How a Little Accounting Quirk Could Send This Stock Soaring

Nathan Slaughter's picture

Tuesday, December 22, 2009 - 12:07pm

by Nathan Slaughter

One of America's premier technology companies has a problem: Too much cash.

You see, because of GAAP rules, it has to conservatively account for sales by spreading it over two years. But it gets the cash upfront. So its reported earnings are tiny compared to its actual cash flow.

The official aROE earnings investors see don't reflect this company's impressive profits. But that may soon change. A new accounting rule will change that would let the firm book most of its revenue upfront.

This past quarter, its earnings per share would have been +58% higher under this new rule.

Once the new rule takes effect, Wall Street analysts will jack up their earnings estimates, the company's reported earnings will surge... and the stock could attract a slew of new investors.

You know this company. You probably use its products. And it's a great stock to own regardless of its accounting policies.

The Details

Steve Jobs and the folks over at Apple (Nasdaq: AAPL) are lobbying the Financial Accounting Standards Board, the group which lays down the nation's accounting laws, to correct a rule that has unfairly punished the firm for years.

Apple decided long ago to extend free software updates to iPhone owners. Unfortunately, that generosity forced the firm's bean counters to spread iPhone sales over the two year life of the phone contract. But here's the problem: Apple takes in that revenue on day one.

When you're selling more than two million smartphones every 30 days, subscription-based accounting methodology leads to severely understated sales and earnings. Last quarter, the firm reported earnings of $1.35 per share, when it really booked a profit of $2.14 -- about +58% higher.

This type of gimmickry is exactly why I favor cold-hard cash flow analysis over manipulated GAAP figures.

Apple, along with Oracle (Nasdaq: ORCL), Hewlett Packard (NYSE: HPQ) and others, have long been pressing for a change. They have a solid case. The rule was part of the Sarbanes Oxley Act-- a response to Enron artificially inflating earnings by reporting income for future events before they occurred.

Apple is essentially doing the exact opposite and deliberately under-reporting. If sales remain level, the problem could correct itself over time. But demand has exploded, and by the fourth quarter of last year the company had to "hide" $3.8 billion of its $4.6 billion in iPhone sales.

Fortunately, the FASB recently voted unanimously to correct the problem. In the near future the company will be able to recognize iPhone sales and costs upfront as they occur. Much of the value in Apple's lucrative smartphone business that had been reflected on the balance sheet will now be transferred over to the income statement.

To be clear, this won't have an impact on cash flow or the company's intrinsic value. But it will lead to truer earnings -- and a much lower price-to-earnings ratio. Under the new accounting rules, the shares would trade at just 19 times forward earnings, compared with the current multiple of about 30.

Without a doubt, that valuation will look much more attractive to retail investors, not to mention many quantitative-driven funds in search of growth at a reasonable price.

There are plenty of other reasons to like Apple. After all, the company sold three million Macs, seven million iPhones and 10 million iPods last quarter -- with most of the world still in recession.

But with this tiny quirk ironing itself out, we could see Apple breaking new ground next year.

P.S. -- This prediction about Apple is just one of 11 investment predictions for 2010 I recently shared with readers of Market Advisor. For the full details on all of the predictions, click here and I'll send you a free copy of my special report "Hottest Investment Opportunities for 2010" just for joining me.

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.