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December 24th, 1999

[1:00 PM] A Careful Analysis of Apple's 1999 Annual Report, Part II
by Wes George

Yesterday, I began an analysis of Apple's latest annual report by noting that Apple has increased unit sales by 25% year over year and maintained upward trending gross margins at 28%. The report is full of positive indications that the turn around at Apple is complete and now it's time to accelerate market share growth into the future.

Liquidity and Capital Resources

The graph illustrating Apple's capital resources in the 1999 annual report is a picture perfect view of an extremely healthy business. Cash equivalents on hand rose at a billion dollars a year since 1997 to $3.226 billion in 1999. Inventories are down to $20 million or 2 days of supply from $437 million or 31 days of supply in 1997. Operating cash flow and working capital are trending up strongly.

What more could a shareholder ask for? How about spending some of that cash to guarantee Apple's place at the top of PC industry in the next decade.

Increased R&D? Not!

The first reform Steve Jobs implemented when he came back to Apple was to scrap many projects engaged in research and development. Apple experienced a 38% ($182 million) cut back in R&D expenditures in 1998 as Mr. Jobs shut down programs not deemed vital to Apple's immediate future.

Generally, cut backs in research and development by a high tech industry leader is the same as borrowing from your future to pay today debts, it's the kiss of death. Many observers at the time cited the cut backs as emblematic of Apple's decline.

A great debate ensued on the stock boards as to whether Mr. Job's surgical cutbacks were good medicine or butchery. In retrospect, it's obvious that Mr. Jobs liposuctioned a ton of fat from the system and the operation was successful. Now it's time for Apple to build back some of that R&D muscle that was lost in Apple's restructuring.

The 1999 annual report claims Apple has "recognized that focused investments in R&D are critical to its future growth and competitive position in the marketplace." However, the R&D budget is up a miserly 4.0% or $11 million to $314 million in 1999 from 1998. Remember that's after a 38% cut in 1998. With inflation running at 2.1%, Apple's commitment to discovering new paradigms in computing through research seems just a little weak, especially in light of the $3.226 billion Apple has in cash equivalents.

In fact, Apple has committed more money to a stock buy back program in 1999 ($500 million) than it has to research and development. And this comes at a time of great uncertainty in the PC market when new forms of computing devices are threatening to swamp the dominant and aging desk/laptop paradigm with a whole new range of choices.

The evolution of personal computers during the 1990's will seem quaint when compared to the next generation shift towards handhelds, networked devices, embedded and wearable computers in development by the likes of Sony, IBM and Sun Microsystems. Large increases in the research and development budget is the only way for Apple to stay the industry leader that R&D innovations, like the iMac and iBook, have made it.

Advertising costs

According to the annual report: "Advertising expense was $208 million, $152 million, and $143 million for 1999, 1998, and 1997, respectively." This seems a rather slow ramp up in advertising dollars for a PC manufacturer with three totally new, paradigm-busting products on the market.

Of course, when demand exceeds a manufacturer's ability to supply a product, spending on advertising becomes a less attractive proposition. This is the catch-22 Apple found itself in with the introduction of the iBook and the G4. Apple needs to massively expand it advertising to grow its market share. Yet, Apple has not been able fill the current levels of demand for its products, much less meet the higher demand that raising consumer awareness with a larger advertising campaign would generate.

In Q2 2000, advertising costs should ramp up faster than in 1999, because Apple will have the factory capacity to meet and expand demand.

ARM Holdings and Akamai

There is much speculation about how much money Apple has made off its investment in ARM Holdings plc, a RISC microprocessor design firm and Akamai Technologies, a global Internet content delivery service. This annual report gives no definitive answer.

According to the annual report Apple owned 16 millions shares of ARM stock valued at $226 million, although by December 17th the company had sold an additional 5.1 million shares for about $134 million. The company still owns 10.9 million shares of ARM stock valued at approximately $690 million. The report does say that Apple "has categorized its shares in ARM as available-for-sale requiring the shares be carried at fair value". This means Apple is in a profit-taking mode, selling-off its stake in ARM as it sees fit.

As for Akamai, Apple purchased 4.1 million shares in June of 1999 and Apple is restricted from selling more than 25% of its shares before one year from the date of Akamai's IPO on October 29th of 1999. However, the 25% of the shares they can sell are "available-for-sale". Apple has listed the value of its Akamai investment as approximately $1.2 billion.

Akamai (AKAM) recently traded at $281, up from the $26 IPO price that Apple presumably paid per share in June. ARM Holdings (ARMHY) traded at $181 yesterday, up from about $45 in September.

Assuming the stock market continues to perform well into 2000, Apple is positioned to reap excellent one-time gains from its investments in these companies. Such one-time windfalls are likely to carry little influence with AAPL investors who look instead to Apple's core business for sustainable gains.

In conclusion:

Lou Mazzucchelli, who was one of the first PC industry analysts to recognize Apple's come back, says of the 1999 annual report, "this is the story of a great year, shareholders and potential shareholders should feel positive."

Indeed, Eric Yang of predicts that Apple will ship about 1.3 million units in Q1 2000 representing 38% growth over the year ago period and the first time Apple has shipped over a million units in a quarter since Q1 1996.

We have an Apple Stock Watch Special Report with all of our coverage on Apple's stock and financial news.


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