Apple's History Puts Its Present into Question

Wall Street seems to be rewarding Apple Computer (AAPL) for its increased earning by giving the stock price a boost of 15% in the last 10 days. On Tuesday it was announced that Apple beat mean consensus earning estimates by 15%. (See Apple's Q3 conference call transcript here.)

I have followed Apple for many years and I can't seem to understand why investors continue to allow themselves to be taken again and again without pause. Apple is replete with examples of how the company has managed to game the system. I will point out the glaring examples that can be proven and hope that others will allow for the facts to stand juxtapose to the exciting stories that have been created to fan the destructive flame of an adoring public.

Below are my top five reasons why I can't trust the way Apple operates as a company.

Problem 1: Option Repricing

Since its IPO, Apple Computer had been the innovator of “serial option repricing.” This method allowed Apple to continually reprice the stock options as the shares of Apple stock fell. This is unique since most companies would reprice their options only one time after the price fell below the exercise price.

In the case of Apple, the options would be continually repriced as the stock went on a downward decline. This is critical since Apple has used options as the primary means of compensation in the executive suite as well as for frontline employees.

It is worth noting that Steve Jobs garners an annual salary of $1. It’s not because Steve Jobs is Mr. Benevolent , instead he is compensated through the value of the options that are issued to him. If the stock price starts to decline then Jobs would be out the value he could have received if he exercised the options at a higher price. This creates the perverse incentive to adjust the strike price of the options lower if the stock goes down.

While the debate of the use of stock options as a form of compensation has died down it should be noted that as early as 1998 the critics of such instruments were vociferous about the risks associated with them. Warren Buffett’s business partner Charlie Munger said that, “stock options resemble ‘a chain letter.’”

According to Dennis Beresford, former chairman of the Financial Accounting Standards Board (FASB), options are similar to a “Ponzi scheme.” And like Bernard Madoff’s scheme, the game really starts to fall apart when a sustained decline ensures.

Source: Welles, Edward O. "Motherhood, apple pie & stock options. " Inc. Magazine. Feb 1998.

Problem 2: Management Compensation

During the days when Gil Amelio was CEO, the board at Apple granted tremendous leeway in how it chose to compensate the CEO. At the time, Apple was expected to lose money for many quarters.

How did the board at Apple circumvent this problem to give Amelio the most compensation? The board allowed the company to pursue a strategy of projecting larger losses in the future than was realist and then beating the lose projections.

From this standpoint, the board would reset the compensation markers for when the CEO would be able to receive their bonus based on quarterly performance on top of their ordinary pay. This meant that regardless of the number of quarters that had passed without profitability, the CEO was going to receive a bonus no matter what happened.

This strategy is similar to what happened to Fannie Mae (FNM) when the company was forced to restate their earnings and fire CEO Franklin Raines.

Source: Crystal, Graef. "One bad Apple doesn't spoil a whole bunch of stock options. " San Francisco Business Times. Jan 31, 1997.

Problem 3: CEO Bailing

On June 26, 1997, when Apple was in the throes of a death spiral in the stock price, Steve Jobs decided to sell 1.5 million shares of Apple stock.

This would seem to be the time when the CEO should be trying to “inspire” confidence in the company stock. Instead, Jobs chose to sell his shares just after selling his NeXT Software to Apple for $6.50 a share earlier in the same year.

Not long afterward, Microsoft (MSFT) inject a large amount of money into Apple. At that point, Apple shares started to rise tremendously.

Source: Mardesich, Jodi, and Chris Schmitt. "Jobs admits selling shares." San Jose Mercury News. August 12, 1997.

Problem 4: Sleight of Hand

Another problem is that Apple always gives conservative guidance on their projections and always seems to beat expectations by a wider than expected margin. This was a strategy that was employed by General Electric (GE) until it could not sustain the lie of earnings management due to the collapse of GE Capital. GE was able to convince the public that all was well with the way they operates. Even convincing management junkies that Jack Welch’s Six Sigma was the reason for the company’s success. Instead, it was the practice of managing expectations and a little accounting mumbo-jumbo that kept things moving.

Did you notice that the analysts who cover Apple stock continually get the numbers wrong. When I compared the analysts estimates tracking eBay (EBAY), Cisco (CSCO), Google (GOOG), Adobe (ADBE) and Apple, I found that Apple was always off target by a wide margin. In the data below, the last five years analysts estimating the annual earnings were below the target numbers as follows:

• Google (GOOG): 2.85%
• eBay (EBAY): 1.35%
• Cisco (CSCO): 1.52%
• Adobe (ADBE): 0.006%
• Apple (AAPL): 5.56%

In the last five quarters, analysts were off of the target numbers as follows:

• Google (GOOG): 3.33%
• eBay (EBAY): 8.25%
• Cisco (CSCO): 7.98%
• Adobe (ADBE): 4.50%
• Apple (AAPL): 15.88%

The relatively huge disparity between analyst estimates for Apple and other “high flyer” tech companies is cause for alarm. How is that Apple projections are off by nearly 100% as compared to other tech companies that are subjected to the same economic downturn in the economy? Either the analysts aren't getting it right or Apple is managing the situation. From the prior track record of Apple, I suspect that the earnings are being managed to the Nth degree.

Note: The preceding annual and quarterly numbers are derived from ThompsonReuters as of July 15, 2009.

Problem 5: Backdating Options

In 2001, Apple was called to task for the issuance of, among other things, a 7.5 million options grant to Steve Jobs. The problem with this is that the issuance, made by Chief Counsel Nancy Heinen, was dated two months prior to the date actually created.

Heinen was later fired from Apple and fined for her role in the illegal activity but it didn't seem that Steve Jobs had any problem with the action until the SEC started doing an inquiry into the unusual backdating of the options.

Strangely, the Apple board, "exonerated Jobs---in part because Jobs 'did not appreciate the accounting implication' of backdating."

It seems strange that Heinen would benefit Mr. Jobs and later get thrown under the bus. It is interesting to note that the Apple board said that Steve Jobs didn't know the implications of such actions even though the board "admitted to frequent backdating."

If Apple had as a practice the backdating and repricing of options since its IPO, then Steve Jobs should have known as the CEO, the implications, from an accounting and legal basis, the actions being taken.

Again, like every good scheme, the act of backdating options didn't come up as an issue until the blowup of the tech sector. Had the Nasdaq stocks continued to move higher I don't think any of the SEC actions would have been taken on the matter of backdating or repricing of options.

Source: Burrows, Peter. Parting Shots at Apple's Jobs; Former CFO Fred Anderson reached a settlement with the SEC over options backdating--but says the CEO deserves part of the blame. Business Week Online. April 26, 2007.

While the products that Apple create are great for the gee-whiz hipster crowd of the new millennium, the actions of the board of directors and executive suite has been questionable at best. As far as I can tell, Apple hasn't cleared the air about the way they have managed the company in the past to justify buying or holding the stock right now.

Disclosure: no positions

Comments

[enzos:]

Comparing Apple and Madoff! You're a pathetic joke mate. Give yourself an upper cut.

Jul 23 06:33 AM

[Roger Knights:]

Apple was inconsiderate to its shareholders, and missed an opportunity to benefit itself, by failing to do a stock buyback in the fall when its shares were very underpriced, and it was sitting on a huge cash hoard.

Jul 23 06:48 AM

[brewer:]

I think your problem is you didn't buy it.

Jul 23 09:38 AM

[pk de cville:]

You are living in some alternative reality circa 1997-1999.

Jul 23 10:04 AM

[john12345:]

Boy. You're in trouble now. Never criticize Apple. There are too many emotional fanboys.

Jul 23 10:18 AM

[Jon T:]

I thought this might be an interesting article when I saw the title.

Just wasted a minute of my life, and the extra 10 seconds to say so.

Jul 23 11:05 AM

[jmmx:]

I don't think you need to be a fanboy to notice how many of your points are on very very old events - over 10 years in some cases.

The only point that is even vaguely relevant today is #4 "Another problem is that Apple always gives conservative guidance on their projections and always seems to beat expectations by a wider than expected margin."

Yes, Apple always gives conservative guidance. Especially in a very uncertain time. Could you have predicted the iPhone sales 6 months ago? Could you have told Apple exactly how many Macs would be sold this past quarter?

Now let us suppose that Apple had given an optimistic guidance and failed to meet it. How many people would then have cried foul and beat up on them or even sued them?

Given all this, I will take my conservative guidance. Now you can choose to not buy a stock for passed perceived transgressions and because they give "conservative guidances" while the company is producing groundbreaking products and growing like wildfire, but to me that appears foolish.

As for me... I'll take my politics liberal, my products visionary, and my management conservative.

Jul 23 12:27 PM

[lstream:]

Do you need any actual qualifications to write for this web site? Remember how the original Mac's used to blow power supply caps, because Jobs hated fans? How could you have possibly missed that scandal? Wish I could get paid to be a professional whiner.

Jul 23 12:39 PM

[waterman:]

Thanks for the trip down memory lane - the late 1990s???

This article really is pretty off-beat and just odd.

While there is a lot to comment on here ... it isn't worth it.

One of my pet peeves that comes up every once in a while is about Microsoft's investment in Apple and the continued misunderstanding or Mis-stating what actually occurred way back then.

"Not long afterward, Microsoft (MSFT) inject a large amount of money into Apple. At that point, Apple shares started to rise tremendously."

Short story ... As part of a settlement of a lawsuit between MS and Apple, the agreement included the purchase by MS of about $150 million of preferred Apple stock which is NON Voting stock. MS also agreed to continue developing MS Office for five years and Apple agreed to use Explorer as the default browser on its Macs. (MS was allowed to convert this preferred stock to common stock and i think they did but then sold it - it was a minor fraction of the total stock issued. Some have calculated it might be worth $18 Billion today)

Yes, aapl stock went up for the next three years after the purchase of stock by MS and the signing of the agreement with Apple BUT the Stock upward movement was due to many factors (certainly it does include that MS Office would be available on the Mac) - BUT probably the most important was the re-organization (Steve Jobs' return) and refocusing of Apple on better products. Perhaps you have heard of the "iMac" which was introduced almost exactly a year later. Then came all the rest ... retail stores, iPod, iTune, OS X, etc.

About that time, Larry Ellison was quoted as saying something like "I have seen what is on the drawing board and Apple will be the Sony of the 21st century" (not an exact quote).

some history ...
www.apple.com/ca/press...

Jul 23 12:45 PM

[yofal:]

Sheesh...

What's with the flurry of hatchet jobs on APPL of late.

This is getting ridiculous…

Jul 23 04:42 PM

[LT:]

Which hedge fund pays you?
APPL beats because you out of date guys can not understand what/why the consumer buys a superior product at a higher price. So therefore it is not APPL that lowballs, it is you guys estimating low sales and 100% negativity.
Maybe you "journalists" should have to put your money where your mouth is...and I mean that before you publish, you have to have your money invested in a long/short trade.

Jul 24 07:04 AM

[jack dee:]

Of course it matters not it you points are real , right or wrong, the fanboys flock to SA to defend the holy Steve.

Jul 28 01:57 PM