By Chris Bulkey, principal analyst at Technology Research Group
Clarification from author: Last September, FASB approved Apple's request to change the way it accounts for iPhone sales. We addressed the accounting change in our F1Q10 earnings assessment titled "Disclosure and Transparency the Real Issues." The earnings press release disclosed the accounting change, but did not specifically quantify financial impact as it pertained to expectations for the quarter. Because the change was detailed in our F1Q10 assessment, we did not rehash the issue in this latest report. Comments on the year on year reduction in revenue deferrals were meant to call attention to the fact that Apple is now working with less "backlog" as a result of new accounting policies.
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 RecognitionSigns 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 QualityIf 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.
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