Why Apple Gets a Sell Rating

NEW YORK (TheStreet) -- Apple(AAPL) reported revenue and earnings of $13.5 billion and $3.33 per share for the second quarter of fiscal 2010 (TRG estimates: $12.02 billion and $2.44 per share).
On the surface this looks like a blowout quarter. Top and bottom-line growth totaled 49% and 86%, both well ahead of expectations. A look behind the numbers suggests otherwise.
Aggressive earnings management comes as no surprise. As noted in previous reports, accounting concerns emerged in fiscal 2009 and accelerated in F1Q10. What does surprise us is the fact that smart money does not appear to be seeing through the trickery. Shares are up sharply in initial after hours trading - misguided bullishness in our view.



Revenue Recognition
Signs of backlog reduction were again apparent. Deferred revenue was reduced 75% year on year and also moved lower on a sequential basis. The decline over the preceding quarter would seem plausible given lower volume (sales down 14% vs. F1Q10). In the previous year, however, revenue deferrals nearly tripled amid 48% sequential sales decline. A reversal of historical tendencies in this latest quarter aggravates the measurable year on year reduction and should raise a red flag.
Earnings Quality
If we normalize reduced R&D expenses (year on year basis, as a % of revenue) and a lenient tax rate, earnings fall to $2.93 per share in sustainable operating terms (12% below reported levels). Precise tax deferrals won't be known until the 10-Q is filed, but we note that corresponding line items on the balance sheet were down roughly 25% year on year (thus pointing to some degree of earnings management). Similarly, we'll have to wait for the 10-Q to assess discretionary expense capitalization and product warranty accounting - both of which were sources of non-operational income in previous quarters. If recent trends hold, sustainable operating earnings will fall even further after factoring in these items.
R&D spending not only raises suspicion in terms of a year on year decline, but the problem becomes even more acute on a comparable basis. Competitor Research In Motion(RIMM), rated sell, spent 6.50% of revenue on product development in its latest quarter as compared to only 3.16% for Apple.
The iPhone is immensely popular and regarded as superior in terms of multimedia applications (i.e., as an entertainment device). Consumer reviews, however, favor the Blackberry when it comes to call clarity, email functionality, and camera quality. Tightfisted R&D expenditures may explain why.
Valuation & Recommendation
Shares are up 15% year to date and valued at 24 times trailing earnings. Chief competitor in the personal computing space Microsoft(MSFT), rated sell, trades at 17 times.
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Microsoft Corporation| MSFT Apple Incorporated| AAPL Research In Motion Limited| RIMM Mobile communications device comparable Research In Motion also trades at 17 times. Microsoft has its share of P&L and earnings quality concerns and has also resorted to cost containment measures to stabilize expense levels. Apple's recent results have not included restructuring or impairment charges. Research In Motion missed estimates in its latest quarter and also has various operational challenges. Earnings management, however, has not been as flagrant as Apple.
Market appraisals for both Microsoft and Research In Motion already discount some of the abovementioned irregularities. Apple may look cheap if recent results are taken at face value. Valuation looks far less attractive without benefit from questionable P&L quality. We reiterate a sell rating and $228 price objective on Apple (target multiple goes to 19 times revised 2010 EPS estimate from 25 times).
--- Written by Chris Bulkey in Narberth, PA