How the iPhone and Poor Management Contribute to Apple's Downfall 76 comments
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In April of 2007, Peter Oppenheimer (Apple’s (AAPL) CFO) announced that Apple will be using what is commonly referred to as the “subscription method of accounting” for sales of the iPhone where the sales revenue from the iPhone is deferred and recognized over a 24-month period instead of at the point of sale. Both that decision and the underlying reason in support of the decision would go down as being one of the worst in Apple’s history. In his opening statement of the Q2 2007 earnings call, Oppenheimer made the following alarming comments:
Since iPhone customers will likely be our best advocates for the product, we want to get them many of these new features and applications at no additional charge as they become available. Since we will be periodically providing new software features to iPhone customers free of charge, we will use subscription accounting and recognize the revenue and product cost of goods sold associated with iPhone handset sales on a straight line basis over 24 months. So while the cash from iPhone sales will be collected at the time of sale, we will be recording deferred revenue and costs of goods sold on our balance sheet, and amortizing both of them into our earnings on a straight line basis over 24 months. We will continue to expense our iPhone engineering, sales and marketing costs as we incur them. This accounting policy will have no impact on cash flow or the economics of our business.
This was the first time the financial community learned about Apple’s plans to defer iPhone sales revenue. Until that moment, everyone was expecting some dramatic blow-out growth rates for 2008. Such hopes were dashed when Oppenheimer decided to give iPhone customers free $9.95 software upgrades at the inevitable sacrifice of Apple’s stock price. In August, I made several arguments on why such an accounting treatment would lead to the eventual manipulation of Apple’s financials both by analysts and the media. I warned that the market would be overly focused on Apple’s P/E ratio instead of its price-to-free cash flow and that such a result could lead to disastrous consequences.
A year and a half later, Apple is trading at the same price it was before the iPhone even existed, is portrayed as a company that struggles to grow and as a company that faced major financial headwinds in 2008 despite the fact that it grew its earnings 125% in Q4 alone. While the recent financial turmoil, the 2008 recession and serious concerns over Steve Jobs’ health is much to blame for the loss in share value, Apple could be trading at much higher levels if the revenue from the iPhone were recorded when received instead of how it’s treated under the current accounting regime.
Newton was Wrong: iPhone Deferred Revenue makes Apples Fall
The underlying problem with the subscription method of accounting is that it makes Apple’s financials appear radically weaker than they actually are. And as any experienced market participant knows, the market rarely trades on reality. Stocks trade on appearances, they trade on fluff, they trade on generalities regarding the health of the economy—what they do not trade on, is reality regarding fundamentals. Especially if teasing out that reality requires anything more than looking beyond the surface.
This accounting treatment of the iPhone hides Apple’s true financial value under the shroud of adjusted earnings to which almost no one seems to pay much attention. It puts Apple at a significantly uneven keel when compared to other similarly situated stocks in the sector. As a matter of fact, it is quite possible that Apple could be trading at $140 a share today if it never introduced the notion of subscription accounting. Here’s why…
If Apple decided against deferring its iPhone revenue, Apple would have reported some truly staggering numbers and growth rates for most of 2008. Notice, this is all an issue of investor and market confidence. Had Apple reported the blow-out numbers portrayed in its adjusted earnings, investor confidence would have both led to greater advances in Apple’s stock price and put up some considerable support during the inevitable collapse in equities this past October of which almost no stock was immune. Instead, investor confidence in Apple has been shot for the majority of 2008 and even the slightest inkling of bad news has led to a dramatic nose-dive in Apple’s stock price.
Just to get an idea of how much of an impact the subscription method of accounting had on Apple’s earnings in 2008, one need only compare Apple’s 2008 GAAP-based earnings with its adjusted earnings which backs out the amortization of the iPhone. When disregarding the deferred revenue mechanism of subscription accounting, Apple actually earned $7.48 in EPS on $38.041 billion in revenue. That compares to the $5.36 in EPS on $32.479 billion in revenue that Apple reported on a GAAP-basis.
This means Apple would have reported an average of $0.53 more in EPS and $1.4 billion more in revenue each quarter in 2008 but for Apple’s decision to give free $9.95 software upgrades to iPhone customers—upgrades of which have only been released twice in the history of the iPhone. That is roughly 40% more in EPS!
That added revenue and EPS would have painted a completely different picture of Apple’s financial health and thus its stock price in 2008. Concerns over Apple’s growth rate would have been non-existent as investors would have been focused on the dramatic increases in sales revenue, earnings and cash on the balance sheet. Yet, because Apple decided it wanted to arbitrarily offer free software upgrades to iPhone customers while making iPod Touch users pay for those very same upgrades, Apple has become a sanctuary for the bear to roam free causing massive damage to Apple’s stock price, investor confidence and historical market favoritism towards Apple in general.
Table 1.1: Comparison between 2008 Non-GAAP and GAP Earnings
FYE 2008 Non-GAAP | FYE 2008 GAAP | Difference | |
Revenue | $38,041 | $32,479 | $5,562 (14.6%) |
Cost of Goods Sold | $24,190 | $21,334 | $2,856 (11.8%) |
Gross Margin | $13,851 | $11,145 | $2,706 (19.5%) |
Operating Expenses | $4,870 | $4,870 | - |
Operating Income | $8,981 | $6,275 | $2,706 (30.1%) |
OI&E | $620 | $620 | - |
Net, Before Taxes | $9,601 | $6,895 | $2,706 (28.2%) |
Taxes | $2,851 | $2,061 | $790 (27.7%) |
Net Income | $6,750 | $4,834 | $1,910 (28.4%) |
Earnings Per Share | $7.48 | $5.36 | $2.12 (28.4%) |
Diluted Shares | 902,406,417 | 902,406,417 | - |
Even now Apple’s management seems to regret using the subscription method of accounting for the iPhone. In its most recently reported fiscal quarter, Steve Jobs all but begged the market and investors to focus more on Apple’s newly introduced adjusted earnings rather than simply looking at Apple’s GAAP-based results. Here’s just a small portion of what Jobs had to say about the iPhone’s impact on Apple’s business, the use of subscription accounting, and Apple’s decision to provide adjusting earnings for the first time ever:
Because by its nature subscription accounting spreads the impact of iPhone’s contribution to Apple's overall sales, gross margin, and net income over two years, it can make it more difficult for the average Apple manager or the average investor to evaluate the company’s overall performance. As long as our iPhone business was small relative to our Mac and music businesses, this didn’t really matter much. But this past quarter, as you heard, our iPhone business has grown to about $4.6 billion, or 39% of Apple's total business, clearly too big for Apple management or investors to ignore. Hence our introduction today of non-GAAP financial results alongside our reported GAAP results.
As you can see, the non-GAAP financial results are truly stunning. By eliminating subscription accounting, adjusted sales for the quarter were $11.68 billion, 48% higher than the reported revenue of $7.9 billion, while adjusted income was $2.44 billion, 115% higher than the reported net income of $1.14 billion. Adjusted net income that is more than double our reported income -- if this isn't stunning, I don’t know what is, all due to the incredible success of the iPhone 3G.
Too big for Apple management or investors to ignore? Really? If Steve Jobs actually believed that the market will all of a sudden begin to act rationally, then he obviously has no clue as to how the market actually functions. Since Jobs released his adjusted earnings showing that Apple reported 115% higher net income than indicated by GAAP-accounting measures, Apple is down over 15 points. As a matter of fact, Apple has gone absolutely nowhere since it reported adjusted earnings back in October. If Jobs and Co. really wanted the market to focus on Apple’s true earnings results and fundamentals, they should have thought about that before foolishly deciding to sacrifice reporting 40% of its revenue just so that iPhone customers can get a free $10 upgrade. This is clearly one of the dumbest financial decisions made by a company that had it all.
As infallible as the market makes Jobs out to be, he is nothing short of massive failure in being able to manage his own stock price. Any normal company would have simply made its customers pay the nominal $9.95 fee associated with its extremely rare software upgrades or held a press conference to clear up any uncertainty regarding the health of its chief executive. With Apple, however, the “we don’t negotiate with terrorists” stance towards the media has led to deleterious consequence. Apple cannot so much as hold a press event to release new products and services without the focus of the event being about Steve Jobs’s health.
The “It’s All Priced-In” Delusion
Many will undoubtedly argue that Apple’s adjusted earnings is simply priced into the stock, that investors and analysts have already figured it into the fundamentals and that everyone already knows about Apple’s adjusted earnings. Nothing can be further from the truth.
First, very few analysts provide adjusted earnings estimates, value Apple on a price-to-free cash flow (which backs out the negative impact of adjusted earnings) or provide GAAP-based earnings estimates which fully consider the impact that deferred revenue will have in 2009. Analyst 2009 consensus estimates have been criticized as being outrageously low due in part to analyst inability to comprehend the impact that deferred iPhone revenue will have on 2009 results. Even bullish analysts such as Charlie Wolf from Needham & Co. analyze Apple’s fundamentals in terms of forward P/E. If 40% of Apple’s revenue is not being released under GAAP-accounting, then how one can truly analyze a company on a forward P/E basis is beyond reason. And these are bullish analysts who fall victim to this obvious error.
Secondly, it’s a stretch to assume that momentum traders, hedge fund managers, and average investors know that Apple is even using subscription accounting. The average trader, hedge fund manager or investors looks to the basic GAAP-based financial ratios to quickly determine whether a company is over or under-valued – a practice that is pretty much full-proof most of the time, but will invariably fail when it comes to Apple. Every time a fund manager or analyst mentions Apple and P/E ratio in the same sentence is yet another indication that the market has failed to value Apple on its adjusted earnings, and this sort of behavior occurs on a daily basis.
Thirdly, when using Apple’s adjusted earnings as a basis of financial ratio comparisons to other tech companies, Apple is far more undervalued than every other similarly situated tech company in the sector. On an EPS to trailing P/E basis, EPS to forward P/E basis, price-to-free cash flow, price to cash, price to operating cash flow, cash per share, total net cash, and EPS growth basis, Apple presents with the best value in the tech sector.
This is largely the result of the market completely discounting Apple’s adjusted earnings. When looking at Apple’s adjusted earnings-ratios, one can accurately conclude that the market is valuing Apple ex-iPhone. If the market was truly “pricing-in” adjusted earnings as some would have us believe, then Apple’s GAAP-based P/E ratio should obviously represent a sizeable premium to others in the tech sector.
Yet, such is definitely not the case. The opposite is actually occurring. Apple has a GAAP-based P/E ratio that is in-line or lower than others in the tech sector which suggests that the market has more than completely priced-out both the actual and potential financial impact of the iPhone. Actual in that the adjusted earnings ratios are pricing Apple significantly lower than its peers and potential in that Apple’s forward P/E fails to contemplate deferred iPhone revenue due to analyst failures in drawing a fairly stated consensus.
Yet, the single biggest indication showing that the market has failed to priced-in Apple’s adjusted earnings is expressed in Apple’s adjusted-based trailing P/E ratio. Apple’s adjusted-based P/E ratio should be in-line with its peers because the adjusted P/E ratio is based on the elimination of subscription accounting. But such is not the case. Apple’s adjusted-based trailing P/E ratio is far below its peers. RIMM’s P/E is at 15.26, GOOG is at 19.02 and AMZN is at 38.07 while Apple boasts a mere 12.11 P/E. In order for Apple to be priced in with its peers, it would have to be trading between $119.82 and $142.12 a share.
What I find to be interesting is that Apple outgrew both Amazon and Google on an adjusted basis but holds a P/E ratio that is far below that of Google’s and one-third that of Amazon’s. This can be explained by the mere fact that the amount of bearishness prevalent in Apple’s stock price far exceeds that of RIMM, AMZN, GOOG, MSFT, CSCO and others.
Even Apple’s outrageously low price-to-cash ratio indicates that there is either an extreme level of pessimism built into Apple’s stock price, more so than almost every other tech company, or that the market has failed to price-in Apple’s adjusted earnings. Apple is currently trading at only 3 times its net cash position which is far lower than every other tech company (see Table 1.3). The ratios in the table below are dated as of closing prices on January 9, 2009 which backs out the confounding variable of selling pressure placed on Apple’s stock as a result of the quasi-resignation of Steve Jobs.
Table 1.2: P/E Ratios & EPS Growth Comparisons within the Tech Sector as of Jan. 9, 2009
Stock Price | Trailing P/E | 12-Month EPS | EPS Growth | |
AAPL (Gaap) | $90.58 | 16.90 | $5.36 | 36.40% |
AAPL (Adj.) | $90.58 | 12.11 | $7.48 | 78.50% |
RIMM | $47.46 | 15.26 | $3.11 | 100.65% |
GOOG | $315.07 | 19.02 | $16.56 | 31.33% |
AMZN | $55.51 | 38.07 | $1.46 | 67.82% |
MSFT | $19.52 | 10.32 | $1.89 | 20.13% |
CSCO | $16.70 | 12.60 | $1.33 | 16.42% |
IBM | $84.70 | 9.98 | $8.48 | 27.52% |
INTC | $14.15 | 11.27 | $1.25 | 18.87% |
HPQ | $37.49 | 11.55 | $3.25 | 25.91% |
Table 1.3: Balance Sheet Item Comparisons within the Tech Sector as of Jan 9., 2009
Total Cash | Total Debt | Net Cash | Price to | |
AAPL | $24.49 Bn. | $0.00 | $27.57 | 3.28 |
RIMM | $1.68 Bn. | $5.82 Mil. | $2.75 | 17.26 |
GOOG | $14.41 Bn. | $0.00 | $45.87 | 6.87 |
AMZN | $2.32 Bn. | $435 Mil. | $4.40 | 12.62 |
MSFT | $19.71 Bn. | $1.98 Bn. | $1.99 | 9.81 |
CSCO | $26.76 Bn. | $6.87 Bn. | $3.39 | 4.93 |
IBM | $9.76 Bn. | $34.41 Bn. | $0.00 | 84.70 |
INTC | $12.20 Bn. | $2.36 Bn. | $1.77 | 8.00 |
HPQ | $10.25 Bn. | $17.85 Bn. | $0.00 | 37.49 |
The iPhone’s Double-Edged Sword on the iPod
Even without considering the damaging implications of subscription accounting, the iPhone itself has acted as a destructive double-edged sword regarding the appearance of Apple’s financial health. On the one hand, the handset market is significantly larger than that of the MP3 market. And so it makes a whole lot of sense for Apple to have entered that market, especially since Apple is in the business of making elegant, revolutionary well-designed software and consumer electronics. Yet, on the other hand, it would be incredibly naive for one to believe that iPhone sales aren’t cannibalizing iPod sales to some degree. While not everyone who is in the market for an iPhone is in the market for an MP3 player, iPhone purchasers who are in both markets have little need to own both an iPod and an iPhone.
The main problem with the iPhone cannibalizing iPod sales is that it makes iPod unit sales growth appear significantly weaker than it actually is. The iPhone is basically an iPod with a phone. One who decides to buy an iPhone over an iPod touch is essentially buying an iPod. Yet, analysts, traders and the media don’t portray it that way. Instead, the financial community tends to view any apparent weakness in iPod unit sales growth as being attributed exclusively to either market saturation or weakness in the consumer.
Rarely, if ever, does anyone consider the breadth of iPhone unit sales when evaluating iPod growth rates. For example, in Q1 2008, the focal point of Apple’s earnings results, aside from guidance, was how iPod unit growth contracted considerably. Analysts and the media had a field day with the “slowing iPod growth story” shortly after Apple reported its fiscal Q1. Apple reported sales of 22 million iPods in Q1 of 2008 up a mere 5% from the 21 million units sold in the year ago period.
Yet, if one were to combine iPod and iPhone sales, he or she would get a drastically different picture regarding iPod unit growth. In Apple’s most recently reported fiscal fourth quarter for example, iPod sales taken alone grew at a pace of only 7.7%. That is in spite of the severe recession and collapse in consumer spending in calendar Q3. Yet, when combining iPod and iPhone units together, the growth rate skyrockets to 58.5% on a year-over-year basis. One could see how easily these numbers can be manipulated to portray Apple as a company that is struggling to grow, as a company that is the perilous victim of dismal consumer spending or as a company that is collapsing under the weight of recession.
The decision to use subscription accounting for the iPhone compounds this problem even further. Because not only do iPod sales appear weaker due to cannibalization by the iPhone, each iPod that is cannibalized as an iPhone sale sees very little revenue recognition in the quarter the sale is cannibalized. This means that Apple’s revenue takes an immediate and drastic hit on each iPhone sale that might have otherwise been an iPod sale.
Thus, what we have here is a perfect recipe for media misrepresentation, analyst confusion and market disorientation regarding Apple’s fundamentals. Because not only do iPod sales appear weaker due to iPhone cannibalization, Apple’s revenue does not reflect this fact because of the subscription method of accounting. These two problems taken together paint a very nasty picture of Apple’s fundamentals when the reality is Apple grew its adjusted earnings from $4.19 in 2007 to $7.48 in 2008 (78.5%) and grew its revenue from $24.637 billion in 2007 to $38.04 in 2008 (58.5%).
Adjusted Earnings for Apple, Inc. (FYE 2007-2008)
FYE 2008 | FYE 2007 | Difference | Growth Rate | |
Revenue | $38,041 | $24,637 | $13,404 | 54.5% |
Cost of Goods Sold | $24,190 | $16,166 | $8,024 | 49.6% |
Gross Margin | $13,851 | $8,471 | $5,380 | 63.5% |
Operating Expenses | $4,870 | $3,745 | $1,125 | 30.1% |
Operating Income | $8,981 | $4,726 | $4,255 | 90.1% |
OI&E | $620 | $599 | $21 | 3.5% |
Net, Before Taxes | $9,601 | $5,325 | $4,276 | 80.3% |
Taxes | $2,851 | $1,599 | $1,252 | 78.3% |
Net Income | $6,750 | $3,726 | $3,024 | 81.2% |
Earnings Per Share | $7.48 | $4.19 | $3.29 | 78.5% |
Diluted Shares | 902,406 | 889,260 | 13,146 | 1.5% |
What Apple Should Do to Fix this Problem…
While there is little to nothing Apple could do to fix the current market perception regarding its fundamentals in the short term, Apple can take certain defensive steps that could potentially alter the market’s views in the long term.
First, Apple should immediately cease giving GAAP-based earnings guidance and instead offer guidance on adjusted earnings. If Steve Jobs really wants the market to shift its focus from Apple’s GAAP-based earnings to real earnings, then he really needs to start offering guidance on an adjusted basis—a practice that several other tech companies already employ. By doing this, Apple would benefit in both the short and long term.
It would benefit in the short term because there are no adjusted-earnings “guidance expectations” that Apple would have to meet because there are no adjusted-earnings consensus estimates at the present moment. Thus, near-term strong earnings results would not be hampered by Apple’s excessive conservatism in guidance because Apple would not be guiding below any expectations. In other words, Apple would limit near-term headline risk regarding its guidance because it would simply not be providing any.
Yet, the major benefit Apple would gain from offering only adjusted-based earnings guidance is that analysts will be forced to comment and give estimates on Apple’s adjusted earnings which will eventually shift the market’s focus in that direction as well.
Another more drastic measure Apple should really consider is doing away with subscription accounting altogether. It could do so in tandem with its next iPhone refresh by stating that third-iteration iPhone purchasers will have to pay for future software upgrades as they become available. All previous 3G and EDGE iPhone revenue would be amortized under subscription accounting while next generation iPhone revenue would be recognized at the point of sale in the quarter in which the sale occurs.
Both of these actions taken together would likely fix market perception regarding Apple’s fundamentals by the end of 2009 as sales of the new iPhone cause Apple’s GAAP based revenue to skyrocket in the latter half of the year. Such a proposal is so obvious that even Apple’s management can't mess this up. Or can they…
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This article has 76 comments:
You should have specified that you meant the fiscal fourth quarter, or "the September quarter." I think the latter terminology is best, as otherwise some readers will think you were talking about the Dec. quarter, whose numbers aren't out yet.
Be happy you feel the price is misrepresented and buy. This is investment opportunity. Why complain others "don't get it". Now is the time a Buffett would get into Apple.
The article is good to justify Apple is sound and undervalued. But to say the accounting Apple used was a detriment is crazy. The accounting practice was an announced program by Apple, is known to all, and by design smoothed what could have been rough waters. And since the waters did not end up rough, all it does is give them a constant growth baseline to continue to build the business under. I submit this is a stroke of genius and great luck.
Apple's low price at the moment offers the company a great opportunity to institute a stock buy-back program.
Apple's accounting is smart for a company looking to grow over the long run. If the market continues to be shortsighted and not properly value their cash flows, then it is a fantastic buying opportunity. That opportunity will eventually disappear. Either the stock market will recognize the value overall, or another company will and they will get bought for a premium over their stock market cap. It will necessarilly happen. A good company will not stay undervalued for long.
If neither of those ever happens than you and I were wrong and their cash flows aren't worth what we think.
The reason for subscription method of accounting has nothing to do with the CFO's preference and everything to do with the service revenue share arrangement with AT&T as it reflects the lock-up of the subscriber over a 24 month period to pay for the subsidized handset. Only RIMM has a similar arrangement with the mobile operators while Nokia is keen in copying that model with its new PDA handets.
Apple is brilliant for having switched to that method and it has done nothing to affect its business fundamentally. The company is still a strong contender for dominance of the market-segment they are in.
Accountants should know their place. Trying to explain business or product strategy choices without understanding the rationale is an exercise in futility.
You have been kind enough to do your best to let everybody see the true situation Apple. I just don't understand the frustration. Will it not be the case that Apple's earnings from the iPhone will emerge in it's future reporting, having a positive on Apple's results while others are suffering more drastic declines.
Anyway, if Apple had been reporting with it's adjusted earnings it most likely would of been "wasting it's sweetness on the desert air" and I'm sure the share price still would of fallen lower than what you expected it would and everyone who bought it would still be down at the moment.
You have a better insight than the majority, how can that possibly be anything other than a good thing?
Management is not supposed to pick the accounting method that they think will be most advantageous for the stock. They are supposed to pick the one that properly reflects the recognition of payment for a service rendered. Thus, the argument should not be about which one makes the company "look" stronger; it should be about which one is proper from an accounting perspective. Otherwise you're looking at it from Enron's CFO's point of view.
Look, I would be the first to say that, as far as PR is concerned, Apple is not the best at navigating controversial issues, aka SJ health etc., the flip side is that they're generally brilliant at PR on the product end.
The central point and frustration about accounting though I think is a bit darker picture. I happen to believe that it's really not all that difficult to disseminate GAAP and non GAAP numbers, I'm not an accountant and it's really not that hard to figure out. It doesn't require getting under the hood all that much either to figure it out and I dare say most honest investors would say the same. So the question is, if that's true, then what's the deal here? Simply put, there's plenty gaming going on with APple stock Zaky, you know this, and this is why I consider your post a form of satire. People with less sincere motivations will be quick to accuse someone of being paranoid, or a conspiracist accusing analysts of playing this game, but we all know it's true.
The poaching of this stock will continue as long as a certain faction of hedge funds and investment houses believe they can forcibly convince those percentages of investors, either individuals or other investment houses, that are either lazy, ignorant for their own good or those that sadly that "follow the heard" mentalities, to stay away from Apple.
Make no mistake about it. The PR outside apple is much worse, and sadly, corrupt, than any misguided PR Apple may have ever done.
i am not sure why you are so upset, though. This accouting treatment will make earning look *better* than they really are in the coming quarters (if sales contract). I would like to see instead a discussion of whether that is a real possibility.
Andy for your shedding light on this poor accounting fiasco.
you can be driving a new ferrari and get stopped by a cop and he can find something wrong and give you a summons. the list of once great companies, that are on the edge of extinction, is unfathomable.
apple is still in business and will continue so. i remember how they were chastised for moving to intel. apple does what it feels is correct and that usually filters down to the shareholders. nobody is perfect, but this financial crisis is worse than 90+% of the public has ever seen.
a terrific axiom: "everything in life is relative."
No wait, they tried that before (Stock options, Steve's Plane, etc)!!!!
Stop doing that.
Secondly, let's not forget that Apple discloses both GAAP and non-GAAP financial results, that show their financial status both with an without subscription accounting. Both the analysts and individual investors use this information when making investment decisions.
Non-GAAP numbers are no secret, and subscription accounting is not the reason Apple stock price has fallen. For anybody who has been living in a cave for the past year, the world-wide economy is down and the entire Consumer Discretionary sector (to which Apple belongs) has fallen with it. This is normal for this sector during a recession.
Sometimes things just happen, and some people feel the need to (attempt to) lay blame. Recessions occur every 7-10 years. You can blame Apple, the Financial sector, Capitalism, the United States, or Human Nature. Regardless, when the economy turns-around (whenever that might be) Apple stock prices will benefit, along with the rest of the Consumer Discretionary sector. It's simply a normal part of investing.
This company is ridiculously cheap with $25 billion in cash and more cash every quarter.
I guess the complaint really drives not to the accounting method chosen, but the business model itself. You have to set up a subscription accounting if you sell a subscription product.
And I agree with the other posters that the free upgrades to the platform (iPhone and iPod) via iTunes is critical for establishing the platform. For the Mac platform, it is already established - that's why you pay for upgrades (not "updates" - i.e. bug and security fixes, as these don't necessarily add features but fix or improve existing features).
Maybe someday they will return to a paid-upgrade model, but for now, the market needs a zero-discouragement policy towards increasing unit sales so that the user base and market dominance is established.
Besides, as I think it was already mentioned, sure, the huge, pre-economic fallout sales were dampered by the subscription accounting. But that also means that as unit sales dramatically decline over the next several quarters, that extreme low will be dampered by the carry over from the boom.
Only investors on the short-term, quarter-to-quarter hype cycle care about this accounting nonsense. And it is certainly overlooking the impact of the Jobs health rumors and general economic collapse to attribute the stock's poor recent performance to the accounting method.
It's like bad science: ignoring any evidence that conflicts with your hypothesis.
On Jan 20 12:57 PM waf76 wrote:
> Recognizing $12.45 a month over a 2 year period for every 16gig iPhone
> over 2 years is stupid.
You say: "Any normal company would have...."
If Apple were a "normal company" we would not have an iPhone at all.
Nor an iPod, iMac, iLife, MacOSX, Snow Leopard.....
The 3G relationship with AT&T is different. They get all their monies up front. Did the Apple CFO comment on that? If they are accounting for 3Gs up front then this whole article is bunk. 3G has outsold the 2G by some margin.
I have owned apple products since an Apple IIe in 1984. I have been a shareholder for over 10 years. Steve Jobs makes some good decisions, has some great vision, and makes some terribly blunders. I am convinced the company will be fine without him; perhaps better, with a major ego out of the way of progress.
I am not alone with this viewpoint, but the media and some analysts continue to pretend that Jobs is the company.
The economy is in the toilet, and the toilet is about to be flushed. With or without Jobs, Apple faces some tough time ahead and this is NOT yet priced into the stock by the market. But the stock is so grossly undervalued I think that January's earnings call will spur a nice positive bounce between now and then.
With the stock at $79/share, and $29 of that as cash/share, $50 is buying a non-GAAP P/E of over $7. As companies force fewer employees to do more with less, technology benefits. A $500 iPhone is nothing, if a few of them allow a company to lay off an $80,000/yr employee. A non-GAAP multiple of 7 times trailing earnings is cheap enough for me to feel confident that I will profit in the near term.
The most critical error here (aside from not providing any weight at all to Jobs' health on the stock price) is neglecting to discuss the full effect of the subscription accounting (SA for this post) of iPhone sales. You pound the fact that current revenues are lower than they would be absent SA. You rail about the current stock price being based more on GAAP-related measures than cash flow. But you barely mention that future revenues will be higher as current cashflow is applied in coming quarters, and you neglect entirely that your logic requires the future stock price to be higher than it would otherwise be.
Your argument says that PE is more important than cash flow to the stock price, and that the stock price is lower now than it should be. Following this logic, the stock price will be higher in the future than it should be, as revenue and PE will be higher then as past cash flow is added to the GAAP measures. So why are you complaining? Why aren't you just buying?
"Since Jobs released his adjusted earnings showing that Apple reported 115% higher net income than indicated by GAAP-accounting measures, Apple is down over 15 points."
Which means it's tracked the market fairly closely.
"As infallible as the market makes Jobs out to be, he is nothing short of massive failure in being able to manage his own stock price."
Good! Do you think Warren Buffett is concerned about BRK? In a successful company, who cares what the stock price is? If it's too low, buy it!
You use a multiple of cash valuation as if it means something. It doesn't. Do a valuation based on the non-cash assets of the company - that's fine. But the stock price multiple of the percentage of cash a company has? Meaningless.
I also question your choice of comparable companies. Google, Amazon, and RIM? By what logic are they comparable? What about Dell or Microsoft? HP or Sony? Cisco even? I'm guessing you'd find the valuations of these companies to be much lower than those you chose as comps.
I guess that's all. Have a nice day.
There are two critical factors in AAPL's decision to use subscription accounting in managing iPhone sales and profit reporting. First, Jobs and company say the U.S. (actually, global) recession coming and say an opportunity. Knowing it's survival and viability is assured by virtue of its cash flow and cash position, AAPL's decision to defer iPhone profits permitted two things to occur within the company's infrastructure . . .
First, the swoon on the stock price because of the failure of the market and market analysts to understand the company's real financial strength will produce a year during which AAPL employees will receive incentive compensation (restricted stock and stock options) at extremely low values. This will ensure employee loyalty and create (again) a huge spike in employee wealth over the next 2-5 years.
Secondly, the articially low stock price will give Steve Jobs an opportunity to implement his succession plan somewhat seamlessly without a single major panic disruption in the stock price. Witness the $5-10 loss in the PPS last week when AAPL announced Jobs' 6 month medical leave. Had the stock price been trading at its true market value (e.g. around $140), the resulting panic wouldn've been far more pronounced and the PPS would've fallen 2-3 times as much . . .
Deferred accounting for the iPhone, when combined with AAPL's cash flow and cash position, is allowing AAPL to rather seamlessly implement radical changes in its underlying mgmt and infrasture without a major disruption to its financials or employee base . . .
It's success it assured in the longer term . . . and its PPS will no doubt recover and push through $200/sh within 1-2 years.
I appreciate your attention to detailed analysis, but I disagree totally with your conclusions. The fallacy in your argument is most clear when you write:
"Secondly, it’s a stretch to assume that momentum traders, hedge fund managers, and average investors know..."
Right there you are clearly stating that Apple SHOULD be managing its business for the momentum traders and hedge fund managers. This is exactly the wrong attitude and, and contradicts what is both Apples modis operendi and their strength.
Apple's objective is FIRST to create extraordinary, electronic devices that provide a fantastic experience to their customers; and secondly, to provide increasing value to their stock holders. They are one of the few companies left n America that have retained this mission, and PRECISLY because they have held to the first, they have been able to richly reward the second. You are suggesting that they abandon this policy.
They would no longer be Apple if they did.
While the factors that you mention seem to contribute to the low stock price, and this is a frustration to us long term investors, There are 2 other factors that are much more responsible, and both are a result of the global recession.
A- In the collapse of the financial institutions and markets, many huge funds were forced to liquidate holdings in order to raise cash. This selling has forced the market down no matter how good the company. It doesn't matter how tasty your apples, if no one is buying your rice will go down.
B- Investors (smart ones anyway) buy stocks not on the past performance of the company, but on PERCEIVED future earnings. With a global recession underway, and unemployment rising spectacularly, the future earnings of Apple, like all others, is in question. This is not only for this quarter and next quarter, but for the next two years or longer. Can YOU tell me when we will have a growing economy again? What if we hit 10% unemployment? 16% unemployment? What if we wallow in a decade long depression? Do you think that even Apple would not be adversely affected?
And so, in this climate of both uncertainty and fear, of course people are going to be very skeptical about purchasing stock in a basically consumer company.
IMHO
And a fantastic opportunity for management to get lower strike stock options. They don't mind the stock price dips so much.
What if they announce a $99 phone, or better, $49 with a 2 year commitment?
In this horrible market, in which every dubious projection is being "marked to worst", Apple is a buy precisely because the company reserves its marketing spin for its product promotion, not its financial statements.
Let's have a cheer for conservatively presented financial reporting!
www.dumbanalysts.com/2...
Had AAPL rose when it was already priced at $175 - this was just back in July - perhaps the sudden drop in October would have scared investors a hellova lot more than what has actually occurred. Furthermore, AAPL's earnings are now almost guaranteed to be quality for years to come. Well done, tizod.
On Jan 20 06:02 AM tizod wrote:
> The article does not make sense to me. Yes, Apple could have registered
> big one time gains with the iPhone. If the product had issues they
> could have crashed just as hard as the blip up. Apple released the
> iPhone very smartly - both marketing and accounting wise. Any investor
> (heck even a rookie) knows Apple has money in the bank, continuous
> cash flow with few new ORDERS, and less risk of crash than most companies
> - especially other consumer electronics stocks. Job's health and
> the overall economy have pressured the stock. But that is proportional
> to the price. If Apple hit the stratosphere and then bad news hit,
> the crash would be harder.
>
> Be happy you feel the price is misrepresented and buy. This is investment
> opportunity. Why complain others "don't get it". Now is the time
> a Buffett would get into Apple.
>
> The article is good to justify Apple is sound and undervalued. But
> to say the accounting Apple used was a detriment is crazy. The accounting
> practice was an announced program by Apple, is known to all, and
> by design smoothed what could have been rough waters. And since the
> waters did not end up rough, all it does is give them a constant
> growth baseline to continue to build the business under. I submit
> this is a stroke of genius and great luck.
On Jan 20 03:20 PM A.S. wrote:
> all you guys bashing on Andy dont understand his point, we all know
> this is the law and AAPL HAD to do it to follow the law, what Andy
> is saying is why doesn't AAPL start charging .99 for the upgrade
> through App Store or iTunes (we only get 1-2 upgrade a year anyways)
> and this will allow them to recognize the iPhone revenue as they
> occur.
This is a possibility of course. But I think Apple does not want its customers to have to pay for OS upgrades. I would not want to do that either.
Besides, the spreading of the income actually HELPS - it somewhat smoothes out quarterly incomes and will actually allow Apple to boast LARGER incomes in quarters where sales are down. Personally, I think it is a great idea! RLLH above put it simply and clearly:
"Bad for the day trader, good for the investor."
AAPL is very straightforward about their earnings and doesn't try to inflate the numbers for the short-term boost. I respect that. The stock will eventually reach a fair value. However, it might not be as high as you think, what with:
1. Strong competition with lower prices on their major products (NOK, RIMM, plus all the computer makers).
2. Massive damage to the U.S. consumer.
3. Long-term aversion of investors to no-yield, high volatility stocks after last year's debacle.
The best thing Apple could do would be to return some cash to shareholders or invest in some venture capital/private equity. The tendency of big tech to stockpile cash at tiny interest rates is one of the biggest value destroyers of the last 10 years. MSFT has seen the light and should do pretty well going forward, but AAPL and GOOG have to get moving. It's not all bad to go into this sort of economic crisis with a cash hoard, but it's shameful to go out of it with one. At today's prices AAPL could buy out plenty of other companies - maybe Bank of America should become Bank of Apple.
The fact that Apple's adjusted P/E ratio is far below that of its peers. The market is discounting nearly 40% of Apple's recorded revenue this past quarter. Just like almost everyone else commenting on this article, you need to read before you criticize. This goes to everyone else who feels a need to comment before reading the article.
Once again. I never said that this accounting treatment was the cause of the collapse in share value from $200 to $80. What I am saying here is that relative to others in the sectors, Apple should be trading closer to $120 a share post collapse. Read the freaking article. There's no need for me to just sit here and repeat myself. Seriously.
On Jan 20 06:34 PM JW.PhD wrote:
> Sorry but this article misses the forest for the trees. The current
> price of AAPL stock has nothing to do with "poor management" regarding
> how iPhone revenue is realized. In case the author somehow missed
> it, we're in the midst of the biggest economic downturn since the
> Great Depression, and that, combined with constant drumbeat of rumor
> and speculation about the health of Apple's CEO, is what has taken
> the stock down from ~$200 to under $80. If the company has managed
> anything poorly, it is the PR campaign concerning Steve Jobs, not
> the introduction and growth of one of the most successful products
> in history. Apple wasn't going to be able to swim against the current
> in this financial market anymore than any other company, no matter
> what their fundamentals might be.
Which means we should ignore all earnings estimates as well, since these are always pro forma.
Features that are strategic for the platform -- the App Store, location-finding -- are all dependent on massive adoption of the latest phone operating system.
The thing I appreciate about apple is that they make the right long term decision -- the one that does right by their customers, and that sets up their products for long-term success. The investor 'optics' can take care of themselves.
Even worse, you don't see the market fall off of your products appeal until it's too late because the subscription lasts 1-2 years. ^months is the typical lifespan for a cell phone to last before you have to spec it up or remake it. Can Apple keep it up as others catch up? It is way too hard to see. I think that's why investors discount it so.
I don't own it and don't have a position in it. However, with tech expected to get a walloping as the recession really bears down on them this year I wouldn't touch it, not because of the iPhone recognition methods or Job's break, but because of macro market fundamentals. Frankly, it's a wonder Apple and IBM aren't well below the price they were a year ago.
> The fact that Apple's adjusted P/E ratio is far below that of its
> peers. The market is discounting nearly 40% of Apple's recorded
> revenue this past quarter.
Andy - This (above) makes your point very clearly. I think it got lost in all of the words dedicated to the evils of subscription accounting and poor management. Poor management would show up in the fundamentals.
However, if people aren't understanding you, then perhaps (it could be, just maybe) your point wasn't clear enough. I think we all could have done without this (below):
> Just like almost everyone else commenting
> on this article, you need to read before you criticize. This goes
> to everyone else who feels a need to comment before reading
> the article.
> R-E-L-A-T-I-V-E. Learn the freaking word.
> Just like almost everyone else commenting
> on this article, you need to read before you criticize. This goes
> to everyone else who feels a need to comment before reading
> the article.
> Read the freaking article. There's no need for me to just sit here
> and repeat myself. Seriously.
On Jan 20 06:02 AM tizod wrote:
> The article does not make sense to me. Yes, Apple could have registered
> big one time gains with the iPhone. If the product had issues they
> could have crashed just as hard as the blip up. Apple released the
> iPhone very smartly - both marketing and accounting wise. Any investor
> (heck even a rookie) knows Apple has money in the bank, continuous
> cash flow with few new ORDERS, and less risk of crash than most companies
> - especially other consumer electronics stocks. Job's health and
> the overall economy have pressured the stock. But that is proportional
> to the price. If Apple hit the stratosphere and then bad news hit,
> the crash would be harder.
>
> Be happy you feel the price is misrepresented and buy. This is investment
> opportunity. Why complain others "don't get it". Now is the time
> a Buffett would get into Apple.
>
> The article is good to justify Apple is sound and undervalued. But
> to say the accounting Apple used was a detriment is crazy. The accounting
> practice was an announced program by Apple, is known to all, and
> by design smoothed what could have been rough waters. And since the
> waters did not end up rough, all it does is give them a constant
> growth baseline to continue to build the business under. I submit
> this is a stroke of genius and great luck.
On Jan 21 01:58 AM Andy Zaky wrote:
> No. Its you that missing the point of the article. This article
> stands for the proposition that subscription accounting has CONTRIBUTED
> to the downfall. Not the cause. Just a mere contributor. As a
> matter of fact, this article speaks to why Apple is undervalued relative
> to others in the sector. RELATIVE. R-E-L-A-T-I-V-E. Learn the
> freaking word. Its undervalued relative to others in the sector
> due in part to the market overlooking adjusted earnings. What is
> the main argument in support of this...
>
> The fact that Apple's adjusted P/E ratio is far below that of its
> peers. The market is discounting nearly 40% of Apple's recorded
> revenue this past quarter. Just like almost everyone else commenting
> on this article, you need to read before you criticize. This goes
> to everyone else who feels a need to comment before reading the article.
>
>
> Once again. I never said that this accounting treatment was the
> cause of the collapse in share value from $200 to $80. What I am
> saying here is that relative to others in the sectors, Apple should
> be trading closer to $120 a share post collapse. Read the freaking
> article. There's no need for me to just sit here and repeat myself.
> Seriously.
I, like many others here, know the freaking word and read the freaking article. And yes, it's understood that you are not saying the accounting is the only cause of the stock's problems. Nevertheless, it's hard to deny that you're pinning a major portion of the fall on the accounting issues. (You did mention the financial turmoil among other factors, but frankly, I think it warranted more than the throwaway gotta-get-it-in treatement you gave it).
As to your present emphasis on "RELATIVE. R-E-L-A-T-I-V-E." performance, let's look at your comps:
GOOG is an interent advertising operation, not a maker of hardware and e-commerce platform (maybe some day that will change, but right now, GOOG isn;t in the hardware radar).
AMZN is a leading e-merchant, not one-to-one comparable to Apple.
MSFT and CSCO are, well come one, we all know. They, like GOOG and AMZN are possibly comparable in the minds of people who aren't really into the market but only into the (once) hot tech names that get publicity, but are not the sort of comps that would make a market-savvy person jump up and down if the P/Es were not strictly in line.
RIMM is the closest bona fide comp. But even it's differences work in its favor and are compatible with RIMM having a higher P/E (RIMM leads in the enterprise market and can reasonably be seen by many as likely to become formidable in the consumer space it just entered, RIMM is a purer smart phone play, and RIMM doesn't have to cope with health uncertainties relating to an iconic founder). You may disagree and argue that this doesn't warrant a higher P/E. Fine. If so,make your arguments re: those issues. But you can't brush them off and suggest the accounting is the big thing.
As to subscription accounting, I agree with others, here, who said the investment community understands this stuff. Those most likely to be confused probably don't know what EPS is anyway and, hence, probably don't care one way or the other what accounting policies are followed by Apple.
I recommend selling AAPL on strength. Any price above $90 is a sell.
:O
My mother would have scolded me if I talked like that as a kid...! :o
BTW, I thought you wrote an exceptional article about the way that AAPL accounts for IPhone revenues...I learned a lot from that. However, I reached a completely different conclusion regarding the merits of this stock.
I still won't buy, but after reading this article, I am more inclined to go long than short. Sorry if you find that disagreeable.
The "regulators" (those who are still looking for Madoff's auditor) have this theory that "investors" are sophisticated and understand the ex-items notes buried in the annual report on page 73 and listed using 8pt font.
Stocks are about stories. Illusions, dreams, romance. People who like hard numbers trade fixed income.
Security Analysis 101...:)
On Jan 21 09:53 PM Harry Tuttle wrote:
> GAAP? are you kidding? everyone knows listed companies are entitled
> to whatever numbers they want to use so long as the beat estimates
> by a penny.
>
> The "regulators" (those who are still looking for Madoff's auditor)
> have this theory that "investors" are sophisticated and understand
> the ex-items notes buried in the annual report on page 73 and listed
> using 8pt font.
>
> Stocks are about stories. Illusions, dreams, romance. People who
> like hard numbers trade fixed income.
Cash on hand is a given... As to viability... AAPL products are increasingly being recognized as higher quality with better resale value than it's competitor's. (see eBay and Craigslist)... This will serve AAPL well in the long run as people look to cut back on and consolidate their gadget purchases. A Macbook with a Windows partition equals two computers. An iPhone is still the closest thing to a real computer that you can put in your pocket. What's not to like from a consumer standpoint?
Throw away all of the pish-posh and rigamarole and think like a cash strapped consumer, and Apple still maintains a level share of sales... In that case... Flat means sales aren't falling. Add to that APPL's margins and one can clearly see that they can afford to comfortably cut prices if times get really hard and still keep consumers eyes turned towards their products. Cachet and Quality. Apple has those in spades.
Long story short... AAPL will weather the coming economic storm better than the vast majority of it's competition.
Look for a low of 60 due to the economy by mid year. Then jump in with both feet. Anybody that got in between 75 and 85 should be looking at the long haul... But shouldn't be too worried. If you got in over 85... Well ... You'd best be real patient.
Nice article and impressive charts. Too bad you're dead wrong. The Apple Q results proved you wrong. Ipod handicap? The only problem Apple has is Steve Job's health. Once it puts it behind, one way or another, the stock will take off again. If it did so well it such bad times, imagine what it can do in better times. Next time do better homework.
"Just wait a year when even handset manufacturer offers 2 or more mature models aimed squarely at iPhone users, and don't require 2-year lockups or GSM phones that only work on one carrier. We'll see how overpriced it is."
Well, we'll see next January. I think you are missing the point. Apple products are not commodities that can easily be copied by a low price, low margin competitor. Furthermore, in this difficult environment the competitors will likely be laying off engineers and cutting budgets while Apple continues to engineer new products.
Yes, in a year or two a competitor may come out with decent competition in some ways for the iPhone that Apple released last summer. But by next January the phone and software will be selling will be far advanced from that. It is very hard to play catch-up with a moving target.
Most of the bulge bracket investment banks are either down the tubes or need massive government bailouts. GM, Ford and Chrysler would be chapter 11 without government assistance.
So you'll forgive me if I don't think Apple is mismanaged. The perfect is the enemy of the good.