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 3
rd
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
timetotime 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 straightline basis over the
currently estimated 24month 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 Apples 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 products 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 products 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