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Author: Plato90s Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 202414  
Subject: The mystery that is Apple Retail Date: 12/29/2002 10:57 PM
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Apple Retail, besides a high profile venture, is also a very mysterious segment in that its account practices doesn't seem to make any real sense.

To begin with, it's necessary to understand how Apple handles its internal accounting. If you already know this, skip to the next section.

Apple runs its business in terms of geographical segments, with Retail being a separate one from Apple North America.

Apple's accounting is done in such a way that it assigns a Cost of Goods Sold [COGS] to its various business units to account for production and overhead costs. The determination of this value is used to determine the profit/loss of the unit, and doesn't have to be directly linked to any real-world logic or events. All other expenses go into Corporate and shows up as SG&A or R&D.

In practical terms, Apple's gross margins (revenue minus COGS) is determined directly by the assumptions the CFO want to use. If Fred Anderson says the COGS for the base model iMac in N. America is $1100, that's what it is. He can say the same for the iMac sold in Japan, even though shipping costs may be lower from the factory in Taiwan to Japan. As long as he can come up with some economic model justifying it, the accounting rules allows the CFO broad latitude in this matter.

That's because it's the assumption that net profit is what's important, and you can't fudge the net profit by messing around with the COGS.

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Apple Retail can't be easily compared to regular retail companies because it doesn't have to bear the capital expenses for store construction. Capital expenditures are close to $200M, but Retail doesn't have to carry that on the profit/loss of its own segment books.

Apple Retail has 807 employees, but the costs for these employees aren't fully accounted for in Retail, but exists, at least in part, in SG&A as corporate expenses. That can be seen on page 29 of the 10-K when Apple disclosed its SG&A expenses went up due to Retail.

So Apple Retail doesn't operate like any kind of standard retail venture. Without having to pay capital expenditure and some operational expenses, Retail should be pretty profitable.

It's not, because the CFO, Fred Anderson, decided to set the COGS for Retail a lot higher than any other geographic segment. The result is that after taking expenses from Retail into SG&A, Apple pours back some of the "profit" from Retail by adjusting the COGS. That appears as "offsetting benefit" in the 10-Q and 10-K's.

The problem is that the COGS is not adjusted in any consistent manner.

(I'm using unit shipment instead of revenue to cut out peripheral/software for which Apple can't adjust COGS)

In Q1, Apple recognized a $8.6M in offsetting benefit on 14k unit shipment.

In Q2, unit shipment increased by 71% but the offsetting benefit only increased by 44% to $12.4M.

In Q3, unit shipment dropped by 17% and the offsetting benefit dropped by 19% to $10M. Note the big disparity with Q2's correlation of unit shipment to offsetting benefit.

In Q4, unit shipment increased 70%, but now the offsetting benefit increased by 100% to $20M. Note there's now an opposite correlation with Q2, where the "benefit" increase outstrips unit sale increase.

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The numbers suggests that there is actually no discernible and consistent business model being used to determine how the COGS for Retail is determined.

If a consistent COGS was used for all 4 quarters, Apple would not be able to show a smooth transition from small losses in Retail in Q1 to a slight profit in Q4.

I posted a while back about how Apple changes its tax rate to smooth earnings.

http://boards.fool.com/Message.asp?mid=17668146

and I believe Apple (more specifically, Fred Anderson) is doing the same thing with Retail. It's useful as a tool to create good buzz and the profitability can be easily manipulated since it's still such a small part of Apple's overall revenue bases.
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