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]

How much will Apple's (AAPL) reported earnings be affected by the new accounting rules approved Wednesday?

A lot, says Piper Jaffray's Gene Munster.

In a note to clients issued early Thursday, Munster offered his estimated earnings per share under the new and old rules for fiscal years 2009 (which ends in two days) and 2010:

• 2009 EPS: $8.21, up from $5.71  — a 43.8% increase
• 2010 EPS: $8.90, up from $6.00  — a 48% increase

Apple wouldn't be required to switch to the new accounting method until Dec. 2010, but Munster expects the company will start as soon as possible, probably with the new fiscal year that begins next week.

"While this has been expected for the last month, we believe this will be a positive for shares of AAPL," he wrote, before raising his price target to $235 from $186.

Of course it's possible that the impact of the rule changes have already been factored into Apple's share price. The stock closed Wednesday at $185.50, having soared 137% over the past eight months. The stock is up more than 10% since Aug. 31, when Munster first reported that the Financial Accounting Standards Board (FASB) task force was considering the rule changes.

What are the new accounting rules? Munster does a pretty good job of explaining them:

He writes:

"Before yesterday's ruling, any product that offered free upgrades to software and services installed on a device like an iPhone required subscription accounting (revenue deferred over 8 quarters in the case of the iPhone and Apple TV). However, the vast majority of the value of the device was realized at the time of purchase. While the value at the time of purchase as a percentage of the purchase price is debatable, we believe about 90% of the value of an iPhone is realized at the time of purchase. Under the previous rules, Apple was only allowed to recognize 12.5% (1/8th) of the revenue from each sale; under the new rules, the percentage will be decided on a case-by-case basis for each given product."

That case-by-case factor means that Apple's earnings under the new generally accepted accounting principles (GAAP) won't be exactly the same as the non-GAAP earnings it's been reporting (alongside GAAP earnings; see chart below) for the past year — but they will be a lot closer. Under the previous accounting rules, says Munster, there was about a 35% difference between the two. Under the new rules, he expects the difference to be closer to 5%.

These and other issues related to the accounting changes are likely to be hot topics of discussion at Apple's next earnings call with analysts, sometime in October.

Below: A chart of GAAP vs. non-GAAP earnings for Apple's third fiscal quarter, courtesy of Kaufman Bros.' Shaw Wu:

Source: Kaufman Bros.

See also:

• Accounting board votes 5-0 for pro-Apple rule change
• Accounting rule change in Apple's favor
• Apple pops on Mad Money report
• Spotlight on Apple's hidden revenue stream
• The day Apple released its iPhone revenue bomb
• Deferred earnings: Apple's hidden revenue bonus

In the end, the vote was unanimous.

After months of lobbying by a stack of blue-chip high tech companies, the FASB — the entity that sets accounting standards in the United States — voted 5-0 Wednesday to approve an accounting change that could boost the reported earnings, and the stock price, of dozens of Silicon Valley firms.

The new rules are expected to be especially beneficial to Apple (AAPL). They would put an end to subscription accounting on the iPhone, a balance-sheet sleight of hand that has depressed reported earnings — and confused investors — from the day the device hit the market.

Apple had lobbied heavily for the change, along with dozens of other firms, including IBM (IBM), Dell (DELL), Hewlett-Packard (HPQ), Cisco (CSCO), Palm (PALM) and Xerox (XRX).

The new rules will allow companies to recognize the revenue from devices that are part hardware and part software — like the iPhone — when the sale occurs, rather than spreading it out over many quarters. The changes aren't mandatory for most companies until 2011, but Apple is expected to put them into effect with the start of its next fiscal year, which begins next week.

Although the rules don't change how much cash Apple actually collects, the impact on its perceived value could be dramatic. In the company's third fiscal quarter, for example, it reported earnings of $1.35 per share using the current generally accepted accounting principles (GAAP). Its so-called non-GAAP earnings, by contrast, were $2.14 a share — 58.5% higher. Under the new rules, reported earnings are likely to be close to or equal to those non-GAAP numbers.

A Mad Money report on the proposed rule changes last week sparked a rally that sent Apple shares up nearly 10.8 points (6.1%) in less than two days. Shares were up another 3.7 points (2%) Wednesday before falling back in late afternoon trading to close at $185.5.

See also:

• Accounting rule change in Apple's favor
• Apple pops on Mad Money report
• Spotlight on Apple's hidden revenue stream
• The day Apple released its iPhone revenue bomb
• Deferred earnings: Apple's hidden revenue bonus

[UPDATE: The FASB voted 5-0 Wednesday to approve the rule change. See here.]

The Financial Accounting Standards Board (FASB), the organization empowered by the SEC to set accounting standards in the United States, is set to vote Wednesday, Sept. 23, on rule changes that could significantly affect Apple's (AAPL) reported earnings and stock price, according to a report to clients issued Tuesday by Morgan Stanley's Kathryn Huberty.

The new rules — for which Apple lobbied heavily — would put an end to iPhone subscription accounting, a balance-sheet sleight of hand that has confused analysts and investors from the day the iPhone hit the market.

Although the changes won't affect Apple's cash flow, Huberty sees short-term benefits "from a technical and sentiment perspective" including (in her words):

1. Inflows from quant driven strategies and retail investors as AAPL shares will screen cheaper on “New” GAAP consensus estimates vs. “Current” GAAP (19x vs. 23x);
2. Likelihood of larger earnings surprises given analysts have consistently underestimated iPhone gross margins which have ranged between 50-60% over the last year.

The bottom line, she writes, is that the new rules allow Apple to recognize the majority of the revenue and direct costs of an iPhone upfront (she estimates 95%), shifting value from the balance sheet to the income statement.

Although the rule change will affect many technology companies, Huberty points out, it is particularly relevant for Apple since the iPhone, which is subject to current subscription accounting rules, represents approximately 33% of its revenue.

The rule changes, if ratified, wouldn't become mandatory until Dec. 2011. But Huberty believes that Apple will begin implementing them in their first fiscal quarter of 2010, which begins next week.

A Mad Money report on the proposed rule changes last Tuesday sparked a rally that sent Apple shares up nearly 10.8 points (6.1%) to a 15-month high of $186.79 before it ran out of steam. The stock closed Monday at 184.02.

See also:

• Accounting rule change in Apple's favor
• Apple pops on Mad Money report

Image: FASB

A change in accounting rules for which Apple (AAPL) — among other high-tech companies — lobbied heavily won tentative approval last Thursday. The change could significantly affect both the company's reported earnings and its stock price.

The new rules are in draft form and must still win final approval from the FASB — the organization empowered by the SEC to set accounting standards in the United States.

But they have the force of law. And they could put an end to iPhone subscription accounting, a balance-sheet sleight of hand required by the old rules that has confused analysts and investors from the day the iPhone hit the market.

Subscription accounting meant that Apple has been under-reporting earnings on its bestselling smartphone for two years — one of the factors, Apple bulls believe, that kept its share price from fully reflecting the success of one most profitable products Apple has ever made.

It's not clear when the rule change will take effect; one option on the table is the start of Apple's next fiscal year, which begins in less than two weeks (although Apple wrote the FASB earlier this month asking for more flexibility in terms of timing).

But whenever it happens, the impact on Apple could be dramatic. In the company's third fiscal quarter, for example, it reported earnings of $1.35 per share using the current generally accepted accounting principles (GAAP). Its so-called non-GAAP earnings, by contrast, were $2.14 a share — 58.5% higher.

"It is our belief," Apple controller Betsy Rafael wrote the chairman of the FASB's Emerging Issues Task Force in August, "that investors, analysts and preparers would benefit significantly from the proposed changes … [The current rule] often results in accounting that does not reflect the underlying economics of transactions and can result in financial reporting that lacks the transparency necessary to fully inform users making investment decisions." (link to pdf)

At the heart of the problem for Apple is its decision to offer iPhone owners free software updates from time to time — a practice that required its accountants to spread the revenue from iPhone sales over the life of a cellphone contract, typically two years.

Apple is not the only company that finds itself in this situation. Software makers like Microsoft (MSFT) and Oracle (ORCL) that do a lot of enterprise business are in the same boat. And indeed, Apple was one of dozens of companies, from TiVo (TIVO) to Xerox (XRX),  that wrote to the FASB in support of the rule change.

But it could be argued that no company's product has been more misunderstood by more investors because of the old rules than Apple's iPhone.

The FASB's Emerging Issues Task Force met on Sept. 9 and 10, and decided in favor of the rule change on Sept. 10, according to Credit Suisse's accounting and tax research team. A meeting originally scheduled for Oct. 15 has been canceled; the next meeting is penciled in for Nov. 18-19.

For more on iPhone subscription accounting, see:

• Spotlight on Apple's hidden revenue stream
• The day Apple released its iPhone revenue bomb
• Deferred earnings: Apple's hidden revenue bonus

Two days before Apple's (AAPL) annual meeting — the first in more than a decade that Steve Jobs won't attend — Financial Alchemist's Turley Muller offers beleaguered shareholders a statistic that should provide some comfort:

Apple's cash holdings have grown at an annual rate of 50% (year-to-year) or more every quarter for the past two years. (link)

"Cash flow, not earnings, best reflects a firm's investment prospects," writes Muller in a post published Monday. This is especially true for Apple these days because the usual standard for evaluating a stock — earnings per share (EPS) — captures only a fraction of the revenue flooding in from iPhone sales.

As Apple's executive team has repeatedly pointed out to analysts, the company doesn't recognize the income from sales of the iPhone in the quarter in which it is collected. Instead, using so-called subscription accounting, it spreads it out over eight quarters — the life of a typical iPhone contract. (See Spotlight on Apple's hidden revenue stream.)

That revenue isn't lost, of course. It flows directly into Apple's coffers, which have swelled over the past two years from less than $12 billion to more than $28 billion.

See Muller's chart below (click to enlarge):

Because most analysts continue to track Apple's EPS without taking this hidden revenue stream into account, says Muller, they're missing the impact of a rising tide of cash.

Apple today trades at 17 times earnings per share, but only 8.5 times cash flow per share. "That's a massive difference," Muller writes. Apple shares have historically traded at 40 to 50 times earnings.

"In my opinion, the short-term economic challenges are priced-in," Muller concludes. "But [Apple's] long-term competitive advantage and earnings power is being ignored. … Eventually, when the economy shows signs of regaining its footing and investors are comfortable owning stocks again, AAPL will go much, much higher." (link)

Some Apple watchers have complained almost since the launch of the iPhone that Wall Street doesn't understand the device's value to the company. Analysts consistently underestimate Apple's revenue, these investors insist, because they fail to fully account for iPhone sales.

The problem has been festering for so long — and the gap has grown so large between Apple's actual earnings and the Street's grasp of those earnings — that Apple finally let the cat out of the bag Tuesday during its quarterly earnings call.

Measured by so-called generally accepted accounting principles (GAAP), the company earned $1.26 a share in 2008 Q4 on revenue of $7.9 billion. This is the form in which Apple (AAPL) has always reported its income.

But on Tuesday, for the first time, the company went one step further. CFO Peter Oppenheimer told analysts that when measured by actual revenue — counting the full value of every iPhone and Apple TV sold in the quarter — the company earned a good deal more: $2.69 per share on sales of $11.68 billion (see transcript here).

The consensus among analysts before the earnings call was that Apple's revenue for the quarter would be about $8.05 billion. Some traders looked at $7.9 billion and thought Apple had fallen short of the Street's target by $150 million. The smart ones looked at $11.682 billion and realized they'd underestimated Apple's earnings by nearly $3.8 billion. They're probably the reason Apple's share price jumped 12% in after hours trading.

How could the analysts have been so wrong?

In the analysts' defense, the accounting methods Apple uses aren't easy to follow — even though Oppenheimer has spelled them out at almost every earnings call.

For reasons that have to do with being able to provide free upgrades over the life of the phone, Apple doesn't book the full value of, say, a $199 iPhone the day it's sold. Rather, its accountants spread that income out over 24 months, booking $8.29 in the first month, $8.29 the second month, and so on until the revenue from that iPhone has been fully accounted for. (Actually, the value of that iPhone is probably closer to $500, once AT&T has paid its share, but you get the idea.)

Given that Apple's iPhone sales have been growing exponentially over the past 15 months and that each month's iPhone revenue includes not just a share of the sales from that month, but a share of iPhone sales from each of the months that preceded it, you begin to see the dimensions of what one might call Apple's iPhone revenue bomb.

"This is a pretty big deal," Steve Jobs told analysts and journalists on Tuesday, as he made his first appearance at an Apple earnings call in 8 years to try to explain the iPhone's so-called subscription accounting system.

"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."

Oppenheimer and Jobs promised to provide adjusted revenue numbers — so-called non-GAAP revenue — every quarter going forward. But they didn't provide any non-GAAP numbers from quarters past, making it difficult to gauge how fast Apple is actually growing.

That's where Andy Zaky comes in. An amateur Apple watcher — and one of the blogger-analysts who humiliated the professionals in a Q4 earnings estimate smackdown earlier this week (see here) — Zaky stayed up all night Wednesday trying to reconstruct Apple's actual earnings in quarters for which it didn't provide non-GAAP data.

His results, published early Thursday on his blog Bullish Cross, and republished by AppleInsider and Seeking Alpha, show that Apple's revenue actually grew 75% year-to-year last quarter, not the 27% that the company reported, while its real net income grew nearly 125%. The pros could learn a lot by studying his findings.

Zaky's results are summarized in the chart below. To see how he arrived at his numbers, click here.