside potential. Hence, the balance of risks is favorable possibly making RF due for a bounce.