Spotlight on Apple's hidden revenue stream
On Wednesday, when Apple announces its fiscal 2009 first-quarter earnings, the business press will rush to report the key metrics: number of units sold for Macs, iPods and iPhones, as well as overall company sales, earnings, and gross margins.
But according to some long-time Apple watchers, what really matters tomorrow is whether reporters and analysts will fail — once again — to recognize the rapidly growing value of Apple's hidden revenue stream.
That revenue stream — roughly 40% higher than the one everybody is focused on — flows from the sales of iPhones, which grew 583% in fiscal year 2008. Most analysts, however, don't include it in their reports to clients because it isn't recorded in Apple's books.
The problem stems from a decision that Bullish Cross' Andy Zaky calls "one of the worst in Apple's history." Rather than recognize income from sales of the iPhone in the quarter in which it is collected, Apple spreads it out over eight quarters — the life of a typical iPhone contract.
The result of this so-called subscription accounting is that revenue from the iPhone in any one quarter is like an iceberg: we only see the tip of it. The other 7/8ths are sitting in Apple's coffers, waiting to be parceled out in future earnings reports.
The failure of traders to take those 7/8ths into account is one of the reasons — along with concerns about the CEO's health and the global economic slowdown — that Apple's (AAPL) share price has fallen in just over a year from $202 to the low $80s.
"What we have here," wrote Zaky on Monday in a post entitled How the iPhone and Poor Apple Management have contributed to the Downfall of Apple, "is a perfect recipe for media misrepresentation, analyst confusion and market disorientation regarding Apple's fundamentals."
In October, Apple finally addressed the problem. Making a rare telephone appearance in an Apple's quarterly earnings call with reporters and analysts, Steve Jobs tried to focus their attention on Apple's so-called non-GAAP (generally accepted accounting practices) earnings.
"Because by its nature subscription accounting spreads the impact of iPhone's contribution to Apple's overall sales, gross margin, and net income over two years, it can make it more difficult for the average Apple manager or the average investor to evaluate the company's overall performance. As long as our iPhone business was small relative to our Mac and music businesses, this didn't really matter much. But this past quarter, as you heard, our iPhone business has grown to about $4.6 billion, or 39% of Apple's total business, clearly too big for Apple management or investors to ignore. Hence our introduction today of non-GAAP financial results alongside our reported GAAP results.
As you can see, the non-GAAP financial results are truly stunning. By eliminating subscription accounting, adjusted sales for the quarter were $11.68 billion, 48% higher than the reported revenue of $7.9 billion, while adjusted income was $2.44 billion, 115% higher than the reported net income of $1.14 billion. Adjusted net income that is more than double our reported income — if this isn't stunning, I don't know what is, all due to the incredible success of the iPhone 3G." (transcript)
Apple's stock jumped 18% in after-hours trading as some traders realized that the analysts they follow had underestimated Apple's earnings by nearly $3.8 billion.
For many Apple investors, the key question tomorrow is whether Apple will sufficiently emphasize adjusted earnings in their quarterly report. For example, will they compare adjusted earnings for this quarter with the same quarter last year, giving analysts — for the first time — a metric by which they can report year-to-year non-GAAP growth?
Zaky wants the company to drop generally accepted accounting practices altogether. He writes:
"Apple should immediately cease giving GAAP-based earnings guidance and instead offer guidance on adjusted earnings. If Steve Jobs really wants the market to shift its focus from Apple's GAAP-based earnings to real earnings, then he really needs to start offering guidance on an adjusted basis – a practice that several other tech companies already employ." (link)
Below the fold: Zaky's charts comparing Apple's adjusted price-to-earnings and price-to-cash ratios to those of Google (GOOG), Amazon (AMZN), RIM (RIMM) and other major tech companies. Needless to say, he believes that given Apple's growth rate and balance sheet, its shares are vastly undervalued.
It's like this…I have a son and he's three years old. Someone (texting on there iphone) runs him over and kills him. I will sue them for not what he currently is worth but what he would have been worth when he grew up and became a nuclear surgeon. You can never bank on tomorrow. (except for the fact that we will all be judged according to our sins, and very soon!).
Gotta echo robert and esp. turley…just look at the CF statement, folks. Cash is a fact…thats the stuff that goes into AAPL's bank account.
AAPL gets $500-$600 in cash any time a phone is sold (and is free to reinvest…meaning they get all of the economic benefit of upfront recognition)…but on the PnL it gets broken up in bite sized pieces.
Earnings are an opinion. they can't be "reinvested." Cash is reinvested. The quicker people embrace that axiom, the easier life will be.
From the comments below, it is amazing how many people don't understand Apple choice of using subscription based accounting.
TO Brian and Yale regarding whether Apple did or did not have a choice. Read the comments by Apple in the conference call transcript. They outright say they have a choice. They say it in that Q2 report I have quoted and they say it again in Q3 2008.
Some commenters are confused. The subscription accounting has nothing to do with AT&T and service contract. The AppleTV is accounting for over 2 years as well. If Apple promised free OS X upgrades with a Mac purchase, then it too, would use subscription accounting. Yet, Apple didn't give away free Tiger and Leopard etc (OS X 10.4 & 10.5) so that's why Mac has normal accounting.
Apple says when one buys an iPhone, future versions of OS are included in the purchase price. Basically that means free to the consumer. Therefore, Apple hasn't fully delivered the product offering at time of purchase when the consumer pays and receives the device. Since Apple has the consumers money yet still owes future software that may become available, it can't recognize the full purchase price of the iPhone upfront, when cash is received. The same is true for AppleTV.
Apple may not actually release new OS versions, it hasn't guaranteed that, only promised that if it does, there won't be any cost to upgrade. That's why touch owners had to pay for 2.0 and iPhone owners didn't.
I think Apple didn't want to charge because it may delay/dissuade users to upgrade, which will interfere with Apple's long-term software and functionality roadmap. Plus, while consumes are accustomed to having to pay for new OS versions for PCs, they are not for mobile devices, that might leave a bad taste in peoples mouth.
Somewhat fortuitously, the subscription accounting helps maintain revenue stream on the books through this economic calamity. During the last recession, Apple had enough cash reserves to weather the storm without significant layoffs. New product development typically takes 18-24 months. The last recession lasted slightly longer than that (and the current one will last even longer), but companies that continue to innovate and develop through the downturns, emerge with products ready for the market. (Like the iPod and iPhone).
This is a terrible article. This is NOT NEWS. Anyone who even takes a look at the 10K filings from Apple, can see clearly that they are doing this amoritization due to their new deal with AT&T, where the cost of the phone is subsidized over the life of the plan. This is a change from when the Iphone 1.0 was purchased without subsidies, and can be booked at 100% of value. This is to comply with Sarbanes-Oxley. It's not a choice. It's the law. What? Apple obeying the law in its accounting practices? What's next? "Spotlight on Google's hidden Email System"?
ex ped: Foolish me. I should have just pointed readers to Apple's 10ks. What was I thinking? As for Sarbanes-Oxley, see the following comment.
This accounting is prescribed by Sarbanes Oxley. Apple didn't have a choice, especially if they wanted to provide free updates, which is a smart move because it keeps people on the same OS and that saves a lot of support time and eliminates a lot of customer complaints, etc…
Sooner or later, these profits all get counted and we will see what happens at that point.
ex ped: According to Zaky, Apple did have a choice. It could have charged iPhone owners $9.95 for OS updates, as it does for the iPod touch, rather than providing updates for free.
Philip Elmer-DeWitt must have a degree in marketing to say something this asinine. GAAP is here to protect us against this exact thing. Inconsistent revenue reporting has dire consequences. Philip is asking us to reap what we can today and forget the consequence of tomorrow (must be an oil futures man). Deferred revenue = moderating future liabilities…. Something all of us should of had a history lesson in during the past 6 months with the banking industry.
Remember that the IPhone broke the model of most 'commodity' phones. The commodities were always heavily subsidized, based on the 2 year contract, so it made sense to recognize the revenue over the life of the contract.
Apple got their money upfront (due to 'fan boys' or whatever – basically, good marketing).
If they were given the choice, I doubt they'd set it up the same way again.
Even though this revenue does not show up in the income statement as such, it would still show up in the statement of cashflow and the footnotes. This revenue would be very apparent to educated financial managers and investors.
This isn't the first time that I have seen a reporter try and explain this. The reality is that it will be still over two years until consistent iPhone revenue can be 100% reported. Only this July will we see the first earnings with eight quarters of revenue, but of course only 250,000 that we sold in June of 2007. By January of 2010, there will be a better understanding of what this author is trying to convey as the first CYQ4's 1/8 revenue leads the trailing eight quarters. In October 2010, the massive 3G opening quarter will finally be at full 8/8 reporting. Buy until 2010 and you will be quite happy!
AAPL gets ALL the money from AT&T at the time of sale (or close to it), as they now use a traditional cell phone model where the provider (AT&T) buys the phone from AAPL, then subsidizes and sells on their own (AAPL also helps them sell). All of the actual cash flow occurs in the quarter the phone was bought. But cash flow is different than revenue recognition. The revenue (and cost-of–goods-sold) is not recognized in one quarter, but 8. Of course AAPL has an allocation for returns, etc.
This article is pathetic. Philip Elmer-DeWitt is a jackass. In this day and age should we be encouraging companies to be less conservative with their earnings reports??!!! Apple is following GAAP rules and recording revenue appropriately since they must account for software upgrades for the LIFE of the phone. The info this author is crying over is easily discovered if you read the footnotes in 10-k's!!! Hooray for a company actually being responbile for once and not trying to OVERSTATE earnings.
According to my calculations, Apple already has about $1.6B in deferred iPhone/AppleTV revenue lined up for each of the next three quarters. In other words, that's the revenue without selling a single iPhone/AppleTV for the next 9 months.
Bill in Bristol:
This is NOT revenue from the phone service contract, this is actual revenue that Apple gets from the sale of the actual phone (you know the $499 paid when they first sold them…now only $199).
They decided to use this accounting to try and match revenue from the sale of the phone with expenses since the expenses will be incurred over the life of the phone contract (many iPhone services are offered free of charge to consumers by Apple, even though they cost Apple money to provide). I presume this plan was done to smooth out the expense of those free services with the revenue from the sale being deferred.
To Bill in Bristol: If every single one of the consumers canceled, it wouldn't matter as Apple has already collected the revenue from the carriers (about $570 and $670 per phone model).
The only reason Apple went to subscription accounting was to allow for free upgrades. According to Apple Legal's interpretation of Sarbanes-Oxley, they could not record all of the revenue until mostly all of the product was delivered.
Next time, bash only when you understand. You look truly foolish otherwise.
The difference between GAAP and non-GAAP is staggering. The drop in the stock price is certainly proof a short term market approach for most investors. Properly matching the revenues when cash recieved over 8 quarters is a good thing as it ensures a pipeline of cash. If investors had long term strategies, the GAAP method would reward the stock price.
To commenters:
1.The assumption that Apple has not actually received this income is wrong. They have.
2. The assumption that Apple might have to repay the income to AT&T is most likely wrong. That's why AT&T charges a penalty to early-cancellers. I doubt that Apple would have to refund AT&T.
3. The assumption that Apple CHOSE to use subscription accounting is most likely wrong. Though somewhat subject to interpretation of accounting regulations, I believe that they probably made the only correct decision at the time.
It's not all gravy. If you are going to recognize the sales in advance of payment (non GAAP) then you need to include provisions for losses and impairment for the number of cases where subscribers cancel, return phones, trash the phones in trying to jailbreak 'em, default on contracts, etc. So what is the demonstrable rate of default and what is the value destruction from that? Who wants to invest now on a story that is substantially the same as MBS's and CDS's, that future income is a given and there is no risk?
AAPL has never cared to pander to short term investors (or more appropriately, traders). It has a long-term focus based on success from customer satisfaction and quality products. AAPL has stated that the subscription model allows them to provide FREE updates to the rapidly evolving iPhone platform. If they accounted for the revenue the same quarter it was sold, they would have to charge for subsequent updates or possibly reopen it's books to account for changes. Something similar happened to the AirPort Extreme to enable 802.11n (2$), and again with the ipod touch (20$),. Their comment then: "[Apple] believes that if it sells a product, then later adds a feature to that product, it can be held liable for improper accounting if it recognizes revenue from the product at the time of sale, given that it hasn’t finished delivering the product at that point.". Nickel-and-diming the consumer for each minor update does not go over well.
Fascinating article. It's been mystifying to me that Apple's deferred revenue stream hasn't been major news. How on earth haven't we heard the likes of Jim Kramer or the Fast Money team talking about this future and guaranteed earnings explosion? I understood it for a while, but after Steve Jobs made a surprise appearance on Apple last earnings call, I thought the secret was out of the bag. In this economy, a future of guaranteed and increasing earnings being tacked on quarter by quarter should be a trigger for serious multiple expansion. Everywhere else you worry when the consumer will return, here it's like you've got millions of sales already absolutely guaranteed — nothing can take them away, they merely show up on the earnings statement. I do understand that the Blackberry is the primary product on Wall Street, but we're talking about forward looking black and white numbers here (not product hype), this is usually the type of detail that attracts serious attention.
Andy Zaky is also dead on by noting that if a conventional accounting model had been used, the explosive growth of the iPhone would have been front page news and momentum investors would have flocked to the stock. In a time where so much money was looking for a place to go, this would have been the outlier that attracted such media and investor attention that it truly has been serious management error to have missed the spotlight that was there for the taking. I'm hoping that Job's rest period will allow some other ideas to move forward within Apple.
For analysts would think the iPod upgrade cycle is dead, they really understand nothing about the iPod Touch. Every single owner of a Shuffle, Nano, or Classic covets their move up to the iPod Touch. While unit growth will be negative, I'd rather sell one Touch than two Shuffles. Watch the ASP growth as the move to the Touch upgrade cycle really begins. The Touch numbers will no doubt be a major point on tomorrow's earnings call.
More "smoke and mirrors" from Apple. I must admit they're really good at it.
The other 7/8ths can't be included until it is realized. What if every iPhone purchaser cancelled their 2-year contract after the 1st month?
GAAP are there for good reason. Any company claiming they're above them is on real shakey ground – especially Apple.
It makes perfect sense for Apple to defer the amount they earn on IPhone sales over 8 quarters because the customer is billed 24 times (e.g. for AT&T) over the course of 2 years (8 quarters). The money comes in in steps. Apple is therefore doing the right thing. (Now if AT&T pays Apple up front on it, it would be wrong.)
As I recall, technology companies had loads of critism heaped on them during the tech bubble for reporting pro-forma earnings, and now this analyst is recommending they do just that. This is a joke, report both and let people sift through the numbers. The critical comments are misplaced – I am an Apple shareholder and this will just lead to more . Changing the reporting to non-GAAP is trying to "game" the system. The earnings will show up in long term valuations of Apple and on balance sheet cash.
A real eye opener of an article! Andy has the best record with respect to Apple of anyone out there, and hopefully more investors, including the mutual fund and hedge fund people, will begin to recognize the true value of Apple. It is overdue for a strong comeback, with or without Jobs at the helm.
Perhaps analysts need to be a tab smarter in the companies and industries they cover. Apple can not pick how it recognizes revenue, that's governed by GAAP. Any business student that's taken accounting 101 understands this. Perhaps we need a certification process for these so called analysts.
This is just more of the wonder that is Steve Jobs. I think he is a brilliant captain of free enterprise. I have made a small fortune on apple stock. He constantly fids ways to underestimate and tracking market bsevers always bite; and he always outperforms. Although, this one is the law, he plays it down beautifully.
Now I must comment to those that always challenge Apple on "the issue of price." Price is only one lelment in marketing. What good a low price if the procuct lacks quality, is not fun to use, is not user friendly, does not have great customer service, great architecture and is the late comer in the market?
I always take a bit higher price amrtized over the life of the product in order to receive the best product quality (I have not had a crash or freeze in the year I have owned my MacBook), the best customer service (ProCare cost $50 a year and I get an appointment, often on the same day, one on one and they always solve my ignorance — "One to One" cost $100 a year and provides a one on one live class for up to one hour a week), the products are fun to use, they are user friendly, they have great architecture, etc. Oh, did I mention I am still making a bundle on the stock?
Mulligan