Apple Remains Overvalued, Despite Its Gadget Glory

We were more than surprised a couple of weeks ago with all the hoopla over Apple’s (AAPL) “blowout” quarter. Sales were up in (most) every device, app, download, etc. For Apple, the world is truly its oyster and if one didn’t know better, you’d think there was a pearl in their oyster shell.

On top of that, the company said if you eliminated subscription accounting metrics, the numbers looked even better.

On the other side of the street is Research in Motion (RIMM), whose management has been a bit more blunt in the market challenges they face. Then, zooming in from nowhere comes Motorola’s (MOT) ‘Droid, adding yet another fishing pole to the smart-phone pond. (Click chart to enlarge)

We own Motorola bonds, so naturally we want to see some new life breathed into the venerable maker of handsets. But, MOT still has to execute, and we know from experience that posturing and execution are two entirely different birds.

But, we digress. We have no knocks against Apple except that its stock is seriously overvalued (still). When it comes to marketing, Steve Jobs and company aren’t slouches and they’ve come a long way from the simpler days of Mac.

Anecdotal evidence of the Apple phenomena isn’t lost on us, either. I know five year-old kids with iPhones, and adults who get anxious when they can’t find their diminutive “pods” amidst the clutter on their desks. At dinner recently, a friend dutifully informed me that if I hadn’t visited an Apple store or kiosk lately, then I was out of touch, or seriously L7 (square).

Yet, beneath the herald of Apple’s gadget glory lie some disturbing accounting shifts which don’t quite support all the fuss. (You can view our analysis of AAPL here.)

First Consideration: there is no substitute for GAAP accounting rules. You can “adjust” earnings, sales, costs, margins, etc. all you want, but “pro forma” is simply a way for a company to show what they think the numbers should be. Thus, Apple has supplied investors with a second set of books.

Second Consideration: Deferring anything is not always a good idea. In Apple’s case, they made a huge effort to tell investors not to confuse GAAP with adjusted numbers, and they hinted to lower margins going forward.

Third Consideration: The income and cash-flow statements allow companies to tweak their numbers (legally). Period-to-period reconciliation is either a change in how margins are displayed or changes in the style of how cash is created by or used in operations, investments and financing.

The balance sheet though, speaks a bit more clearly as to where all assets and liabilities get parked (until at which time they either get converted to cash or simply remain stashed in an accounting broom closet.)

So, this in mind, let’s just forget about subscription accounting for a moment and Apple’s seeming devotion to transparency. Again, this is not an accusation of Apple’s accounting methods, but our contention that its stock price is over-valued.

Analysts, too, suggest that, absent subscription accounting rules, cash-flow, earnings and margins would be much higher. CNBC’s Jim Goldman even waxes gushingly to the staggering profitability of Apples latest results. He’s obviously a fan.

But, but...but, we think the rising accrual ratios presented in the GAAP numbers, along with increases in non-operating assets, reveal a continuing decline in the quality-of-earnings being reported by Apple in recent quarters.

How so, you say? Well, we know that sales are hot and by the company’s own admission, demand outstripped supply (component availability issues were mentioned). Reported GAAP earnings for September ’09 grew 34.8% over the prior quarter on a boost of 18% in earnings for the similar periods.

Receivable’s jumped 25.1% quarter-to-quarter, while cost-of sales jumped 17.73%. Other current “assets,” though, rose almost 14%. What’s interesting about other assets is this generally includes restricted cash, pre-paid expenses, deferred tax assets, but excludes cash, inventory, receivables, short-term investments, etc.

However, when you strip out deferred taxes (approx. 1/3), these non-cash assets have risen dramatically in the last two quarters. Accounts payable too, (including accrued expenses) show an uncomfortable rise, even if one were to include deferred revenues into the picture. Which begs the question: If cash-flow is so copious and you’re sitting on mountains of cash, why be such a piker with your vendors?

Ultimately, what we’re seeing (in our dual cash-flow research) is a sequential decline in operating cash-flow, combined with a sequential increase in balance sheet cash flow. On top of that, management made a point to say component costs would be rising.

The company is also vague about when they will adopt the newly revised FASB rules, which they and others lobbied hard for. Yet, in the same breath, management admits that adopting these more favorable accounting rules will be complex and likely involve arbitrary latitude in determining values.

So, they are quick to throw two sets of books at investors with the caveat that creating one set of books out of the two will be a formidable task.

This, gets us back to RIMM. Blackberry jam is rather tasty, except when it’s smeared all over one’s face. Shares have taken a drubbing since Apple’s rosy earnings and again in the midst of ‘Droid’s entrance into the arena.

However, a comparison of dual-cash flow and accrual analysis between the two rivals clearly indicates that RIMM is a far better value than the big AAPL. (You can view our analysis of RIMM here.)

We do note that Apple’s capital productivity is more efficient than RIMM’s, but the bottom line is the rise in non-cash accounting at AAPL is greater than the difference in the GAAP vs. “adjusted” figures being presented.

Disclosure: MOT bonds

Comments

[Fred LA:]

Conflict of interest, Enough said.

Nov 05 12:58 PM

[Stuff and N...:]

Isn't the deferred revenue stream from iPhone and AppleTV accounted for as "restricted cash"? A large jump in the amount of "other assets" could therefore simply indicate that there's a whole lot of money piling up in the bank due to the subscription accounting model.

As for accounts payable increasing - it seems to me that until and unless Apple's creditors start complaining / filing lawsuits / deferring production, then I, as an investor in AAPL, would prefer that my company pay its bills exactly when they are due, and not a moment earlier. Interest on all the money Apple pays its suppliers isn't chump change.

Beyond this, you don't provide any specific target for AAPL's valuation, nor do you show how you got there. It's just "overvalued". Bah. Show me numbers. Prove your case, or begone.

Nov 05 01:20 PM

[Roger Knights:]

"However, a comparison of dual-cash flow and accrual analysis between the two rivals clearly indicates that RIMM is a far better value than the big AAPL."

If you count RIMM's "beans," it has more of them; but Apple's are growing to the sky.

Nov 05 01:21 PM

[Roger Knights:]

PS: What I should have said was that Apple has "magic" beans--ones that will grow to the sky.

Nov 05 01:25 PM

[Old Developer:]

If I had MOT bonds I'd be afraid of Apple too! If Apple decided to sell to Verizon it could put the last nail in that coffin. Heck, MOT bonds, what were you thinking?

Nov 05 01:26 PM

[LongAAPL:]

Jason owns MOT so Jason doesn't like AAPL. You wasted a lot of time and effort to show your bias by trying to influence the uninformed.

Nov 05 01:27 PM

[NDinMSP:]

None of these articles seem to take into account Apple's constant innovation. How do you know a stock is overvalued when you have no idea what they might invent next? And why is every other company scrambling to imitate Apple? What do they know that you don't?

Nov 05 01:29 PM

[RLLH:]

As an investor in Apple stock I tend to agree with you. But there is the constant temptation to hold on just a bit longer and squeeze out just a little more money from the Apple fanatics.

Nov 05 01:39 PM

[jack dee:]

Using your logic just about every positive story about apple should be trashed , most are by people with openly stated vested interests.


On Nov 05 12:58 PM Fred LA wrote:

> Conflict of interest, Enough said.

Nov 05 01:39 PM

[nytesky:]

This type of analysis assumes that companies are stagnant at this point in time. If Apple releases a tablet and it is wildly successful, this widens their product line and opens up additional revenue streams (movies, tv shows, e-books, comics).

This brings up another point. It is very difficult to compare AAPL with any other company because they are in so many industries. They compete with MSFT & GOOG, RIMM & MOT, HPQ & DELL and AMZN. They are uniquely a software developer, hardware manufacturer and both online & brick and mortar retailer.

MOT has a lot of potential. They have huge Google support and are already at the bottom. RIMM on the other hand, is having a difficult time translating their corporate success to consumer success because of many competitors including AAPL, GOOG and (a lesser extent) PALM. Software is driving smart phone sales now and RIMM has an increasingly antiquated OS.

Lastly, never believe Apple guidance. They are overly conservative. The previous quarter they also said that margins would be down, yet it went up. Surprise!

Nov 05 01:41 PM

[nytesky:]

One more thing, the smart phone pie is growing. So it is possible that AAPL, RIMM, MOT, GOOG and PALM will all be successful, make lots of money and keep the mobile phone market innovative and competitive. A win for all companies and consumers alike. Success at one company does not always portend failure at another.

Nov 05 01:44 PM

[JamesApple:]

Without hard numbers I cannot accept the author's argument. Tech company accounting should be more realistically tied to large profitable sales instead of accounting principles and theories only. Accounting is an art not a science. What people see is the mercurial rise in Apple's dominance and prosperity with brightening future prospects, whereas Research in Motion is rapidly declining having to buy back the falling stock in an attempt to slow down further drops in share price. Even with Rim's buybacks, there do not seem to be any measures to restraint to Rimm's continous free falls in the coming quarters as we see continuous sales drops in Rim product and service offerings. After all, if a company, like Rim, cannot sell its products and services, what is it doing in business?

Nov 05 01:53 PM

[JamesApple:]

In this economy, superior goods like iPhone continue to retain their value, whereas inferiror goods like Rim blackberry continue to decline. Many companies heavily discount their inferior goods to salvage the residual values sunken into the production of these goods. Heavy discounting through giveaway campaigns of blackberrys and Rim's stock buybacks are indicative of Rim being a maker of inferior goods unable to produce superior goods and survive as a business.

Nov 05 02:00 PM

[calebcar:]

I'm not an accounting whiz, but I can usually follow this type of article. The lack of numbers and ratios made it hard to understand.
" these non-cash assets have risen dramatically in the last two quarters. Accounts payable too, (including accrued expenses) show an uncomfortable rise."
"what we’re seeing (in our dual cash-flow research) is a sequential decline in operating cash-flow, combined with a sequential increase in balance sheet cash flow." some hard numbers and proportions would be helpful.
I shouldn't have to read the statements to get an initial impression of the article.

Nov 05 02:03 PM

[iranewlander:]

Yeah, Apple must be overvalued because their products are easy to use and upgrade. At least here in So. Calif. there is a third-party vendor (in whom I have NO interest other than curiosity and admiration) who for 25 bucks (US)* will help you with the 'easy' upgrade to W7.
www.makeitwork.com/con...
*Offer expires November 6, 2009 at 11:59pm. Cannot be combined with any other offer(s).
Where do they get these notions? I have legacy apps running XP and have no choice, but I have two Macs for that purpose, a Mac in the Box and a PowerBook. Say what you will, for Apple, like Ford,
Quality is; Jobs won!
wereport.com

Nov 05 02:29 PM

[Eldernorm:]

Analysts are so great at pointing out how they know so much. Of course its always after the fact that they like to point out such things. :-)

So if Apple is so over valued maybe its because you did not buy in at $80 and would like another chance. If the stock can be twitched down some, they you can buy and enjoy the ride up.???

But I do agree with one of the above. Companies are dynamic. And if the company is innovate and dynamic, they skate to where the puck WILL be. Not race all the other analysts to where the puck WAS.

Just a thought.
en

Nov 05 02:41 PM

[Arnold Rein...:]

From Apple's latest 10K:

Accounts payable Sept 26, 2009: $ 5,601, Sept 27, 2008: $ 5,520

Given how much Apple's business has grown in the last 12 months, they must be paying more promptly, not less.

(am long on aapl)

Nov 05 02:42 PM

[JW.USC:]

How about coming clean regarding your obvious vested interest in Micro$uck?

It's pretty obvious from reading your hundreds of comments where you consistently trash Apple.

On Nov 05 01:39 PM jack dee wrote:

> Using your logic just about every positive story about apple should
> be trashed , most are by people with openly stated vested interests.

Nov 05 02:53 PM

[JamesApple:]

Rim has a huge worry on how to clear its accounts receivable holding account comes February when huge drops in blackberrys sales fail to bring in enough money to pay for bills they owe their suppliers and partners? On top of that, Rim has a huge payroll to meet, all kinds of expenses. Can I see those general account ledgers and real operating income and expense Rim statements? I stand to be horrified if I hold any Rimm shares.

Nov 05 03:36 PM

[JamesApple:]

@nytesky. Rimm cannot be innovative, not in the company of Apple, Google, Palm.

Nov 05 03:40 PM

[VSD:]

How are you valuing apple? It is going to earn oer $10/sh in 2010 i.e. 12x fwd p/e. It is growing at 35% yoy. 30% of PCs shipments in 2012 will run macos.

Nov 05 04:04 PM

[Julian Ivan...:]

Wow - I remember reading analysis like this when AAPL was at $10 (pre-split)...and $35.. and $50... and it was NEVER going above $100. $200 was plain "STOOOOPID" right? I mean, earnings growth on a scale never achieved by a mega-cap and sustained through the worst recession in 80 years means nothing, right? You, my friend, are the best contra-indicator there is. While generally well-educated and eloquent individuals such as yourself can continue to spew forth saddeningly ill-informed and ill-judged analysis, I am reassured that the AAPL-bus still has many, many yet to welcome on board. I think I'll start following you and once you start going bullish on AAPL, I'll know its time to get off :)

Good luck with them MOTs... go easy on the analysis though; you might cut yourself with that RAZR-sharp brain of yours. Personally I think you're off your ROKR though. Tell you what, why don't you add a dash of RIMM to your portfolio, and a sprinkle of PALM - all of which are about to vanish into the tarpit of history.

Bon chance.

Nov 05 05:28 PM

[jack dee:]

shame on you , I have posted dozens of times stating very clearly I hold positions in lots of stocks, MSFT GOOG MOT , are some of them.

and if apple dropped to the right price I would buy it...


On Nov 05 02:53 PM JW.USC wrote:

> How about coming clean regarding your obvious vested interest in
> Micro$uck?
>
> It's pretty obvious from reading your hundreds of comments where
> you consistently trash Apple.
>
> On Nov 05 01:39 PM jack dee wrote:

Nov 06 12:01 AM

[Wireless Wiz:]

First Consideration: GAAP accounting rules simply are not 100% accurate in describing the true economics in every business. The company by rule has to defer most of iphone revs/cogs, not by choice. Adjusting for this gives one a true picture of the business.

Second consideration: Lower margins might be a strategic move to increase the addressable market, i.e. lower prices.

Third consideration: A balance sheet is a snapshot in time. Has it occured to the author that perhaps this is a timing event in that they are ramping up for holiday sales and perhaps have been starting to build supply for the holiday season near the end of Sept and this just shows up as a payable that has been taken care of after the quarter end.

As an investor, I follow the free cash flow, and unless Apple is lying, they put up about $11.25/share of free cash flow in the last year, eneding Sept 30. With almost $38 per share in cash, and $11.25 trailing 12 months FCF, I arrive at a valuation of roughly 13.7X, net of cash. How is this overvalued? Seems VERY cheap to me.

Nov 06 10:36 AM

[LaChic:]

I'm going to agree with the author in part, i think apple products reflect more of a trend than anything else, I personally would not get into apple at these levels because I'm nervous about the markets right now, do i think apple could go higher? probably? but I'm pretty sure you will be able to pickup apple around 100 or lower a share if you wait. When the market corrects for real, apple will go down just like the rest of the market.

Nov 06 02:25 PM