What you Should Know About the Books

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By RodgerRafter
January 9, 2001

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A month and a half ago, I wrote a post on: What you Should Know About Apple's Earnings.
One basic point underlying that whole post was that corporate earnings are fickle. A company's officers understate or overstate the company's earnings to suit their own short-term objectives, and fluctuations in the economy can lead to wide swings in earnings from year to year. On top of that, deceptive accounting practices (especially when it comes to options grants) mean that the earnings of almost every company these days are grossly overstated.

To me, book value has always been much more important than earnings as the first step in trying to value a stock. The supposed purpose of accounting is to place an accurate value on a company in the form of shareholder equity (or book value), which is a company's assets minus its liabilities. Earnings just show how much shareholder equity has grown during a given quarter, but the real assets and liabilities are what matter over the long term.

Wall Street is mainly in the business of buying low (buy underwriting stock offerings or causing investor panic) and selling high (pumping and dumping when stocks are at their highs). Wall Street doesn't like to quote book value for two main reasons, IMO. First, book value is much less volatile than earnings, so it can't really be used to hype stocks at their peaks and panic them when stocks are at their bottoms.

Instead you usually see analysts touting models like P/E (bad), Price to Earnings Growth (twice as bad), Revenue Growth (sheesh!), and Return on Assets or Return on Equity (exactly backwards). With each step down that path, analysts get further away from a company's true value and deeper into the realm of obfuscation and deceit.

P/E is unreliable because corporate earnings are unreliable (see the earlier post). Earnings growth is misleading because the growth rates rarely can be maintained. Newly and barely profitable companies often start showing tremendous earnings growth simply because 2 cents vs. 1 cent equals 100% earnings growth. As for revenue growth:

Let me add to that post the practice of companies like Lucent and Cisco, whereby they loan start ups and cash poor companies millions of dollars to buy their products. This allows LU and CSCO to report big revenues and profits now, even though they know that many of these loans will go bad in a couple of years. Typical customer of both LU and CSCO:

Lastly, RoA and RoE give exactly the wrong picture, because Assets and Equity are put in the denominator. A company that has a lot of assets (like cash) is solid financially, but suffers in this valuation model. Instead, a company that leases all of its property and equipment, and blows all of its cash on a stock buyback program has very little in the way of assets and shows a very high RoA. Likewise, a company buried under a mountain of debt has very low equity and can show a great RoE when the economy is good. When the economy goes bad, however, this company goes bankrupt. Companies short on assets often call up their investment bankers with a desperate need to raise cash, thus giving Wall Street reason to hype these kinds of stocks and create rationales for models like RoA. Give me book value as the first and most important step toward finding bargains in the stock market, and leave the other models to Wall Street and the suckers who buy the hype.

Well, that intro went a little longer than I expected... Now on to AAPL's books.

Recently, much has been made of Apple's Cash ($1.191B) and Short Term Investments ($2.836B). The $300 Million in Long Term Debt sometimes gets ignored, but that still leaves a net of $3.727 Billion that guarantees Apple will be able to survive any prolonged economic downturn. Best of all, it currently generates a net $62 million per quarter in interest income, no matter how well computer sales go. It doesn't, however, mean that Apple can't trade below $12 per share. Any stock can trade at any price. When Wall Street takes a stock down, there will invariably be more sellers than buyers because most people are stupid, and there will be more people who panic and take losses than there will who have the guts to buy at the bottom. Likewise there will always be plenty of suckers willing to buy a "hot" stock at the top.

I've always been against Apple's stock buyback program because I'd rather have the cash. Through September of 2000, Apple had spent $116 million to buy back 2.55 million shares at an average of $45.49 per share (ouch). Fortunately, Apple doesn't abuse the buyback like a lot of other companies. Dell spent several years spending every penny they earned on their stock buyback program and they only have $1.78 per share in cash as a result. Oracle is still doing that and has cash per share of $0.78. IBM has only $1.73 per share and has more than ten times that much in debt. All of them will see an especially big blow to their earnings when the economy slows. I only approve of share repurchases when a company is trading below book value.

Much has also been made of Apple's drive to bring down inventory levels, but this is misleading for a couple of reasons. Inventories dropped from $437 million at the end of Fiscal 1997 to $33 million at the end of Fiscal 2000. It's true that Apple did have a big problem with stale inventory back in 1997, but making a big deal out of current low inventories is a mistake. The whole idea of "inventory turns" was popular with analysts a couple of years ago. By dividing inventory by sales you were supposed to find out how efficient and quick a company was in turning out product. Of course it was all just nonsense concocted to help sell Dell stock at its highs. All it really showed was how much a company relied on outsourcing and how quickly product could be moved into the channel. As we painfully learned last quarter, it's how quickly a company can move product out of the channel that matters. Now that DELL and AAPL are at relative lows, you don't hear much about inventory turns.

Apple supposedly owns $313 million worth of Property, Plants and Equipment, but this is probably understated by a good deal, especially considering what has been happening to real estate prices in Cupertino. Similarly the "Intangible" assets acquired from NEXT and Power Computing are understated. Every quarter P, P & E items get depreciated and Intangibles get amortized (written down in value on the books and counted against earnings) so that Apple will have to pay less money in taxes. Therefore it makes sense to depreciate things as fast as possible, even though it brings down book value. All the NEXT and PC assets were amortized out of existence in 2 to 3 years. Theoretically, that means everything acquired from those companies (Web Objects, and the nuts and bolts of OS X) is now obsolete and worthless.

Such conservative accounting by Apple management is commendable. In contrast, Compaq is amortizing items from the Digital acquisition over 5 to 20 year periods, thus enabling them to show much better short-term profits. Apple's overly rapid depreciation and amortization understates Apple's true worth. Apple also expenses about 5% of revenues on R&D every year. This builds up valuable intellectual property that doesn't show up on the books. For these reasons, Apple's true worth is much higher than its stated book value per share.

Another big "Intangible" is Apple's "brand," the customer loyalty and product recognition that has been built up over the last 20+ years. The "installed base" of Apple customers has gotten a lot of attention. Advertising expenses count against earnings, but they build up mind share that doesn't show on the books. Apple's customers are the most loyal in the industry.

I had to cringe last January, when Steve started boasting about how Quicktime had led Apple to invest in Akamai, and how the investment had grown to be worth over $1 Billion dollars. It was pretty obvious at the time that $2.14 Billion in "investments" was a temporary function of a Nasdaq in full frothiness. Now that apple has finished selling off its stake in ARM and now that the stock market has brought AKAM and ELNK back down to size, Investments have dropped to $776 Million. That's closer to being accurate, but still probably a couple hundred million too high. Still, if Apple can work with the Investment bankers like they did for ARM, we could still end up pulling out a few hundred million in profits on the deals. Only time will tell there.

Since Accounting isn't perfect, we have to make some crude estimates to find out what Apple is really worth. Starting with a book value per share of $4.1 Billion, I add $200 Million for P, P&E, but take it away because of the Investments. For Apple's Intangibles, I'll give a very crude $2.5 Billion based on all the Intellectual property, and accumulated customer loyalty. Valuing Apple at $6.1 Billion leads to $20.35 per basic share.

I don't use the diluted totals, because they represent shares that will eventually be purchased from Apple at prices ranging from the $6 something granted to employees during the repurchase all the way up to Steve's 20 million shares at $40+ (which will be ITM someday). The net result is a wash with regards to book value in my estimate.

Stocks tend to oscillate between being overpriced and under priced. Apple was overpriced in 1995, under priced in 1997, and overpriced again in 1999. It's now under priced here in 2001 and a victim of Wall Street's wrath, but someday it will be enjoy another period of being overpriced and being a Wall Street darling. If you are into the whole LTB&H thing, you can buy anywhere below $20 and be confident that someday you'll get a chance to take a nice fat profit.