Apple's Financials: Polished Exterior but Check the Oil

Feb.10.11 | About: Apple Inc. (AAPL)

With Apple’s (NASDAQ:AAPL) market cap now in excess of $329 billion and analysts raising their price targets and estimates, investors might want to scour the financial statements and see if the reported numbers tell a similar story.

The broader macro story of AAPL’s success is nothing short of phenomenal. Shareholders have been rewarded handsomely and all things Apple remain wildly popular.

However, given the large headcount of analysts covering AAPL (currently 42-53 depending on earnings, revenue, or both), it's a safe bet to expect diversity in the range of estimates. Yet, at over 4x sales and almost 6x book value, it can’t hurt to take the pulse of earnings quality and cash-flows supporting them.

Balance-sheet: Rock-solid, backed by $59.7 billion in cash / marketable securities and no debt.

Enviable Cash: Cash and short-term marketable securities account for 61.4% of total current assets. Non-current marketable securities represent 76% of total non-current assets while combined current and non-current cash / equivalents / marketable securities pencil in at about 69%* of total assets.

*Note: a significant amount of AAPL’s cash / equiv. / marketable securities are held by foreign subsidiaries.

At first blush, this might suggest operating results are being achieved with less than one-third of AAPL’s total asset base. Yet, it also indicates a bulk of AAPL’s stated assets are not materially contributing to returns-on-equity.

Given the incredible capital appreciation of AAPL shares in recent years, we don’t expect investors to give much concern of Apple’s cash-to-asset relationship. To many traders, it is simply a luscious apple pie, each slice tastier and more profitable.

We also don’t expect much in the way of a regular dividend for several reasons: repatriating cash from overseas would have huge income tax implications; Apple CEO Steve Jobs reiterated a preference for the comfort of cash over dividends and buybacks; COO Tim Cook reinforced this further by saying future acquisitions would focus on buying companies for their talent and technology, rather than as assets that add to revenues.

As for a special cash payment, who knows? AAPL execs are infamous for coyness and secrecy, but the company’s cash position and potential future earnings growth do offer the possibility.

Cash-Flow Components of Earnings: Our dual-cash flow model has detected several cash-flow trends meriting attention.

  1. Although operating cash-flow spreads remain solidly in positive territory, Q1 2011 marks the third consecutive quarterly decline in the dual cash-flow ratio.
  2. OCF as a % of revenues has also declined in each of past three periods.
  3. Recent and confirmed Merriam Report signals are both bearish

In contrast, balance sheet cash-flow (BSCF) appears to be moderating in recent quarters, which is constructive to overall earnings quality.

click to enlarge images

Dual Cash Flow signals and ratios AAPLClick to enlarge

Q1 2011 Revenue Metrics: Modest deterioration in R&D*, cost-of-sales and accounts payable were offset by slight improvement in S/G/A (as a % of sales).

*Keep an eye on R&D spending: AAPL increased R&D spending 34% in 2010 compared to prior year. Part was due to added headcount, capitalized prior year development costs and stock-based compensation. Yet, R&D as a % of sales in Q1 2011 was only 2.57% of sales and declining since 2008.

Q1 2011 Capital Productivity: Asset participation (per each $1 of sales) revealed modest improvements in inventory and capacity, offset by slight increase in accounts receivable.

AAPL Accruals and Capital ProductivityClick to enlarge

Accruals: In Q1 2010 AAPL adopted new accounting standards resulting from the issuance of ASU 2009-13 and14. Under new revenue recognition rules (which are informally called the “Apple rules”), AAPL can assign a value to the software and account for it over time and book revenues for the hardware sooner.

Under previous “subscription” accounting rules, AAPL deferred revenues and related cost-of-sales (iPhone and Apple TV), recognizing these on a straight-line basis over the product’s estimated economic life.

AAPL has historically employed a significant amount of accrual accounting in their earnings reports. This trend continues as AAPL’s accrual figures have rose in each of the past three periods. Further, the most recent accrual ratio (Q1 2011) is highest (+8.02) of all seven periods reviewed and extremely bearish.

Looking at the statement of cash flows, a lion’s share of the Q1 ratio are related to increases in deferred income taxes, adjustments to equity compensation expenses, non-cash adjustments (to reconcile net income to cash provided/used in operating activities) and increases to non-operating assets/liabilities during the period..

Near-term, the issues of declining “true” operating cash flows and rising accrual trends will likely be overshadowed by the aforementioned analyst sentiment and product announcements, etc.

Bottom Line: Apple shares have had one heck of a run in recent years, confounding contrarians, short-sellers and us too. However, for investors still onboard rocket “Apple”, it will not hurt to keep an eye on the vital profit “constituents” in an earnings report.

Equity prices might be fueled by future expectations, but financial statements provide important clues about the engine getting you there.

Valuation: Based on our analysis of the seven periods through Dec. 25, 2010, we assign an estimated fair-value of $338 to AAPL shares. Earnings quality is A-

View entire AAPL report here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.