Apple's gap is closing quickly
The opportunity to cash in on the iPhone's subscription accounting has mostly passed
Source: Deagol's AAPL Model
Apple (AAPL) is scheduled to report its fiscal 2009 earnings next Monday, Oct. 19, and in the days ahead investors can expect to hear a lot about the new accounting rules that will allow Apple for the first time to book iPhone revenue when the sales occur, rather than spreading it out over eight quarters.
The effect of the old rules was to create a gap between Apple's actual revenue and its GAAP revenue (for generally accepted accounting principles) — the number the company is required by the SEC to report every quarter. This gap grew wider as iPhone sales accelerated, pouring billions into the company's coffers that weren't reflected in its earnings per share.
Many investors and analysts were well aware of this phenomenon. But many weren't, and the company's share price whipsawed dramatically as the stock fell in and out of favor over the past two years. The latest pop came three and half weeks ago when CNBC's Jim Cramer, anticipating that the new rules would boost Apple's EPS, told his Mad Money audience to go "all Jimmy Appleseed."
But Cramer's advice may have come too late, according to the chart posted above (and reproduced full size below the fold).
Source: Deagol's AAPL Model
The graphic is the handiwork of an amateur analyst who calls himself Deagol. Deagol, who prefers to be known by his nom-de-Web, has achieved a large following on the investor boards where he posts detailed estimates of Apple's quarterly earnings that regularly beat those offered by the professionals working for the big banks and brokerage houses. (See, for example, here.)
Deagol's chart compares Apple's forward-looking GAAP and non-GAAP price-to-earnings ratios and then shows the percentage difference over time as a big gray shadow.
The gap, as Deagol draws it, peaks around the mid-2008 forward-looking PE's, which corresponds to a period when Apple was about to begin selling iPhone 3Gs by the millions but would report only a fraction of the revenue. Beginning with next week's report, according to Deagol's current estimates, the money pouring in from subscription accounting will start to catch up to the growth in iPhone sales, and the gray shadow should begin to subside.
A year from now, GAAP earnings and non-GAAP earnings will be moving more or less in lockstep. Forward-looking perception and reality are converging.
Whenever Apple's accountants decide to adopt the new rules — and the betting is that they will begin this quarter — the effect is likely to be anticlimactic.
"This opportunity," writes Deagol, "is largely behind us."
To see his full analysis — and get a preview of his Apple fourth quarter estimates — visit Deagol's website here and read his postings on The Mac Observer's Apple Finance Board.
See also:
- Apple's 2009 earnings up nearly 44% under new accounting rules – analyst
- Apple pops on Mad Money report
- Accounting rule change in Apple's favor
- Spotlight on Apple's hidden revenue stream
- The day Apple released its iPhone revenue bomb
[Follow Philip Elmer-DeWitt on Twitter @philiped]
@ jmmx – previous post – main point
I should add – As has been mentioned by others here including deagol himself.
Id you will excuse my beating my own drum here, I have to say that I mentioned this effect (Deferred numbers catching up with non-deferred number) in several comments many months ago
Again – If I have it correctly… then the difference between "real" revenue and deferred-accounting revenue for any given point in time, would depend on the difference between CURRENT iPhone sales (revenue), and the average of sales over the past 24 months. So, there may be more gap than the chart shows.
As long as sales are accelerating, the gap will be significant. With entry into China, the potential expansion beyond single telcom contracts, and just normal expansion as more users come on board, the sales rate may very well continue to expand sharply.
Actually I figured this out years ago and I touted a price of $260 for last year before the collapse. I called $200 back in 06. Apple will eventually make $300. My guess Dec. 10. $220 is a foregone conclusion. Get long or go home. And if they drive it back down on low volume; well so much the better.
While I agree with the premise of this article, I actually end up disagreeing only because I'm expecting that we will see huge growth in iPhone unit sales for the foreseeable future. This growth means that despite having 'a full pipeline' of iPhone revenue feeding from previous quarters, the accounting change will have sigificant impact on apple's eps during this time of rapid growth. We'll look back at this time as see the inflection point as iPhone reached critical mass and really took hold of the smartphone market. The key point here is that as the pace of this growth is no longer muted by subscription accounting, we will see a large expansion in the multiple that apple receives. The word is 'momentum', and it is not always rational, but when it takes hold there is no stopping it. I'm not even going to state the result, but for a moment jot down apple's earnings at this time next year, and give yourself a moment to multiply that by an exuberant multiple from both a country bouncing out of recession and for a company that we see as defining innovation and showing meteoric growth. What did you get if you left your recessionary p/e at home?
I said "30M vs. 20M units for FY10 and FY11"
Aw crap, I meant to say 30M vs. 20M units for FY10 vs. FY09, which is 50% growth, dangit.
I said, "and Apple growing at 4x the industry growth."
5x now with the latest iPhone numbers (30M vs. 20M units for FY10 and FY11). Also, since Apple's FY2010 includes this 2009 holiday season instead of the 2010 one (which industry reports obviously have in their forecasts), it's not fair to compare my FY unit numbers to calendar-based industry estimates.
@ Asymmetric:
"Apple has a minuscule world-wide share of all phones (40%) implying Apple losing share."
Not sure I get this. Are you saying 40% growth would be below the WW handset growth for 2010? If that's what you mean, I would question that WW handset growth will exceed 40% in 2010. I see maybe 10%, and Apple growing at 4x the industry growth. 2011 is a bit too far out and I tend to slightly discount 2-year-out projections for risk.
Agreed on Gartner's significant digits. I mean, I do that all the time, but I'm actually an amateur 
@Deagol: The following are the y/y iPhone unit growth rates for the trailing 5 quarters for which data can be calculated: 159%, 578%, 88%, 90%, 644%. You are suggesting that these narrow down to <50%?
Apple has a minuscule world-wide share of all phones (40%) implying Apple losing share. That itself implies that the product is unsatisfactory relative to the competition–something survey data does not back up (see recent JD Powers data).
Oh, and forget Gartner. Look at the significant digits in their forecasts–amateurs.
@Pete Mitchell:
"[...this change] will likely precipitate a move in the PPS to $220 or so by Christmas "
Pete, take a look at the graph. See the dashed lines after Sep-2009? The blue line stabilizes at a 25x multiple right in time for Christmas. This means there's a price I expect AAPL to trade at that time, based on calendar 2010 EPS and a 25x multiple, what I refer to elsewhere as fair value. Using non-subscription EPS estimates, this price would be $255.
Yes, for December. That's where I think AAPL should trade. But that doesn't mean it will trade there. Not even close, sometimes. When it was at $80 the disconnect with me was $100+ upside. It took the market 9 months to catch up. It still needs to catch up, but the difference is now the equivalent of a swing trade in AAPL. My whole point is that this last 30% upside from 190 to 250 is meager compared to the opportunity when AAPL was knocked down below $80 with excuses of "PE contraction" while at the same time the real EPS was being underestimated by up to 60%. That represented a more than triple gain for the stock (200%) in a year.
Of course this is nothing new, as bloggers like Zaky and Muller have pounded on the issue since early 2008. I'm just saying this latest hype by Cramer, Blodget, and even Enderle now behind AAPL, and all the analysts scrambling with their targets, and any investor reacting to it now, are all coming quite late to the party.
@Asymmetric: How does 28M and 33M (from 20M this FY) imply "almost flat growth"? Unless my calculator is wrong, that's 40% and 18%.
But I realize that's still quite below your expectation of 100% annual growth for the next 2-3 years. As I said right after your quote, I will be revising those as needed. In fact, I just revised iPhone units to reflect a little bit of the recent Gartner's projections. So now I'm at 30M and 36M for 2010 and 2011.
Article somewhat misleading . . . while the opportunity associated with the "maximum % difference between AAPl's GAAP and non-GAAP earnings may have passed (Deagol got that right), the lag-time for many WS and institutional models is about 90 days.
For that reason, the full impact of the convergence of GAAP and non-GAAP accounting for the iphone (due to the elimination of subscription accounting) won't fully be embraced by most investment models until December or so.
Between now and then, AAPL's reported earnings – and its "official" announcement in two weeks that it has abandoned subscription accounting for the iPhone — will likely precipitate a move in the PPS to $220 or so by Christmas . . .
As Deagol points out, "This relatively quick "filling of the GAAP" is mostly due to my conservative iPhone projections of 28M and 33M units for the next two fiscal years. "
This assumption is almost flat growth in iPhone units. The difference between GAAP and non-GAAP depends entirely on the *growth* in iPhone units. Flat growth means a narrowing of the gap. 100% growth (as has been the case for 2 years now) means a widening of the gap.
Do your own math.
Thanks for the plug PED!
Don't mind my friend Smeags aggressivity here, he's usually over-confident and gets easily distracted by shiny objects (you old scoundrel you).
But there's one thing Smeagol is right about. Because these are forward-looking PE's, thus the points beyond the middle of 2008 in the chart (where the falloff starts) begin to have an estimated component, and are completely based on my current estimates by the "present" markers on Sep-2009.
My track record notwithstanding, readers should be aware of this and I apologize for not being more emphatic about the forward-looking nature of the PE's (even though it's mentioned in the article and the chart legend).
This calculation is simply wrong. It also makes a series of rigid assumptions about growth, share of iPhone sales within AAPL's earnings, and about margins etc
ex ped: I don't know, Smeagol. Deagol has a pretty good track record. What's yours?
Philip:
I applaud your persistence and indeed your grit in following what has become a confusing issue – Apple's deferred revenue accounting concerning the recognition of iPhone handset sales.
With everything that's been written about the issue, this article is among the first (thanks to data provided by Deagol) that demonstrates this is far less of an issue than what's been presented in the financial press.
It's not as if the deferred revenue has been hidden by Apple. The cash gains on each iPhone unit sold is represented in the cash assets on hand. The deferred revenue (iPhone revenue yet to be recognized in GAAP eps calculations) is represented on the balance sheet in the form of a liability. This liability is systematically exhausted as deferred revenue from iPhone unit sales is recognized over successive future periods. By reviewing both Apple's SEC filings and the company's quarterly financial disclosures which highlight the company's GAAP and non-GAAP performance, it's fairly easy to predict future recognized revenue and earnings gains from prior iPhone sales.
As Deagol suggests, the variance between recognized iPhone revenue and non-recognized (deferred) iPhone revenue will gradually narrow as the percentage gains in iPhone unit sales over the previous eight financial quarters diminishes. The iPhone is emerging from its nascent sales stage and following the completion of the product's global rollout the reported quarterly spike in sales over prior periods will gradually diminish. As a long-term investor deferred revenue accounting is a non-issue because the future recognized revenue from prior iPhone units sales is both known and its impact on future reported eps predictable.
Aside from the impact of deferred revenue recognition on current eps calculations, the one financial performance metric that's distorted by deferred revenue accounting is the the ratio of operating expenses to reported or recognized revenue. While Apple defers both the revenue and the manufacturing costs on iPhone unit sales, all other costs (marketing, administration, etc.) are fully recognized in the quarter in which those costs are incurred. In other words, all other costs associated with the iPhone are reported thus increasing operating costs as a percentage of recognized revenue in the current quarter. For short-term investors who play current eps and immediate performance metrics, deferred revenue accounting might impact their numbers. But for long-term investors such as myself deferred revenue accounting makes no difference at all.
Apple uses deferred revenue accounting on iPhone and Apple TV sales. Apple has also been using deferred revenue accounting for years on AppleCare and MobileMe revenue, deferring revenue recognition over the term of the respective service contracts.
The honest approach you have taken to reporting on the deferred revenue recognition issue is both refreshing and much appreciated. I also hold Deagol's exhaustive work on Apple's financial performance in high regard.
There's no "magic" in the deferred revenue recognition model and the more it's demystified for readers the better. Deferred revenue recognition has no impact on Apple's long-term performance and the fundamental strength of the company's financial and product performance remains unchanged no matter the impact of deferred revenue accounting on the recognized revenue and earnings in the current and near-term quarters.
Yes, non-GAAP and GAAP should eventually converge after about 8 quarters, after Apple started counting this way, as long as iPhone sales stay relatively constant. However, as long as iPhone sales continue to grow, then GAAP numbers will lag the non-GAAP ones. Right now, iPhone sales tend to be a little bumpy, depending upon where we are relative to new releases.
Given that Apple can release new models, and expand the line with an iTablet, I'm not completely convinced this opportunity is passed, nor that the gap between GAAP and non-GAAP may not grow even larger.
The fact that non-GAAP and GAAP do indeed start to converge after a while, is probably the largest reason why more investors didn't make a stink during this period of transition. The deferred revenues hit the top line eventually, but it did cause alot of heartburn, when you read articles that Apple sales were slowing, when in fact, the opposite was occurring.
Yes, the percentage DIFFERENCE of Apple's forward-looking GAAP and non-GAAP price-to-earnings ratios is subsiding under subscription accounting. However, by booking all iPhone revenue when sales occur, Apple's REPORTED revenue will still increase by double digits (look at the gray area in the chart from 2010 and onward).
The deferral revenue method smooths out a company's financials and, in some situations, may be considered as "managing financial reporting" which, as we have seen with some companies, has been detrimental to investors.
One reason Apple's stock price plunged during 2008 was BECAUSE subscription accounting did not show Apple's true, positive growth during that period of time.
Apple's first year unit iPhone sales were 1% of the world mobile phone market. Apple has been forecasted to achieve as much as 20%, and even higher, of the world mobile phone market. The reported revenue under this forward looking scenario is enormous, and the forecasted Apple stock price of $265 a share may turn out to be quite conservative.
If the reports are correct that the U.S. Army is using Apple computers for security purposes, Apple will continue to see increasing enterprise adoption of its computers for this and numerous other reasons. And, the iPod's business and gaming software and camera addition will keep that product line humming.
Apple's growth engine is firing on all cylinders.
Yes the revenue deferral method reflects much lower revenue during the period of rapid growth, but once revenue growth slows a little, quarter revenue on either method works. However, in running a business I prefer the deferral / existing method. It help better manage your financials. When you use the sales method, you start the year with zero revenue and in effect have to sell everything during the year to hit you numbers. That becomes harder and harder. Under the deferral method, you start the year with a significant level already in backlog and it makes managing your financial must easier. As for stock price multiples, the stock market should apply a higher multiple for companies using the deferral method because their is significantly less risk.
http://www.theregister.co.uk/2009/10/12/microsoft_t_mobile_danger_server_outage/