A great many negative articles regarding the future of Apple (AAPL) have been written since their latest quarterly report. To be fair, Apple delivered a rare "miss" of analysts' expectations in earnings, and their guidance for the upcoming quarter was highly conservative. These issues helped create an opening for a flood of negativity on the company. In reality, were it not for an obscure accounting rule, Apple would have beat in earnings as well as revenue.
It is important to understand the facts before concluding on the meaning or long-term implications of a financial report. While Generally Accepted Accounting Principles (GAAP) typically facilitate accurate reporting, sometimes they can lead to timing issues in recognizing expenses or income that obscure the underlying operating results of a quarter. This occurred in Apple's fiscal Q412 earnings release.
A widely overlooked anomaly in Apple's report reveals greater underlying strength for their quarter. The CFO and the Treasurer explained the reasons for the anomaly during their quarterly conference call, but most analysts and followers of the company do not appear to have given credibility or notice to the explanation. If we account for the anomaly, the quarterly report looks substantively better and further reveals the excellent health of the company.
Other Income and Expenses (OI&E)
Apple's Q4 revenues came in very strong at $36B, slightly ahead of the professional analysts' expectations and showing 27% growth over prior year. Reported earnings were up 24% over prior year, but $0.08 per share under analysts' estimates and not keeping pace with revenue growth. The slower earnings growth vs. revenue growth has been an important financial element of the recent negativity regarding Apple.
Apple CFO Peter Oppenheimer noted in the conference call that earnings had been impacted by -$51 million dollars due to a loss in Other Income and Expenses (OI&E). The OI&E line item includes interest income on Apple's massive cash hoard as well as other finance and investment related income, expenses and other items. Oppenheimer explained that normal "interest income and investment gains were more than offset by higher-than-expected currency hedging expense. Under accounting rules, foreign exchange fluctuations late in the quarter required us to accelerate recognition of premium expense related to Q1 and Q2 hedges."
He essentially told us that the swing from the typical income reported in OI&E was a result of accounting rules forcing them to recognize premium outlays normally not recognized in the P&L until the quarter in which the hedge impacts operating results. They had already put out the cash for the hedging premiums; they just normally don't recognize the premiums as a P&L expense until later. This was a crucial note overlooked by most who have commented on Apple's quarter.
The OI&E Anomaly's Impact
Apple typically reports substantive income in the OI&E line. You would like to think that they are earning something on the $120+ billion in cash that they hold. Indeed, for the first three quarters of FY 2012 they reported:
Apple's Reported OI&E
Prior years also show strong positive income that logically accelerates as the cash hoard grows. They reported income of $155M in FY 2010 and $415M in FY 2011 in OI&E.
What all this means is that Apple reported a significant non-cash charge to FYQ412 earnings because they accelerated the recognition of outlays for currency hedging premiums that were placed to hedge currencies for their upcoming fiscal Q1 and Q2. Given the late quarter currency fluctuations, accounting rules forced them to recognize premiums for the hedges in the quarter. Who knows, maybe they made some bad bets, but Treasurer Gary Wimpfler explained later in the conference call that they expect to recoup the reported losses in future quarters.
The always-conservative Peter Oppenheimer forecasted a whopping $380 million in OI&E for fiscal Q113. This would be the highest OI&E Apple has reported in recent history by almost $100 million. They also expect a further positive impact to the OI&E line in fiscal Q213.
Adjusting for the Timing Anomalies
As Wimpfler noted, Apple will essentially report a reversal of the $51 million hit in the upcoming two quarters. The prudent investor should adjust for this over these quarters, and realize that fiscal Q412 earnings were actually better than reported in a significant way especially given their close proximity to analysts' expectations.
To make this adjustment is fairly straightforward. We start with the run rate for OI&E. Given the ever-growing cash hoard; the best estimate for this rate is probably the latest results. As detailed above, Apple had been showing an average of $191M per quarter in OI&E in the earlier quarters of FY12.
Wimpfler remarked that interest income was above what they expected for the quarter, but we will be conservative and simply believe the Net OI&E without the timing anomaly would have come in at the $191 million run rate. This implies that the currency premium timing issue was a charge of approximately $242M. Equivalent to the $191 million run rate adding back the $51 million loss reported.
To check this reasoning, it is useful to test the assumptions vs. the already issued forecast for fiscal Q113 and an estimate for Q213. Since the cash is growing and for simplicity we will assume that without the benefit of the premium expense reduction the OI&E for fiscal Q113 and Q213 would come in slightly above the 2012 run rate at about $200M per quarter. We can then derive a conservative assessment of the timing impact for each of the three quarters.
We already have Apple's forecast for fiscal Q113 OI&E at $380M. We will also be conservative and expect that about 75% of the timing adjustment should be spread to Q113 and the remaining 25% to Q213.
This analysis indicates that the assumptions regarding the impact of the premium timing expenses are reasonable.
Apple's fiscal Q412 report contained substantive timing anomalies affecting the OI&E line. If we normalize and adjust for the anomaly over the three quarters that Apple has clearly stated will be impacted, it paints a different picture of the fiscal Q412 earnings. It means that Apple was forced to understate earnings for the most recent quarter by approximately $242 million, which equates to $0.25/share. That implies an actual $0.17 per share BEAT of expectations and YOY growth of 27% in earnings (equivalent to the revenue growth).
Viewed from this reasonable lens, Apple earnings grew as fast as revenues for the quarter. Obscure accounting rules and unusual currency fluctuations in this case distorted the picture of an otherwise very strong and encouraging quarter. Apple will see the financial benefit of this timing problem in future quarters, and investors should consider how different opinions regarding the health of the company would be if Apple reported a beat for earnings in the most recent quarter.
Disclosure: I am long AAPL.