Financial and Managerial Accounting (AC 630 B)

FALL TERM 2005

Thursdays Instructor: Mr. Andreas Rambow

Research Assignment Financial Analysis: Apple Computer Inc.

Prepared By: Yeo Bee Lin Date: December 8, 2005

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Contents

1. Financial Analysis .........................................................................................3 1.1. Company Overview...................................................................................3 1.2. Ratio Analysis ...........................................................................................4 1.2.1. Profitability .......................................................................................4 i. ii. iii. iv. v. Return on Investment ......................................................................4 Return on Investment (DuPont Model) ............................................4 Return on Equity..............................................................................5 Price Earnings Ratio........................................................................6 Dividend Yield, Dividend Payout, and Preferred Dividend Coverage Ratio..........................................6 1.2.2. Working Capital and Measures of Liquidity .....................................6 i. ii. iii. Working Capital ...............................................................................6 Current Ratio ...................................................................................6 Acid-Test Ratio ................................................................................7

1.2.3. Activity (Assets Management) .........................................................7 i. ii. iii. iv. Total Assets Turnover .....................................................................7 Inventory Turnover ..........................................................................8 Number of Days Sales in Accounts Receivables ............................9 Number of Days Sales in Inventory ................................................9

1.2.4. Financial Leverage ........................................................................10 i. ii. iii. Debt Ratio .....................................................................................10 Debt/Equity Ratio...........................................................................10 Times Interest Earned ...................................................................10

2. Conclusion ...................................................................................................11

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1. Financial Analysis 1.1. Overview Is Apple Computer Inc., (Apple) growth sustainable? This is the research report on Apples Year 2005 (September 24, 2005) financial statements to analyze its business and financial sustainability in comparisons with the industry giant Dell, Inc (Dell) Year 2005 (January 28, 2005). Below are the small introductions on Apple Computer Inc. and Dell, Inc. Apple had a long history in the design, manufacture, and marketing of personal computers (Power Mac) and related software, services, peripherals, and networking solutions worldwide. Apple currently enjoyed more than 87.3% market share worldwide for its iPod on MP3 players and its personal computer products Macintosh enjoyed approximately 2% of worldwide PC markets. Along with iPod, the company also designs, develops, and markets the related accessories and services. Apple also offers online music stores with its iTunes software made available for both Mac OS and Windows. Its online music store accounted for 70% of the legal download market. Apple offers PowerSchool software product, a Web-based student information system for K-12 schools and schools districts; and a variety of other service and support offerings. It also offers various Apple-branded computer hardware peripherals, including iSight digital video cameras, iTalk voice recording tool for iPod, iTrip FM transmitter, and a range of flat panel TFT active-matrix digital color displays. In addition, the company sells a variety of third-party products, including computer printers and printing supplies, storage devices, computer memory, digital video and still cameras, personal digital assistants, iPod accessories, and various other computing products and supplies. The company offers its products to education, consumer, creative professional, business, and government customers. Apple sells its products through its online stores, retail stores, direct sales force, as well as through third-party wholesalers, resellers, and value added resellers. The company operated 110 retail open stores, as of June 30, 2005. As of last Apple was founded in 1976 by Steve Wozniak and Steve Jobs and is headquartered in Cupertino, California. Dell, Inc. used to be Dell Computer Corporation has later changed its name in 2003. The company is founded in 1984 and is headquartered in Round Rock, Texas with the business concept of selling computer systems directly to customers and Dell with its operating efficiency Dell managed to provide customers with best solutions to meet customers needs. Based on the latest market share survey by IDC, Dell enjoyed a 17.8% of total worldwide PC market. Dells presents internationally post a strong growth for the company. Currently, 38% of its revenues are from international markets. Meanwhile, it also poses higher risk if not efficiently operate. Dell offers a wide range of computing products such as servers, storage, workstations, networking products, notebook, desktop computers, printing and imaging systems; and software and peripherals, including titles, monitors, plasma and LCD televisions, MP3 players, handhelds, and notebook accessories. For services arena, Dell offers various types of services, from technology consultation, IT management services, application development, integrating solutions, and infrastructure design. It also offers a range of financing alternatives, assets management services, and other customer financial services for its business and customers. Dell is favored by large corporate, government, healthcare, and education accounts, as well as small-to-medium businesses and individual customers, because of its operating efficiency, Dell understand customers needs and support with full integrated solutions to satisfy those needs with best prices and therefore it is favored.

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1.2. Ratio Analysis Let starts the research by gathering all the financial data of Apple and Dell for analyzing the business and financial performance for both companies, and draw conclusion to support the research findings. The Income Statements, Balance Sheets and Statement of Cash Flows for both companies are attached as Appendixes. 1.2.1. Profitability Measures i) Return on Investment Apple (in mil.) 1,335 1,650 8,050 11,551 13.62% 16.84% Dell (in mil.) 3,043 4,254 9,311 23,215 14.31% 20.01%

Net Income Operating Income Beginning Assets Ending Assets ROI on Net Income ROI on Operating Income

Apple and Dell both had strong ROI above market average of 8% 12%. They both gave investors much higher return comparing to the average market rate. Apple had a much stronger sales growth of 68% from Yr2004 to Yr2005 (mainly due to its iPod sales that craze the digital music players market) in comparison to Dells growth of 18.72% from Yr2004 to Yr2005; and both companies in the same industry standard and particularly, Dell is much bigger in terms of assets and revenue. It was a very significant progress for Apple to be able to achieve the Net Income level with a slight fall short of 0.69% from that of Dells. ii) Return on Investment (DuPont Model) Apple (in mil.) 13,931 4,043 1,650 1,335 8,050 11,551 29.02% 11.84% 9.58% 1.42 13.62% 16.84% Dell (in mil.) 49,205 9,015 4,254 3,043 19,311 23,215 18.32% 8.65% 6.18% 2.31 14.31% 20.01%

Net Sales Gross Profit Operating Income Net Income Beginning Assets Ending Assets Margin (Gross Profit) Margin (Operating Income) Margin (Net Income) Turnover (Net Income) DuPont Model on Net Income DuPont Model on Operating Income

Apple

Gross Margin 29.02%

OE 17.18%

Operating Margin 11.84%

FE 2.26%

Net Margin 9.58%

Dell

18.32% 9.68%

8.65% 2.46%

6.18%

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By using the DuPont ROI Model, both companies show the same return on investment as compared to the general ROI model. Therefore, to make a more details comparison, I studied both companies gross, operating, and net income margins for a more comprehensive assessment. Based on the calculation of Gross Margin, Operating Margin and Net Margin, computed based on the percentage of Net Sales for both Apple and Dell; we can see that Apple has a higher Gross Margin of 29.02% compared to 18.32% from that of Dells. It shows that Dell in this case has higher cost of goods sold compared to Apple, therefore this gives you an idea about Apple and Dells pricing strategy in terms of finished goods and products mixed. Both companies had wide range of product offerings; however, Dell probably adopted a lower selling price mix strategy due to its business nature; it is to sell direct to customers and in volume. In contrast, Apples new inventions of iMac personal computer range and its most popular iPod digital music players had given Apple the edge to enable higher selling price mix and this explained why Apples gross margin is higher. From the list shown above, the differences between Gross Margin and Operating Margin show the Operating Efficiency (OE) for both companies in terms of percentage to net sales. This explained the operating expenses for both companies to make their operating incomes. Apple has a greater gap of 17.18% compared to 9.68% from that of Dells because Apple spent 3.8% of its revenue in research and development and 13.38% for its operating expenses; Apple has about 110 retails open stores for its products offerings and this explain the high operating cost of 13.38%. In comparison, Dell only spent 0.94% of its revenue in research and development and 8.7% on its operating expenses. This shows that Apple strike to constantly improve its products offerings and innovations in order to attain a sustainable growth in the future, and that explain why Apple has a higher operating expenses in percentage in comparison to that of Dells. Judging from the same list from above, the differences between Operating Margin and Net Income Margin show the Financial Efficiency (FE) for both companies in terms of percentage to net sales. This shows that how well Apple and Dell managed their financial expenses in order to generate higher net income from their management activities. Both companies enjoyed gains from their short-term investment and those gains increased the net income by 10% and 4% for Apple and Dell respectively. ii) Return on Equity (ROE) ROE Net Income Operating Income Beginning Owners' Equity Ending Owners' Equity ROE on Net Income ROE on Operating Income Apple (in mil.) 1,335 1,650 5,076 7,466 21.29% 26.31% Dell (in mil.) 3,043 4,254 6,280 6,485 47.68% 66.65%

From the industry average of 10 15%, both Apple and Dell were exceptionally well performed. They both gave stockholders a return of more than 20%. For Dell it was extremely high mainly due to its stock buyback activities since year 2004 and now from the latest data, it has $10.758 billion of Treasury Stocks and the number manipulated the actual return on equity for this instance as compared to Apple. Dell commits to continue its stocks buybacks for the Yr2005 to achieve a 1.25 billion of number of common stocks with value not more than $20 billion. It showed that Dell intent to manipulate its ROE and to reduce its number of share in circulation. In this instance, assessing Apples financial statements are less intense as compared to Dells.

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iii) Price Earning Ratio (PE) Apple $52.67 1.56 33.76 Dell $40.93 1.18 34.69

Market Price per Share Earnings per Share PE Ratio

Apple had a stocks split 2-for-1 in February 28, 2005, the original market price before stock split was $89.62; after the stocks split the market price per share was $44.68. Judging from the market price per share indicated in the above list; Apples stock price had gone up by $7.99 per share after the split. Apple did not take on additional loans to swap its debtto-equity ratio, and therefore did not affect the diluted earnings per share. The high PE ratio for Apple was mainly because the market had high expectation on Apple to be able to deliver its promise for growth through more inventions and innovative products. However, the higher PE ratio for Dell can be explained by the stock buybacks for the past two year and thus resulting in reducing number of share outstanding (which was due to Dells compensation plan couple years ago) and indirectly increased its earnings per share to further manipulate its PE ratio. iv) Dividend Yield, Dividend Payout, and Preferred Dividend Coverage Ratio There was never a dividend payout for Apple since Yr2000 and same for Dell since Yr2003. These do not mean that Apple or Dell were unable to pay stockholders dividend for their high earnings, they are however keeping the retained earnings for financing their future growth. Furthermore, the market price per share had gone up so much that the stockholders would not mind without dividend payout. 1.2.2. Working Capital and Measures of Liquidity i) Working Capital Apple (in mil.) 10,300 3,484 6,816 Dell (in mil.) 16,897 14,136 2,761

Current Assets Current Liabilities Working Capital

Apple has very healthy working capital, due to its strong cash and cash equivalent $3,491 mil, short-term investments $4,770 mil, but relatively low accounts receivables of $895 mil, and other current assets. With its accrued expenses because of these are obliged longterm contracts which increased it current liabilities by $1,705 mil. However, given the increased in current liabilities, Apple still gave a strong working capital to cover its shortterm liabilities more than twice. It is however the reverse for Dell in measuring its working capital. It is a strange management decision to allow its Accounts Payable to go almost as much as its current assets. The current liabilities for Dell are made up solely from Accounts Payable, on the other hand, Dell has relatively low Accounts Receivables and that explained the lower Current Assets possibility. It also showed that Dell has been good in collecting its debts and reversely delayed payments to its suppliers. This may look good in terms of the companys perspective, but if the suppliers are tied up with the long lead time to receive their payments, the possibility in getting a good supply chain support could deteriorate in the long run. As for Apple, they practiced a more balance approach to their creditors in terms of payment lead time and the suppliers would probably be more than

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happy to continue to give their supports to Apple in the long run. For this instance Apple has a much well rounded thought to give due consideration in future growth and getting support from the suppliers. ii) Current Ratio Apple (in mil.) 10,300 3,484 2.96 Dell (in mil.) 16,897 14,136 1.20

Current Assets Current Liabilities Current Ratios

Add-on to Working Capital analysis, Apple has a very strong current ratio of almost 3 times to cover its short-term obligations. This also explained why Apple did not take up additional short- or long-term loans to finance its growth, or for debt payment; because Apple is so rich in cash and its short-term investments that it could repay its current obligations for almost 3 times. As for Dell, it did not look good with a 1.2 time of current ratio; solely because of its rocket high Accounts Payable. Even though Dell may argued that it could still cover its obligations with sufficient current assets on hand, however these current assets are not all cash assets, they would take time to convert to cash for debt payments, therefore, to further strengthen my analysis for Dell, we have to analyze its Acid-Test Ratio below to reinforce my findings. iii) Acid-Test Ratio Apple (in mil.) 3,491 895 4,770 3,484 2.63 Dell (in mil.) 4,747 4,414 5,060 14,136 1.01

Cash & Cash Equivalent Accounts Receivable Short-Term Investments Current Liabilities Acid-test Ratio

The current assets that are easily converted to cash are listed above, and Apple still has a very strong ratio for this. Mainly due to Apples operational efficiency to maintain a manageable accounts payable and accrued expenses low in comparison to its current assets items. Apples cash and cash equivalent items are generated from operating activities ($2,535 mil from cash flows statement) and additional stock issuance of $543 mil partially offset for its long-term assets purchases of plant, property, and equipment (Notes in Annual Report). Dells Acid-ratio is even more disappointing; it dropped to 1.01, which means the current assets that are easily converted to cash are almost on par with its high current liabilities of accounts payable. This seems fine in the industrial standard; however, this could be quite a disappointment for investors to see this in a high PE ratio company. This gave a strong message to investors that whether Dell is managing its operating effectively and efficiently. Especially the Accounts Payables are occupied the overall current liabilities, this could means that Dell is tapping on the suppliers so much that could result in negative effect in the near future. On the flip side, Dell spent about $2,317 mil in cash to stock buybacks and this also explained the low ratios for its liquidity measurements. 1.2.3. Activity (Assets Management) i) Total Assets Turnover

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Net Sales Beginning Assets Ending Assets Total Assets Turnover

Apple (in mil.) 13,931 8,050 11,551 1.42

Dell (in mil.) 49,205 19,311 23,215 2.31

The turnover for Apple is lower compared to that of Dells. Therefore, I analyzed the pricing strategy and the profit margin for both companies to further understand why the lower turnover for Apple on this ratio. I found that Apple has higher profit margin with low assets turnover and Dell has lower profit margin with a higher assets turnover, I see the corelation in this ratio in terms of pricing strategy. The higher pricing strategy charged for a product mixed the lower the turnover ratio is. Because the ratio measure the efficiency level of using the assets to generate revenue, if the product mixed strategy price based on volume, will give a higher assets turnover ratio; and Dells business is based on volume and operating efficiency therefore gave a higher turnover in assets. Whereas Apples product mixed, strategy price based on life style and value and therefore Apple has higher profit and that explained why Apple in this case has lower Assets Turnover ratio. HP (in mil.) 79,905 74,708 76,138 1.06 IBM (in mil.) 96,293 104,457 109,183 0.90 Gateway (in mil.) 3,649 2,028 1,772 1.92 Sun (in mil.) 11,070 14,503 14,190 0.77

Net Sales Beginning Assets Ending Assets Total Assets Turnover

Net Sales Beginning Assets Ending Assets Total Assets Turnover

To further prove the relationship in terms of pricing strategy would affect Assets Turnover Ratio, I have checked on the Assets Turnover Ratios for HP (Yr2004), Gateway (Yr2004), IBM (Yr2004), and Sun Microsystems (Yr2004) as shown in the above table. Take a closer look to the ratios, Gateway (has low profit margin of 8.4%) is in a volume based business as well and thats why the companys turnover ratio is higher, it is however not as efficient as Dell, probably because of its inefficient operating activities incapable to make sufficient revenue for its volume based products and resulting to a net loss of US$567 million. However, looking at the ratios for HP, IBM, and Sun Microsystems, they are much lower, and HP (has higher profit margin of 25% compared to Gateway) is in the wide range of products mixed pricing strategy too, but there are numerous products that HP are charging at premium prices like its high-end enterprise servers and data storage systems, as well as the razor blade product of its printer cartridges, these are the premium priced products HP offer and therefore its Assets Turnover is in between the companies shown above. Now, lets look at IBM (has high profit margin of 37%) and Sun Microsystems (has high profit margin of 41%), the two companies focused on high end products and generate more premium prices of theirs product offerings, IBM especially has its high profitability in its global services unit. Comparing the profit margins of these 4 companies and counter matching them with the Assets Turnover ratios, these ratios further proof to my analysis of pricing strategy has distinct co-relationship on Assets Turnover ratios. ii) Inventory Turnover

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Cost of Goods Sold Beginning Inventory Ending Inventory Inventory Turnover

Apple (in mil.) 9,888 101 165 74.35 Apple (in mil.) 13,931 165 84.43

Dell (in mil.) 40,190 327 459 102.26 Dell (in mil.) 49,205 459 107.20

Net Sales Ending Inventory Inventory Turnover

Apple has lower inventory turnover as compared to that of Dells. However, that does not mean that Apples inventory and sales activities are not well managed. Lets look at the ratio on Cost of Goods Sold and Net Sales; Apple has higher turnover on Net Sales compared to Cost of Goods Sold. The difference between the two ratios is COGS and Net Sales. This tells us something about Apples pricing strategy. The Profit Margin for a product is the net of sales deduct the cost of goods sold. Therefore, Apple has higher pricing charged to its products offering as compared to that of Dells, even though Dells Inventory Turnover Ratio is much higher in this case. But looking at Dells turnover ratio on Net Sales; it is close to that of Cost of Goods Sold, therefore this also explained that Dell has lower pricing charged to its products offerings. They are however very efficient in terms of keep the inventory low or showed that both companies are strong in sales volume; and therefore able to turn the inventory for more than 74 and 104 times in a year for Apple and Dell respectively! iii) Number of days sales in Accounts Receivables Apple (in mil.) 895 13,931 365 23.45 Dell (in mil.) 4,414 49,205 365 32.74

Accounts Receivable Net Sales Number of days' sales Accounts Receivable (# of days' sales in)

Apple is collecting its debts in a cycle of 23 24 days. This is good, as most of the companies will only pay on monthly basis; it is unusual for companies to pay its creditors in advance or before the bills are due, even though most companies do have sufficient cash to pay their bills earlier, there are no incentives for most companies to make early payments. I search around for information that whether Apple had given any cash discount to encourage early bill payments, however, there is nothing I could find in the companys Annual Reports, Financial Statements and even research on the internet. Which means, Apple did not offer cash discount at all, the best way to look at the reasons behind the short collection cycle are probably due to Apples online stores and Apples owned retail stores that collect payments right away when customers purchase the products; also its online music stores that had more than 200 million song titles sold online, these probably contributed to Apples short collection cycle too. Same instance for Dell, its online stores as well are collecting payments right away when products were purchased. Therefore, the short collection cycle in this new millennium will be getting shorter and shorter if purchases transactions are to be done online. This also explained why both companies are rich in cash, as they are much efficient in collecting debts than paying its creditors. iv) Number of days sales in Inventory

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Inventory Cost of Goods Sold Number of days' sales Inventory (# of days' sales in)

Apple (in mil.) 165 9,888 365 6.09

Dell (in mil.) 459 40,190 365 4.17

The time required for both Apple and Dell to convert its inventory to sales is unbelievable. They were both too efficient in terms of cutting the inventory low and production cycle time, even though Apple has a slight slack of 2 days compared to that of Dells, they were both however unbelievably excellent in terms of operating efficiency. To further understand the secrets behind these two companies that achieved such a short cycle time, I read through the notes and business strategies for both companies and realized that both companies had excellent supply chain management in terms of accessing suppliers to purchases and deliveries. They both had long-term contracts and agreements with theirs key suppliers in order to secure consistent raw materials supplies and deliveries cycle time. They both achieved a good Just-in-Time inventory management system. Also, that explained why both companies financial successes in recent periods have been due in part to its supply chain management practices, including their abilities to achieve rapid inventory turns. 1.2.4. Financial Leverage i) Debt Ratio Apple (in mil.) 4,085 11,551 0.35 Dell (in mil.) 16,730 23,215 0.72

Total Liabilities Total Liabilities and Owners' Equity Debt Ratio

Apple has paid up its long-term debt during the FY2004, since then it has not taken up any long-term debt to finance its operation, mainly due to its cash rich and strong owners equity and big retained earnings. The debt ratio of 0.35 came from its accounts payable, accrued expenses (supplier agreements, the warranty and related costs), and non-current liabilities (deferred tax liabilities, deferred revenue non-current). Whereas, Dell has taken up some long-term debt in 28 January 2005 of $505 mil in Senior Notes and debenture which matured in three years time, the interest of 2.059% and 2.392% are to be recorded and payable yearly in Yr2005 financial statement. The other huge portion of liabilities came from its accounts payables. Dell has a payment cycle of 73 days and that explained the high number of liabilities in measuring its debt ratio. However, both companies are well performed without much financial leveraging. ii) Debt/Equity Ratio Apple (in mil.) 4,085 7,466 0.55 Dell (in mil.) 16,730 6,485 2.58

Total Liabilities Total Owners' Equity Debt/Equity Ratio

Apple has a very healthy debt-equity ratio of 0.55; this emphasized that the company has been good in managing its total Owners Equity to payout its short- and long-term payment obligations. Dell has a very unhealthy debt-equity ratio of 2.58, but look further to its balance sheet, it has a total of $10,758 mil of Treasury Stock that reduces its Total

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Owners Equity, and therefore if these stocks were outstanding in circulation, Dell would have a debt-equity ratio of 0.59. Thus, Dells ratio may look very unhealthy but given a more detail research and study, the actual scenario prevailed. So, both companies are good in managing debt and equity and no signals of deepening debts problems. iii) Times Interest Earned There are no interests payable to be calculated for both companies, this means that both Apple and Dell did not make use of the financial leverage to help in financing their growth. A smart use in financial leverage could help company to gain advantage over taxes provisions and even higher the diluted earnings per share. However, judging from the financial strengths of both Apple and Dell, both companies had more than sufficient cash and owners equity to finance its growth, and therefore the options of taking up loans or long-term debt are not taken into consideration especially for the case of Apple. 2. Conclusion Finishing up the research analysis of Apple financial health and its future sustainability, I strongly recommend investors to invest in Apple Computer Inc. Apple not only has strong financial stability, but also continues to invest in research and development to gain sustainable growth in the future. This research report also proven that Apple has strong operation teams to manage its costs and revenue generation. Further to its operation efficiency, Apple is currently rich in cash and short-term investments of $8,261 mil as of 24 September 2005. Last but not least, Apple is well managed in terms of its debt to equity measures. This company has sufficient Owners Equity, retained earnings to fund its future growth and Apple has managed to keep its liabilities in a comfortable level. Operation efficiency is one of the key success factors in supporting the companys business strategies. Therefore, this company will still go strong for at least another two to three financial periods.

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