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Apple's Options: How Much Pain?

By Alex Salkever These are heady days for Apple shareholders and CEO Steve Jobs. In the span of two weeks, Apple (AAPL) announced that the U.S. military would be building a supercomputer with 1,500 Apple G5s. Luxury carmaker BMW unveiled a program to connect iPod music players directly to the stereo in some vehicles. And the launch of the iTunes Music Store in Europe bagged 800,000 song buys in its first day of sales.

On the strength of this news and the runaway success of the iPod music player, Apple (AAPL) shares have surged above $33, closing at $33.18 on June 24. This is the highest ground the stock has inhabited since the fall of 2000, and well up from the $26 to $27 range of only a few weeks ago.

The run-up would seem to validate the wave of bullish analyst reports coming from Wall Street over the past two quarters. On June 22, investment banker Merrill Lynch upped its target price on Apple shares to $39 and reiterated its buy rating.

PRICED IN? Though the bulls are clearly running, at least one influential stock watcher thinks trouble looms for Apple shares over the next year or so. Albert Meyer, principal of Second Opinion Research, sees problems for Jobs & Co. when Fair Accounting Standards Board (FASB) Rule 123, which would force companies to expense stock options, kicks in.

When that happens (the precise date for implementation is still uncertain), Apple's earnings per share could fall, says Meyer, who doesn't own Apple stock. He bases his argument on an analysis of Apple's earnings numbers for the most recent four quarters, a period that ended on Mar. 27, 2004.

Most analysts on the Street say they've already priced the cost of options into the Apple equation. And Apple does calculate those costs in a footnote of its earning reports. But its options exposure is high compared to other tech companies, Meyer claims. If stock options had been treated as a cost on the balance sheet, Apple's earnings over the past four quarters would have fallen 69%, from 46 cents per share to 14 cents per share, according to his calculations.

BIG DIFFERENCE. That compares to reductions of less than 50% for Dell (DELL), Hewlett-Packard (HPQ), and other tech companies. Even Microsoft (MSFT), which announced that it would begin expensing options last year and has far less options exposure than Dell or HP, has seen its share price stagnate amid broader tech advances.

More worrisome, in Meyer's view, Apple earns nearly twice as much from interest on its cash holdings as it does from operations. If the cost of stock options and interest earnings are subtracted, then Apple would have earned just 5 cents per share in the past four quarters. Only 11% of the earnings that Apple reported over the past four quarters came from profits of its operations.

"Is it a tech company or a credit union?" quips Meyer. To match its interest profits, Apple would effectively need to double real earnings in the next 12 months. That will be hard when Apple itself has admitted it expects to see the margins on its iPods drop in the coming year.

SKY-HIGH RATIO. Meyer may have a point, in my view. According to numbers compiled in April by Merrill Lynch, Apple ranked 74th out of 86 tech companies in terms of how much estimated 2005 earnings could decline if stock options were to be treated as a line-item cost on the balance sheet. (In that calculation, 86th place would mark the steepest decline.) By comparison, HP ranked 23rd, and Dell ranked 35th. With options expenses included in balance-sheet calculations, Apple's price-earnings ratio for fiscal 2005 would soar to 187, according to the Merrill numbers. Under those same calculations, Dell and HP would post p-e ratios of only 28.4 and 16.4, respectively.

High p-e ratios are common with fast-growing startups. But such stratospheric heights are hard to justify for mature tech companies, even those with hot new products.

Merrill analyst Steve Milunovich has since adjusted his earnings estimates upwards for Apple in his most recent note, released June 22. That would bring Apple's p-e ratio down considerably. But even with the revised earnings estimate at the current share price, Apple's p-e for 2005 if options are expensed would be 109. That's still in the nosebleed zone.

CASH-FLOW FREEZE? Some analysts are valuing Apple on the basis of strong cash flow, and it has built its cash pile to a solid $4.6 billion, about $13 per share. But should the cost of issuing options be incorporated into labor costs, Apple's annual free cash flow could conceivably fall by hundreds of millions of dollars, if Meyer's line of analysis is correct.

Apple declined to comment for this story but did issue a statement saying it respects the views expressed by its shareholders regarding expensing stock options, and it's monitoring the progress of new rules proposed by FASB.

At each of the last two annual meetings, Apple shareholders passed resolutions requesting that it expense options. But the board has decided not follow shareholders' wishes, although it has shifted executive compensation away from options and toward restricted stock, which does appear on the balance sheet.

MINORITY REPORT. Apple bulls see no cause for concern. They argue that the Street has already factored in the options overhang. "We have certainly taken into account the options issue in terms of dilution and cash flow," says Steve Lidberg, a senior research analyst at Pacific Crest Securities who has an outperform rating on Apple shares. (Lidberg owns no Apple shares, and his firm has never done nor is it planning to do any work for Apple.)

A number of Wall Street analysts I spoke to agreed with Lidberg on the record but privately allowed that neither they or anyone else really knows what will happen when FASB 123 takes effect. Meyer thinks Apple is properly valued as an $18 stock. Personally, I think it's worth more than that. But I agree with Meyer that Apple's current valuation may prove unsustainable. Salkever is Technology editor for BusinessWeek Online. Follow his Byte of the Apple column, only on BW Online

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