Apple Inc. (AAPL) Understates Earnings, Investors Should Value It On FCF Basis: Bernstein

In a note to investors published today, Bernstein analyst Toni Sacconaghi weighed in on why Apple Inc. (NASDAQ:AAPL) has chosen to keep a large offshore cash balance and not repatriate to the US. Mr. Sacconaghi noted activist investor Carl Icahn’s notion that Apple’s real tax rate is roughly 20% below what the company reports, which is around 26%. In his note, he mentions different aspects and implications of Apple’s decision to keep cash abroad.

Mr Sacconaghi’s analysis shows that the tech giant’s international tax rate is quite low at 4% – compared to 16% on average among non-financial, non-energy large cap firms. As a consequence, this makes it quite unappealing for Apple to repatriate cash back to the US, where it has to pay more in taxes. The analyst observed that low overseas tax rate is not unusual among tech companies, such as Oracle Corporation (NYSE:ORCL) (12% in last fiscal year) and Microsoft Corporation (NASDAQ:MSFT) (10%), and highlighted the fact that overseas cash can be reinvested to get a tax exemption in US.

But some problems that emerge are that the cash is kept idle overseas and that companies need to pay the difference between the international tax rate and US tax bill (the prevailing rate is 35%) if they are to repatriate cash to pay for dividends, share repurchases and domestic merger and acquisitions.

Regarding the question as to why there is a difference between Apple’s real and reported tax rate, Mr. Sacconaghi simply says that Apple has chosen not to permanently reinvest its offshore cash and accrue GAAP taxes on a portion of it. An important point to note is that Apple is not repatriating and not paying the tax on its foreign cash but is just recording it as an accrued tax in its reported income statement. If Apple reinvested all of its offshore cash like most companies, then its reported tax rate would have been much lower and according to the analyst, it would boost the earnings per share (EPS) by around 9%.

Mr. Sacconaghi also elaborates on three points that he believes impact Apple due to its decision not to permanently reinvest its overseas cash. Firstly, the iPhone maker’s reported GAAP taxes increase; the analyst computes that Apple would have saved $3.5 billion in taxes in FY14 and its effective tax rate would have been 19.6%. Secondly, the measure reduces Apple’s net profit. Thirdly, this gives rise to deferred tax liabilities (DTL) on the balance sheet. As per the Bernstein report, Apple has accrued around $19 billion in taxes, increasing DTLs from $2.7 billion to $21.5 billion in the past five years.

It seems that the decision not to permanently reinvest its cash abroad is solely taken by Apple, Mr. Sacconaghi writes. Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) essentially give the authority to the management, to choose how much cash they want to reinvest and how much tax they want to accrue on the left over portion of the income. The analyst thinks that Apple stands as a unique company in contrast to other tech firms, which have permanently reinvested their income abroad and hence do not accrue any taxes.

So why exactly does Apple undertake such a decision? Mr. Sacconaghi outlines two reasons. According to the first hypothesis, Apple gains the flexibility of repatriating cash under any circumstance or tax holiday. According to the analyst, perhaps Apple is worried that any cash that is considered permanently reinvested might not be qualified for repatriation under a tax holiday or in a general in the future.

As far as the other hypothesis is concerned, Mr. Sacconaghi said: “The other reason that Apple may choose to not permanently reinvest some of its offshore cash (and accrue tax on it) is that it provides cushion to manage or increase earnings in the future. By choosing to permanently reinvest a higher percentage of its offshore cash going forward, Apple can accrue less tax.”

In addition, the analyst noted that Apple has partly undertaken such a measure in the last two years. From FY12 to FY13, the company reduced its provision of foreign income from about 50% to around 35%. The move, according to Mr. Sacconaghi, increased FY13 and FY14 EPS by 3.4% and 3.7%. “Apple’s effective tax rate did not decline over this period because 1) foreign PTI as a percentage of total PTI declined from 66% in FY2012 to 61% in FY2013, and 2) Apple’s foreign tax rate increased from 1.9% to 3.7% (Exhibit 5) – Apple’s move essentially padded falling PTI contribution from foreign subsidiaries. If Apple were to end provisioning altogether, FY 2014 EPS would have been $0.47 higher, or 9%,” the analyst added.

In the end, Mr. Sacconaghi confirms Carl Icahn’s thesis and says that Apple’s earnings are understated, potentially by 10%. This compels him to say that Apple should be valued on Free Cash Flow basis, rather than on net income. The analyst pointed out that Apple has historically returned around 120% of its net income as FCF. About two-thirds of this upside has come from DTLs and one-third from stock-based compensation. Also, it was said that Apple’s valuation appears more attractive, when done on an EV/FCF basis, due to its hefty cash balance.

Bernstein rates Apple shares at Outperform with a $142 price target. Apple shares are currently trading up to $130.48 as of 11:59AM EDT. Across the Street, 56 analysts have provided coverage on the stock, out of which, 39 rate it a Buy and 14 recommend a Hold.