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A lot of innacurate analysis has been posted on this board since the warning was announced a month ago (some of it my own). Hopefully this post can clear a few things up. Please excuse any new innacuracies that I produce.

Starting with the top line...

Revenues for the 4th quarter were reported at $1.870 Billion. Apple had been projecting more than $2 Billion. The Q4 number benefitted from 3 weeks worth of channel stuffing, or about $432 Million. Stripping away the haze of the channel stuffing, we have revenues effectively comming in at $1.438 B, which is only a 7.6% gain vs. Q4 1999.

For fiscal 2000, revenues rose 30.14%, but that number benefitted both from $432 million being shifted back from Q1 2001 and about $275 million being shifted forward from Q4 1999 (blamed on the G4 false start). For a better picture of Apple's revenue growth, use 13.5% as your number.

Apple supposedly will try to unstuff the channel this quarter, so the $1.6 Billion projected Q1 '01 number translates to $2.032 expected revenues when you add back the $432 million. That's still a 13.3% expected decline year over year, mainly because Q1 2000 was overstated.

Apple is going to have to deal with some very unfavorable revenue comparisons in 2001 because 2000 was so drastically overstated. This may have something to do with the decision to offer rebates. Companies like to offer rebates because they make revenue numbers look better than they really should. My understanding is that the rebates typically get charged as a marketing cost and bring down profits without bringing down revenues.

Costs and Margins
Gross Margins came in at 24.97% in Q4, which is the worst they've been over the last 10 quarters. This follows last quarter's 29.75%, which was by far the best. The conspiracy theorist in me says that Apple shifted a lot of fixed costs from Q3 to Q4 to make last quarter's margins look good. The realist in me says that last quarter we were selling stale product lines at old prices and this quarter we were selling all the speed bumps and updated products at better prices.

Expenses have started climbing again. In Fiscal 1997 R&D expenditures were $485 Million. Then Steve went crazy with the chainsaw and cut them down to $303 M. Since then they've risen every quarter and reached $101 M in Q4 2000 and $380 M for the year. A lot of cool but unprofitable projects got the axe in 1997, and that was probably the biggest reason Apple returned to profitablity. Now the increased R&D spending seems to be focused within the overall "incremental growth" strategy, allowing Apple to build on its core compitencies and gradually work its way into new growth opportunities.

S,G&A spending has droped and then risen again in a similar fashion. It went from $1.286 Billion in Fiscal '97 down to $908 Million during Typhoon Steve, but has now worked its way back up to $1.166 Billion this year.

The problem for us shareholders is that these costs are grossly understated. In fact, Apple compensates employees with millions of dollars in stock options every year. According to the 1999 Anual report, Fred gave himself 950,000 shares worth of options at 17 5/16 on 3/2/99. (narrowly missing the year's low of 16 1/2 3 weeks later) Those options can end up being worth $26,212,083 if AAPL appreciates 10% per year over ten years (not bad for one year's work). You or I would have to pay considerably more if we wanted to buy a similar options package from an underwriter like Goldman Sachs. Yet, the Accounting Principles Board's Opinion #25 states that these compensation costs don't have to count against earnings. Fred's package was only about 8% of the total number of options granted to employees that year, and it pales in comparison to the 20,000,000 shares worth that Steve's buddies gave him earlier this year.

This year also saw $98 million worth of one time charges (back in Q1). Realistically, the $90 million that payed for Steve's jet shouldn't have been counted as a one time charge since it was basically a compensation expense. It would have been geven a better picture of earnings to have averaged it in over several quarters. Of course accuracy isn't the true purpose of earnings statements.

Back in 1996 and 1997, Apple took something like $2 Billion worth of restructuring charges. Analysts, who's main purpose is to sell stock to the public, like to pretend that one time charges are a good thing, because they'll improve earnings down the road. What a restructuring charge really means is that earnings were overstated in the past and that they'll be overstated in the future, and that the negative effects of all that overstating are being rolled up into a tidy little one-time package and flushed away where nobody will have to look at it. This process typically helps the analysts sell stock.

In Apple's case, analysts used them as evidence that Apple was going bankrupt. More pragmatically, the massive write offs probably helped Fred keep R&D and S,G&A numbers down for Fiscal 1998, so that Apple could return to profitability ahead of schedule.

Operating Income
After we've deducted Expenses and Costs from Revenues we end up with Operating Income, which more or less tells you how good an idea it is to make and sell Macs. With all the seasonal factors and subtle manipulation that goes on between quarters, it's good to look at progress over the years to get a better idea of the trend. Operating Income went from a $1.1 Billion loss in Fiscal '97 to a $261 Million gain in '98 to $359 Million in '99 to $522 Million in 2000. Even with the distortion factors stated above, the trend is still very good. Selling Macs is indeed a good idea.

One time Gains
Remember the Newton? Apple teamed up with a couple of other electronics giants to start up ARM which made low-power chips used in the Newton (I think I'm getting the story right). Apple owned a little over 40% of the venture. ARM did pretty well as a company, but when Steve axed the Newton, Apple decided to bail out on ARM. ARM went public, selling shares to the public to raise cash, and Apple took the opportunity unload millions of shares for a $40 Million profit.

Benefitting from a raging bull market and the hype that goes with an IPO, ARM went up about 50% from the IPO price, and AAPL took the opportunity unload another batch, this time for a $32 Million profit. Since the underwriters had another huge block of stock to unload, the hype continued and ARM more than doubled. So AAPL sold some more, and the stock went up again. The process has gone on now for several quarters, with Apple dumping and the underwriters pumping and dumping at even higher prices. ARM's Market cap is currently about 50% higher than AAPL's, even though AAPL once owned 40% of ARM.

In 9 seperate quarters, AAPL has made about $637 Million in "one-time gains" off of ARM. Unfortunately, We've just about run out of ARM stock to sell. The one time gains are often included in P/E calculations which can be very misleading (as if P/E calculations weren't misleading to begin with).

Old posts referencing ARM in anyone is really bored:

Apple is now sitting on more than $4 billion in cash and short term investments (typically safe short term bonds). The interest from these reserves made up 42% of our income for Q4 2000, and 28% for the year. Interest income has grown for the last 8 quarters: from $5, 10, 19, 24, 34, 40, 49, 52 to $62 Million in Q4.

Q1 2001 is supposed to be a break even quarter. Since interest income will probaby be close to $70 Million, it suggests that Fred is expecting an operating loss of more than $60 Million during the Christmas season. More than half of our projected $1.25 per share earnings for 2001 will likely come as a result of having more than $4 Billion in the bank. Fred doesn't expect the Mac selling business to do very well in the the upcoming year, I guess.

The taxes you see on the earnings statement are just for accounting purposes. Apple hasn't had to actually pay taxes to the government for quite awhile. One reason for this is the rules regarding options that have received some play in the media lately. Corporate lobbyists have managed to convince congress that the taxes payed by employess on their stock options should count as a compensation expense and be deducted from a company's taxes (ironically, these same corporate interests have lobbied the accounting principle's board to have options grants not count as a compensation expense on earnings statments).

Excuse me while I diverge: The flaw I see with this reasoning is that the money made by employees on options grants comes at the expense of investors in the stock market. Every dollar gained on the exercise and sale of options has a direct equity cost to the existing shareholders who's equity declines as a result of dilution, or to the new shareholders who end up buying the newly created stock at inflated prices and eventually sell at a loss. Either way, the government's immediate gain of tax revenues is ofset by lowered tax revenues down the road. Companies shouldn't be able to use employee gapital gains to count against their own income taxes.

For Apple, the biggest reason we haven't had to pay hard cash to the US Govt. is because of all those huge write-offs we took back in 1996 and 1997. The government doesn't actually write companies a check when they lose money, but they do allow the companies to count losses against future earnings and avoid paying taxes when they again become profitable by giving tax credits.

From an accounting perspective, Apple would still have had to count theoretical taxes against earnings on the earnings statement to reflect the fact that tax credits were being used up. Fortunately, Fred planned ahead when he was taking those huge write-offs in 1997. He reasoned that since there was no guarantee Apple would ever become profitable enough to use up all of its tax credits, a "valuation allowance" should be taken against these credits to lower their value on the books.

One effect of this was that the huge write-offs ended up being even larger in 1997 because Apple didn't book all the tax credits. The other was that when Apple became profitable in 1998, Fred was able to state that the valuation allowance was overdone so that he could use it to offset taxes on over the last 12 quarters. The effective tax rate was 6.08% in '98, 11.09% in '99 and 28.02% in 2000, which led to especially misleading earnings in 1998 and 1999.

Earnings have been growing nicely over the last 3 years, but so has the number of shares outstanding. As a result, EPS and Book value per share haven't appreciate as much as we would like, and these are the factors that determine what AAPL will be worth over the long run.

Basic shares outstanding has gone from 247 Million in Fiscal 1997 to 325 Million in Fiscal 2000. If you bought a stake in 1997, you watched 24.8% of it get diluted out of existance over the next 3 years. Enough options are in the money, that diluted shares are reported at 360 Million. This means another 10% will likely get diluted away, even if no more stock options are ever given out again.

(I fear that Apple's diluted shares number is actually even worse than it appears. At this year's shareholder's meeting I tried to get Fred to tell me why Steve's 20,000,000 options weren't counted against the Q1 diluted total when they were ITM for the entire quarter. He tried to dodge my question, but when I persisted he essentially said it was because they didn't want to count them. The conspiracy theorist in me wonders if he knew then that Steve's options would be OTM by the end of the fiscal year.)

The positive side of all this dilution is that Apple raises some extra cash every time shares are awarded. The negative side is that the amount is small relative to the value of the shares. Often companies buy back stock to hide the effects of dilution on EPS, but this has an even more negative effect on Book Value per share.

Well... I've spent too much time on this post already. Feel free to critique it and correct any mistakes I've made. Next week I'll probably ramble on about the balance sheet or short interest.

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