Apple Accounting Change: Why it Matters

APPLE (AAPL) STOCK PRICE: 


Jan. 20 = $78.20 


July 20  = $152.91

Sept 23 = $185.50

As widely reported, the FASB, the governing body that sets US accounting standards, unanimously voted on Wednesday to approve an accounting change that changes the way hardware-software solutions are accounted for.

Instead of revenue being recognized over several quarters (or two years in the case of Apple’s iPhone), now revenue can be recognized per generally accepted accounting principles (GAAP) at the time of sale.

To be clear, this has no impact on Apple’s cash flow, which given skepticism with perceived financial engineering by industry analysts and investment banks, has led some to say that this news is background noise, and that it should not impact your investment thinking one iota.

I disagree. While the core fundamentals of Apple's business are reason enough to celebrate (see Related Posts below), to suggest that investors shouldn't weigh the accounting change in their assessment is akin to saying that travelers should pay no attention to changes in currency exchange rates.

The fact remains that metrics like sales, profits, price to sales and price to earnings are core metrics that feed into every consumer finance site/chart/etc., and every analyst compares companies on the same basis.

It would be wonderful if the market was perfectly "efficient," and investors and analysts had previously priced in the qualitative impact of subscription based accounting rules (as Apple has broken them out for some time), but the fact remains that, for the most part they don't, so investors should focus on both the core fundamentals AND the macro picture.

To frame this one, in the June earnings report, under the old rules, Apple generated $8.34B in sales, and $1.23B in net income. 

Under the new rules, sales mushroom to $9.7B, and net income to $1.9B, a 16.3% bump in sales, and a jaw-dropping 54.5% increase in profits. 

Think about what that means in terms of an apple-to-apple comparison (pun intended).  On a price-to-earnings basis, it’s akin to getting a $1 for 65 cents since, based upon last quarter's numbers, $1.35 per share of earnings now becomes $2.09 per share of earnings.

In the abstract, that means that if the market was truly pricing Apple stock as a multiple of its then price of $152.91, at the revised per share earnings, Apple stock is worth $236.73 based upon the exact same fundamentals when earnings were announced July 20.

Now, of course, since then, buoyed by strong earnings and awe-inspiring performance metrics (across multiple vectors), coupled by the increasing drum beat that a change was likely in how subscription based accounting is handled under GAAP, the stock has risen during this period 21.31% to $185.50.

Regardless, that STILL suggests that Apple stock could readily bump up another 21.64% in absence of a macro market correction (a very real possibility) and/or the release of negative news for the company (they are clicking on ALL cylinders, but the possibility is always there, to be sure).

Also, as a frame of reference, during the same period (i.e., July 20 to the present), Apple’s closest peer in terms of being a "gold standard" stock, Google, has jumped 15.88% to sit at a price-to-earnings of $34.59 vs. $32.42 for Apple (again based upon the old accounting logic).

In other words, you can pay slightly more for Google knowing full well that on pure macro factors alone, Apple could bullet forward another $50/share, as the accounting change is "priced into" the stock.

For my money, I'd buy Apple instead (disclosure: I am a current shareholder of Apple stock).

UPDATE 1: According to Gene Munster of Piper Jaffray (the one Apple analyst that I think has a clue - he's good), under the new rules, Apple's 2009 earnings would be up nearly 43.8%, which in the abstract says (to me) that Apple stock settles out at $219.88 purely on macro considerations (i.e., not factoring the good or bad of forward presented news about the company, markets or the economy).  Munster shows Apple 2010 earnings being 48% higher, the composite of which makes him believe the stock is worth $235 (his new price target).  Also, he provides a good articulation of how the rule change applies to what type of product, explaining that "Before yesterday's ruling, any product that offered free upgrades to software and services installed on a device like an iPhone required subscription accounting (revenue deferred over 8 quarters in the case of the iPhone and Apple TV). However, the vast majority of the value of the device was realized at the time of purchase. While the value at the time of purchase as a percentage of the purchase price is debatable, we believe about 90% of the value of an iPhone is realized at the time of purchase. Under the previous rules, Apple was only allowed to recognize 12.5% (1/8th) of the revenue from each sale; under the new rules, the percentage will be decided on a case-by-case basis for each given product."

Related Posts:

1. Analysis of Apple's "It's Only Rock and Roll" iPod event
   
2. Analysis: Apple June Quarter Earnings Call - Keeping it Real
   
3. Holy Shit! Apple’s Halo Effect
   
4. Built-to-Thrive - The Standard Bearers: Apple, Google, Amazon 

Comments

[Paul Harper]

Very interesting post & obviously has ramifications for other companies in this sector.
Am a first time reader of your blog, now in my RSS.
Good work, thanks.

[Mark Sigal]

Thanks for giving a read, and taking time to comment, Paul. Again, the irony is that Apple has diligently broken this out for a couple quarters running but until the FASB recognizes it, the market treats it as theoretical value.

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