Apple: Unlocking iPhone Profits

Doesn't everyone realize by now that Apple's (AAPL) earnings guidelines are pointless? First, Apple always gives low guidance and then handily beats -- they have been doing that for as many quarters as I can remember. But, more importantly, Apple's reported earnings more and more have absolutely nothing to do with reality. In the old days (prior to the iPhone), earnings meant something. You could ooh and ahh over the great Mac and iPod revenues. These days, Apple's earnings tell you less and less about how the company is doing. In fact, next quarter, they will be fairly useless.

That's because iPhone sales are not accounted for at the time they are sold. Rather, because of Sarbanes-Oxley, Apple is forced to dribble out iPhone revenue and earnings over 24 months. That means, for instance, the colossal selling of one million iPhones over three days barely will budge next quarter's earnings. Rather than getting reported as complete transactions next quarter, the revenues and earnings appear according to when the sales were made in the quarter. Those one million phones were sold about 10 days into the quarter leaving about 82 days of time for reporting; they will be entered as 82/730th of revenues and earnings, or 11% of the actual sale. Apple has, however, actually paid the costs of the iPhones they have sold and pocketed their earnings. Imagine how little of the actual earnings will be reported on iPhones sold the last day of the quarter: 1/730th! The subscription method of accounting they must use totally underestimates their earnings.

Apple, during its conference call, pointed out just that:

However, the iPhone is currently a small part of our total revenue and gross margin, as a result of subscription accounting. And with the introduction of the iPhone 3G and our authorizing carriers in over 70 countries, we expect to sell significantly more iPhones this quarter and in the future than we have and we are very happy with the margins in our new model.

Next quarter will tell very little about how Apple did. Apple is launching one of its most exciting and lucrative products ever and making hoards of money. The reported earnings will not reflect that. With such a successful start in 22 countries, it would not be unreasonable to sell 4 million phones this quarter. Thus possibly 2 billion dollars of revenue will be largely absent next quarter's report.

What will be in next quarter's earnings report? Mac and iPod sales and one eighth of the revenues and earnings of the previous 6 million iPhones sold. The fractional old iPhone sales reported will be less than 1/5th the likely number actually realized for iPhones sold in the quarter. And who wants to look at earnings that are in the past. An earning's report is not supposed to be a history lesson. Early this year, Apple had a problem with consumers unlocking their iPhones. Now investors have a problem. They have to unlock Apple's real iPhone earnings. It's foolish to sell Apple on a forecast of next quarter's earnings -- they so grossly underestimate the truth as to be worthless.

The conference call spelled it out:

In the first three quarters of fiscal 2008, Apple generated over $5.4 billion in cash on $3.7 billion in net income. The primary contributor to the difference between our reported income and our cash growth is the tremendous cash generation from iPhone sales that has not been fully reflected as earnings yet due to subscription accounting.

So how do investors figure it all out. Certainly next quarter's cash flow is going to be immense. That spread between cash generation and net earnings is going to be far wider as Apple ramps out the iPhone throughout the world. Cash flow clearly is a better way to see what is going on with Apple. I've come up with another way, by far not perfect and with lots of assumptions, but here goes:

(Reported operating income) + (Profit per iPhone) x (iPhones sold in the quarter - all iPhones sold in the past/one-eighth) = true operating income

You can pick your own best estimate to profit per iPhone. I've seen them ranging $150 to 375.

Regardless of where you set your value of profit per iPhone, you're bound to come closer to the real deal and unlock the true Apple earnings. Next quarter, reported operating income will likely underestimate true income by $600 to $700 million. So,please, in future quarters do not be fooled by EPS numbers that totally miss the real story.

Disclosure: Author holds a long position in AAPL

Comments

[pabs]

iphone is only a fraction (albeit growing) amount of the appl business

[tom1234]

so like i have been saying ---when aapl reports earnings and beats the market expectations---do you not see that they really sandbag (in a good way) the actuall income for that quarter ---that the income is higher and yet the market moves south because jobs stubbed his toe or some crazy excuse--they clearly state that the acounting of earnings for that quarter qill be spread out over 2 years ---2 years ---2 years ---

[scottybe]

I thought the original iPhone's revenues and earnings were recorded that way because AT&T gave Apple a cut of their service revenue off the devices. Not so with the iPhone 3G.

[Appleshuttle]

Well, what do you know, someone actually understands Apple's earnings.

Amazing The Street can't grasp that in addition to sandbagging regular
earnings by about 25% in their guidance, because of their interpretation of federal regulations, the number they are reporting may under report earnings by as much as $1.00 a share this quarter.
They real saving grace about this is Apple will be reporting earnings
from this quarter's explosive sales for two years(it will increase earnings every quarter for two years). Every quarter at least for the next year (two years after the iphone first went on sale)earnings will automatically grow faster as every iphone sold in the prior two years is accounted for in their earnings.

apple is consistently growing their earnings, despite this under reporting of actual earnings, by a percentage higher than their PE.
This is unheard of. If you consider things like their cash, no debt,
deferred earnings, and actual reported earnings, Apple is one of the
cheaper valued stocks out their at the same time as being one of the hottest companies out there. The next time someone says to you that
they don't want to buy Apple stock because its too expensive, give them an earful!

T

[Grouch4460]

I believe that should be plus one eighth of all previous iphones sold. Also a more accurate calculation would be to assume all iphones sold in the quarter are sold at the midpoint (they get no quartly earnings (1/730) for phones sold on the last day of the quarter but 89/730 for those sold on the first day.)

[mollytjm]

and the first store in China is open in time for the Olympics. sales there should be huge. Apple knows how to run retail space and just about everything else. it's a great value investment.

[Network Effect]

Has anyone considered that the product transition that is going to take place is that Apple is going to start charging businesses for placement in the Apps Store? Apparently 25 million apps were downloaded in a week, so this is a huge oportunity for anyone trying to sell something. And big and small businesses are coming by the droves to promote their products/services in the Apps store. The problem this creates is the same problem that eBay, Google, et al all face - a computer screen is only so big. A really great search engine and category scheme can go along way towards helping consumers navigate the mess, but at the end of the day, there's only so much that you can cram into a small amount of space. So, at this volume, you have a massive disequilibrium of supply and demand as it relates to placement in Apple's apps store. This creates a huge opportunity to charge for placement. Just a thought.

[retiarius]

As commented upon elsewhere, AAPL is trading at 16X cash flow
net of cash. From Apple's quarterly press releases, here's
a table of cash + short term investments (in billions):

Q1 07 11.8
Q2 07 12.6
Q3 07 13.7
Q4 07 15.4
Q1 08 18.4
Q2 08 19.5
Q3 08 20.7

Cognoscenti know that Apple runs this cash through subsidiary
Braeburn in Nevada, free from state income tax. If interest
rates rise back up to the level of last year, a substantial portion
of quarterly earnings will be interest income.

[outsidethebox]

I didn't like the article when it started, but after digesting it all, I have to say, you spent some very worthy time putting it all together and it's better than 99% of the financial analysts covering the stock have now or ever could have done. Thank You.

[Gears of War]

scottybe:
You are confusing Apple's 24 month subscription accounting with the iPhone/AT&Ts old subscription based revenue sharing agreement. They are two separate issues. Apple and AT&T no longer have a subscription based revenue sharing agreement (its now a subsidy), but Apple is still using subscription accounting for the iPhones.

Case in point-the AppleTV is using the same subscription accounting reporting (over 24 months) as the iPhones, despite having no AT&T or other deal involved.

[GSlusher]

For scottybe: Re-read the article. Apple's accounting method has nothing to do with carriers. It is because of accounting rules in the Sarbanes-Oxley law. If they didn't account for earnings over time, they'd have to charge for significant updates, like the recent firmware update, which they DID charge iPod touch owners for. As a bit of "proof," Apple also accounts for earnings on the Apple TV over 24 months, for the same reason. Apple also had to charge for an update to the first Intel iMacs that unlocked the 802.11n wireless capability.

[Constable Odo]

I'm glad everyone is upbeat about Apple sales. I'm sure I'm not the only one to notice that the more products Apple sells and the more profit they make, the stock price goes DOWN in proportion. Isn't there anyone here that can contact WS and tell them that's not the way it supposed to work?
Somebody mentioned that Apple knows how to run retail space. I think they'd better get some tutoring from Amazon. Apparently Amazon can sell snow to Eskimos judging from their earnings this quarter. At least WS can recognize Amazon's skills and that really makes a difference in a company's stock price.

I don't know if this is true or not but I read that the average person in China won't be able to afford any Apple desktop computers since even the midrange models are as much as what a Chinese worker makes in a year. I'm sure there is some untruth to this, but surely Apple wouldn't be investing in China if they couldn't turn some profits.

[Blad_Rnr]

GREAT analysis! You said what many just don't get.

And what other company has this kind of growth with an almost endless supply of new products in the pipeline that build on one another and that give almost every user a solution? Example: can't afford an iPhone with the 2-year contract? Get an iPod Touch! It gives someone 90% of the capabilities without the contract. Brilliant!

Why Apple went down after the earnings report is beyond me. These analysts just don't get it. What other company is making money hand over fist, selling real products, like Apple? They are a technology juggernaut that is not going to be stopped anytime soon.

[mfin]

How does it affect the stock valuation is the key question. And I think it will not however you grab the ear.

[macHobbes]

@ Constable Odo:

Somewhere else I read that the whole asian market is not about _desktop_ computing, it is about _mobile_ computing. And that's where Apple is headed...

[wfm100]

While "the average Chinese" may not be able to afford any retail Apple products, remember China has a population of over ONE BILLION THREE HUNDRED MILLION (1.3 B) people, and if just the upper 20% of the population can afford to buy Apple products, that's a new market of over 260 million potential customers!

Remember, India is coming along too, with an additional population of over ONE BILLION!

[REB]

@ Constable Odo:

When you count the growing middle class and rich Chinese it would seem that their consumer PC market may match America's soon. Certainly, in the major cities Apple's stores will find Mac customers. The potential of an internet tablet could be huge in addition to the iPhone.

[tom1234]

molly ---aapl does the highest cost of sales per square foot ---there is no one close to their square foot sales ---there is no one that does the volume of sales per square foot as aapl---

[zahadum]

where is michael dell when u need him?!

(recall that dell told a reporter (fortune?) a decade ago that the prospects for apple were dim: he suggested apple closes its doors & return its remaining cash to its shareholders (since that would be the only money they could ever expect cupertino to ever generate for them in the future).

... ah yes, the gold old days - when the trade press (let alone the business press) could be relied upon to repeat whatever lies redmond fed them.

where are the msft shills when you need them?!

[K Marx]

Once again, we can thank Uncle Sam for "protecting" us innocents with the Sarbanes-Oxley law. While it was SUPPOSED to prevent the likes of ENRON (1 company in ?? years) from playing a shell game with earnings, as always, it ends up creating an imposed and indecipherable shell game for just about every company in the U.S. including mine. Contact your Senator and Congressman and tell them to repeal this POS law. We don't need no stinkin' gov't help - just get out of our way!

[PK de C'ville]

Great read. Thanks for the info.

Would you write another article comparing Apple's Cash Flow numbers to other businesses? Much appreciated.

[KenC]

I wrote an article on this topic at macdailynews' Opinion page, 3 months ago, after the FYQ2 conference call.

macdailynews.com/index.../

[OldFart Peter]

The IC industry went through a similar accounting crunch a few decades ago. Sales to distributors were recorded on shipment date, rather than when the distributor sold them to an end customer. Some companies (notoriously National Semi) would ship products to a distributor on the last day of a quarter, the distributor would ship them back a few days later, but the company reported great sales for that quarter. This practice was stopped, and such sales could only be reported when the distributor sold the product. The IC company results were less "game-able", but I am sure it was harder for the accountants, since the distributor had to add a new reporting channel to their suppliers, etc. However, the industry has survived this change to the financial reporting rules. NS survived, unlike Enron.

[Partners in Grime]

Sounds like an accounting nightmare!