Apple becoming a bigger cash flow machine

"We believe that free cash flow and deferred revenue will become more important metrics in driving Apple’s shares through fiscal 2008, perhaps eventually trumping the current quarterly frenzies over iPod and Mac unit sales," Ben Reitzes and his team of analyst told clients in a research note on Thursday.

The analysts say the company's focus on free cash flow growth should expand its price-to-earnings (PE) ratio, similar to events that played out at rival Dell when the PC maker's PE expanded from about 18x to about 30x at its peak in late 2003.

"This year, a free cash flow rebound has contributed to a 29 percent surge for shares of storage leader EMC as well," Reitzes wrote. "In Apple’s case, a free cash flow expansion could have similar results in our view."

Given that more than 80 percent of revenues from Apple's new Apple TV and iPhone products will show up as deferred revenue under Apple's new accounting principles, the analyst said free cash flow could evolve into a better indicator of the company's true "cash profit" once the iPhone translates to material value in the first fiscal quarter of next year.

On the other hand, the analyst said Apple TV may take another year or so to take hold given his view that iTunes will need to offer more films and even pay-per-view services in order for the solution to be attractive enough to compete more effectively with cable boxes and DVD players.

While Reitzes has not yet made material adjustments to his revenue or per-share estimates, he did raise iPhone unit estimates given indications that the product should be extremely well received in the U.S. and his view that build plans out of the supply chain look very compelling vs. unit estimates for sell-through in the second half of the year.

"We are establishing free cash flow estimates of $4.90 per share ($4.37 billion) for fiscal 2007 and $6.50 per share ($5.97 billion) for fiscal 2008," the analyst wrote in his note to clients. "These estimates factor in projected unit sales of 950,000 iPhones in fiscal 2007 and 8.1 million iPhones in fiscal 2008."

Given those estimates, Reitzes said Apple is undervalued on a free cash flow yield basis versus other growth stocks. He raised his price target on shares of the Cupertino-based company to $160 from $133.

"Our new price target is based on our view that within a year Apple should achieve a 4.5 percent free cash flow yield," the analyst wrote.