Equity Valuation and Analysis with eVal Apple and the iFad

Case Overview Comprehensive analysis of a growth company employing conservative accounting Assessment of company involves: Evaluation of future growth opportunities Sustainability of current profitability Impact of conservative accounting on future earnings

Overview of Business Apple designs, manufactures and markets personal computers, mobile communication devices, portable digital players and a variety of related software and services http://www.apple.com Introduction of new products, particularly the iPhone, drives strong growth from 2007-2009

Business Strategy Analysis (1) Sources of competitive advantage Integrate its own hardware, operating system and applications to provide best-of-class products and services Focus on innovative new products through aggressive investment in R&D Expand distribution network via Apple Stores

Business Strategy Analysis (2) Key Risks Competitors imitate products Better 3rd party operating systems Lack of Apps for custom operating system Run out of ideas for new products

Business Strategy Analysis (3) Apple Integrated consumer products IBM Integrated IT solutions for enterprise clients

Accounting Analysis (4) Revenue Recognition for iPhone and Apple TV: For both iPhone and Apple TV, the Company has indicated it may from time−to−time provide future unspecified features and additional software products free of charge to customers. Accordingly, iPhone handsets and Apple TV sales are accounted for under subscription accounting in accordance with GAAP. As such, the revenue and associated cost of sales are deferred at the time of sale, and are both recognized on a straight−line basis over the currently estimated 24−month economic life of these products, with any loss recognized at the time of sale. Costs incurred by the Company for engineering, sales, marketing and warranty are expensed as incurred.

Accounting Analysis (5) To restate revenues, we add back the net deferred revenue and to restate costs, we add back the net deferred cost Net deferred revenue = $6,908 (from SoCF) OR, Net deferred revenue = $4,485+$10,305-$3029-$4,853=$6,908 (from BS) Net deferred costs = $3,703-$1,931+$1,468-$1,089= $2,151 (from Note 4) Restated Revenue = $36,537+$6,908 = $43,445 Restated Cost of Sales = $23,397+$2,151=$25,548 Restated Gross Margin = $43,445-$25,458=$17,897 Change in Gross Margin = $17,897-$13,140=$4,757 Income before Taxes = $7,984+$4,757 = $12,741 Provision for Taxes = $12,741*($2,280/$7,984) = $3,638 Restated Net Income = $12,741-$3,638 = $9,103

Accounting Analysis (6) Underlying Economics Recognition at time of sale makes more economic sense. While Apple has indicated that it may provide additional unspecified features and software free of charge for these products, they likely represent a small fraction of the sale in economic terms.

Ratio Analysis (7)

Ratio Analysis (7)

Ratio Analysis (8 & 9) Relative IBM, Apple does not use debt financing, thus losing out on the ability to leverage its high RNOA into an even higher ROE Relative to IBM, Apple sits on a larger balance of financial assets, which slow down its turns without commensurately increasing its margins Apple could increase its ROE by paying out excess cash (dividends, stock repurchases) and issuing debt.

Forecasting Analysis (10)

Forecasting Analysis (10) There are two obvious reasons why these assumptions lack plausibility Subscription accounting is deferring sales revenue and gross margin for iPhone. As this unwinds, sales growth will rise and gross margin will widen Cash balance is unlikely to stay constant as a proportion of sales (but what will Apple do with it?) Suggested changes Based on answers to question 5: bump sales growth to 30% for 2010, then back down to 11% in 2011 reduce CoGS/Sales to 59% in 2010 Trend cash balance to 10% of sales terminal value

Valuation Analysis (11)

Valuation Analysis (11) eVal default estimated intrinsic value/share is $136.75 Stock market price of $190 looks more reasonable, because it factors in revenue and margin bounce from reversal of conservative accounting for iPhone

Valuation Analysis (12) The analyst values Apple at 16x EV/FCF on CY10E FCF estimate of $11,241 The approach is not grounded in sound valuation theory. The 16x multiple appears to be purely subjective The use of FCF rather than earnings appears to be a way of getting around Apple’s conservative accounting for subscription revenues

What Happened? Q1, 2010: Retrospective Adoption of New Accounting Principles Under the historical accounting principles, the Company was required to account for sales of both iPhone and Apple TV using subscription accounting because the Company indicated it might from time-to-time provide future unspecified software upgrades and features for those products free of charge. Under subscription accounting, revenue and associated product cost of sales for iPhone and Apple TV were deferred at the time of sale and recognized on a straight-line basis over each product’s estimated economic life. This resulted in the deferral of significant amounts of revenue and cost of sales related to iPhone and Apple TV. The new accounting principles generally require the Company to account for the sale of both iPhone and Apple TV as two deliverables. The first deliverable is the hardware and software essential to the functionality of the hardware device delivered at the time of sale, and the second deliverable is the right included with the purchase of iPhone and Apple TV to receive on a when-and-if-available basis future unspecified software upgrades and features relating to the product’s essential software. The new accounting principles result in the recognition of substantially all of the revenue and product costs from the sales of iPhone and Apple TV at the time of sale. Additionally, the Company is required to estimate a standalone selling price for the unspecified software upgrade rights included with the sale of iPhone and Apple TV and recognizes that amount ratably over the 24-month estimated life of the related hardware device.

2010 Results Exceed Expectations

Mad Money Version of Case http://www.cnbc.com/id/15840232?video=1255375408&play=1