Reconstructing Apple’s 2008 Earnings to Reflect iPhone Sales

Now that Apple has reported its earnings for the full 2008 fiscal year, I think it’s important for investors to focus on how Apple would have performed if it fully recognized the revenue and earnings from its sales of the iPhone. Apple’s true 2008 financial results have been hitherto veiled under a shroud of financial secrecy that I set out to finally irrevocably uncover since Wall Street analysts apparently cannot do their jobs. Someone needs to put an end to this nonsense and if not the analysts, then it’s up to the investment community to make such determinations on their own.

The Apple earnings confusion has largely been the result of Apple’s relatively (un)complicated subscription method of accounting for sales of the iPhone. Most analysts seem to be either thoroughly lazy, or genuinely perplexed by this fairly simple concept; and so I thought I might make their jobs a little easier by reconstructing Apple’s 2008 earnings results to reflect what Apple actually earned in 2008. After reviewing several research notes by analysts for the months of September and October, it doesn’t surprise me one bit that “the analysts are at the bottom of the s**t heap” or “at the lowest level of the investment banking hierarchy” as described by John Rolfe and Peter Troob in Monkey Business.

While the broader market is down well over 40% this year, Apple’s stock has been significantly more deflated than others in the tech sector due in large part to Apple’s decision to give iPhone customers free “once in a blue moon” software updates rather than having them pay a $10.00 nominal fee. Who would have thought that a simple decision to waive a small $10 fee would cause so much destruction to shareholder value and billions in losses in market capitalization? Apple should have determined that analysts would simply be too stupid to give their investors a full and accurate picture of Apple’s true fundamentals. But that is neither here nor there. The table below lays out what almost no analyst has dared to show their clients regarding the reality of Apple’s earnings results in 2008. The method used for determining adjusted earnings is relatively simple and straight forward, and could be found here for those who are interested in the inane details. The table below lays out the adjusted earnings results for each of Apple’s fiscal quarters in 2008, which includes full revenue and earning recognition for sales of the iPhone and Apple TV.

Table 1: Breakdown of Apple, Inc., Non-GAAP Adjusted Earnings for FYE 2008

Q1 2008

Q2 2008

Q3 2008

Q4 2008

FYE 2008

Revenue

$10,802

$8,005

$7,552

$11,682

$38,041

Cost of Goods Sold

$6,859

$5,283

$4,917

$7,131

$24,190

Gross Margin

$3,943

$2,722

$2,635

$4,551

$13,851

Operating Expenses

$1,206

$1,159

$1,208

$1,297

$4,870

Operating Income

$2,737

$1,563

$1,427

$3,254

$8,981

OI&E

$200

$162

$118

$140

$620

Net, Before Taxes

$2,937

$1,725

$1,545

$3,394

$9,601

Taxes

$941

$505

$448

$957

$2,851

Net Income

$1,996

$1,220

$1,097

$2,437

$6,750

Earnings Per Share

$2.22

$1.36

$1.21

$2.69

$7.48

Diluted Shares

900,054

899,329

903,167

904,786

902,406

Table 2 (below) lays out just how much of a difference the subscription method of accounting had on Apple’s financial results by comparing Non-GAAP earnings (which includes full recognition of revenue from sales of the iPhone) with GAAP-based earnings results which employs the deferred revenue mechanism of subscription accounting). There are a couple of key points that investors should take away from analyzing this comparison. First, that Apple didn’t record nearly 14.6% of the revenue it actually received from sales of the iPhone throughout 2008. In fact, for each quarter in 2008, Apple reported an average of $1.391 billion less in revenue than it should have reported but for the obtuse and unrealistic requirements of the Generally Accepted (Asinine) Accounting Principles (GAAP).

Secondly, one should also notice how Apple reported $2.12 or 28.4% less in EPS than what it actually earned in the “real world.” This is particularly troubling because Apple’s trialing P/E reflects a much higher multiple than what reality dictates. On a GAAP “fantasy” basis, Apple is trading at 17.19 times 2008 GAAP-based earnings. Yet, under adjusted-earnings, which contemplates actual “reality,” Apple is currently trading 12.31 times last year’s earnings. GAAP accounting principles actually makes Apple’s stock price appear significantly less attractive from a valuation perspective than it actually is.

Thirdly, one should notice how Apple reported 30.1% less in Operating Income than what it actually earned. This means that Apple is reporting only two-thirds (2/3) of the actual results from its primary operating activities. Operating Income is supposed to be a reflection of the health of Apple’s core business. OI&E, the tax rate, and diluted shares are malleable from one quarter to the next. But operating income tells the investor how Apple’s business is really doing. EPS is for show, while operating income is for the serious analyst. I have to question an accounting measure that requires a company to simply “leave out” 30% of its primary business from earnings reports because that company decides to give its customers a “once in a blue moon” free $10.00 software update. I thought Sarbanes-Oxley and the accounting measures imposed after Enron were suppose to makes companies more transparent, not less!

Table 2: Comparison between 2008 Non-GAAP and GAP Earnings

FYE 2008 Non-GAAP

FYE 2008 GAAP

Difference

Revenue

$38,041

$32,479

$5,562 (14.6%)

Cost of Goods Sold

$24,190

$21,334

$2,856 (11.8%)

Gross Margin

$13,851

$11,145

$2,706 (19.5%)

Operating Expenses

$4,870

$4,870

-

Operating Income

$8,981

$6,275

$2,706 (30.1%)

OI&E

$620

$620

-

Net, Before Taxes

$9,601

$6,895

$2,706 (28.2%)

Taxes

$2,851

$2,061

$790 (27.7%)

Net Income

$6,750

$4,834

$1,910 (28.4%)

Earnings Per Share

$7.48

$5.36

$2.12 (28.4%)

Diluted Shares

902,406,417

902,406,417

-

Table 3 below compares 2008 adjusted earnings with 2007 adjusted earnings, which is useful in analyzing the various trends in Apple’s growth rate. Since Apple started selling the iPhone in the final days of fiscal Q3 2007, adjustments to Q3 and Q4 of 2007 were necessary to make the data comparable from one period to the next. It would be silly to compare 2008 Adjusted Earnings with 2007 GAAP based earnings. The methods used in making the adjustments from GAAP to Non-GAAP earnings can be found here.

Right away, one ought to notice the staggering growth rate in both revenue and earnings that Apple displayed in 2008. Apple’s real revenue grew 54.5% from $24.637 billion in FYE 2007 to $38.041 billion in FYE 2008 – a full $13.4 billion growth in revenues. Even more impressive is Apple’s 81.2% growth rate in adjusted net income. For a company that is trading at 12 times 2008 earnings, it doesn’t take a genius to conclude that Apple is severely undervalued. Especially since Apple currently trades at about 3.37 times its cash position – which is objectively and significantly lower than every other large cap tech company.

GOOG trades at 7.18 times its cash position, RIMM at 15.51 times cash, AMZN at 9.15 times cash, MSFT at 9.13 times cash, CSCO at 3.62 times cash, IBM at 10.96 times cash, INTC at 6.54 times cash, and HPQ at 5.15 times cash. What is more, only GOOG, AAPL and MSFT have no debt of the companies mentioned above. Apple has the largest net cash position than any of those companies and Apple has more net cash than RIMM, GOOG, AMZN and IBM combined. I will take up the issue of valuation later on this week where I’ll give a comprehensive analysis of several large cap tech companies. Preliminary research indicates that Apple is extensively more undervalued than every other large cap tech company at current levels and this is due almost exclusively to the subscription method of accounting. In order for Apple to be trading at the same current valuation as GOOG, RIMM, AMZN, MSFT, CSCO and IBM, Apple would have to be trading at $206.25 – and that’s after this current correction in the market place. The fact of the matter is, Wall Street never valued Apple properly prior to the beginning of this bear market. Apple should have been trading at $300 before this recent downturn and even after this excessive sell-off, Apple should be trading at $158.92 at current S&P levels. I leave it to my readers to make their inferences about where Apple might be headed in 2009 and 2010. Much more to follow.

Table 3: Comparison between 2008 Adjusted Earnings and 2007 Adjusted Earnings

FYE 2008

FYE 2007

Difference

Growth Rate

Revenue

$38,041

$24,637

$13,404

54.5%

Cost of Goods Sold

$24,190

$16,166

$8,024

49.6%

Gross Margin

$13,851

$8,471

$5,380

63.5%

Operating Expenses

$4,870

$3,745

$1,125

30.1%

Operating Income

$8,981

$4,726

$4,255

90.1%

OI&E

$620

$599

$21

3.5%

Net, Before Taxes

$9,601

$5,325

$4,276

80.3%

Taxes

$2,851

$1,599

$1,252

78.3%

Net Income

$6,750

$3,726

$3,024

81.2%

Earnings Per Share

$7.48

$4.19

$3.29

78.5%

Diluted Shares

902,406

889,260

13,146

1.5%

Disclosure: Long AAPL, GOOG, and RIMM.

19 Responses to Reconstructing Apple’s 2008 Earnings to Reflect iPhone Sales

  1. Very nice analysis. I’d been keeping a spreadsheet and model for several years that creates similar information, and have been ringing the “Apple’s results are substantially understated because of iPhone subscription accounting” as often as I can. Keep up the great work.

  2. Your analysis just proves again that analysts that claim to cover tech especially Apple typically are undereducated with no practical experience in the tech field and have no business writing about something that know little about.

    The Kathryn Huberties out there are little more than empty vessels, making the most noise but all of it meaningless.
    They hurt the US economy with their less than honest forecasting because everytime a stock like Apple has good news, they find a way to devalue it with their slant which usually causes it to devalue in the market taking other aligned tech stocks with it. The process snowballs from there, we’ve seen it over and over in the last several weeks. It’s almost as if they are shorting the stock they write about.
    Perhaps the SEC should look at the collective accounts of everyone they know, everyone in their phone/email records. There has to be some reason they’re doing this.

    We need to find a way to make them accountable for what they say, publically when it flies in the face of the truth.

    Perhaps some felony weight jail time?
    Just a thought.

  3. Andy,

    Do you think that it is possible that Apple will ever change its accounting method so that it can record revenue when the product is sold? Also, if not, when do you think that the “full effect” of the iPhone revenue bomb will be felt. In other words, when will it catch up and when will each quarter approximately reflect Apple’s iPhone sales?

  4. No Apple will not change this accounting ever unless forced to do so by a change in GAAP. The $800 million tax hedge that results from this accounting system more than makes up for the undervaluation of the company. All of Apple’s employees are the primary beneficiaries of this system since their stock options and purchases will eventually make them some of the highest paid employees in silicon valley. Apple also benefits because this unrealized gain is really easy to understand and an excellent tool for recruiting the talent this company thrives on. Can you see any downside for the company? With all of their cash they are not a take over target, and the stock price does not prevent them from pursuing strategic purchases. I sure can’t see a problem for anyone except day traders and uninformed analysists.

  5. Gregg Thurman

    I think Apple is going to cease subscription accounting for the iPhone by the end of fiscal 2009.

    Everybody seems focused on the “free upgrades” mantra as the reason for subscription. I disagree, as there are many ways that Apple could have avoided subscription had they wanted to. As pointed out by Andy, Apple could have charged a very nominal fee for the upgrades or, Apple could have included them with iPhone AppleCare. Including the upgrades with AppleCare would have resulted in higher AppleCare sales. Apple already, and has since they began selling it, using subscription accounting for AppleCare revenue.

    I believe that Apple was forced to use subscription because of the ongoing fees they received from ATT (carrier fee participation). Since the launch of iPhone 2.0 Apple gets paid full price at time of sale, AND no longer participates in carrier fees. Apple and ATT settled up deferred carrier fees with a one time charge (to Apple’s income) in fiscal Q3.

    Further I think by the end of fiscal 2009 Apple gross revenue (including iPhone) will exceed MSFT revenue, making full reporting extremely important, not just for valuation purposes, but also for marketing cache, “Apple is now larger than Microsoft”.

  6. Gregg Thurman

    “All of Apple’s employees are the primary beneficiaries of this system since their stock options and purchases will eventually make them some of the highest paid employees in silicon valley.”

    Actually this is one of the strongest reasons, in my opinion, for Apple to cease subscription.

    Apple just awarded a buttload of restricted shares to 5 top managers. They vest in 2013. What better way to “pad” the value of those shares, than to fully report iPhone revenue? Max “padding” occurs when Apple has reported full iPhone revenue for at least 2 years prior to vesting.

  7. Great postings. Thanks.

    I think you could take a look at all the deferred revenue, and get a pretty good estimate for what earnings will be like next quarter. Seems like the non-gaap in Q1 will get a nice boost from the deferral from Q4. Maybe that will make analysts start to notice. There’s not really a need to stop deferring the revenue, since it will just effectively catch up as growth slows to single digits.

  8. MaysonicWrites

    Here’s a bit of analysis (rough cut) that I haven’t seen elsewhere:

    Net out the cash from the stock price:

    (approx) 95 – 25($/s) = 70

    70 / 10 EPS (annualized Q4 2008) = 7

    both the cash/share and the annualized EPS seem fairly conservative, so AAPL looks like a steal. Comments?

  9. Hedgefunds are the only worm in the apple.

  10. Apple is so tied into the American economy that, from a forward-looking perspective, I don’t think their valuation is that unfair. Apple is potentially a bigger risk than all of those companies except for RIMM because of their perceived dependence on US discretionary income (even though this is entirely true anymore). If unemployment rises to 15% in the US, Apple’s earnings could go in the tank, then AAPL’s price woouldn’t seem so unfair. Stocks are always priced for the future, not the past. We’re in a panic right now about the future, and Apple has a panic price. Be greedy where others are fearful, my friends.

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  13. Anonymous, the last great recession in the US saw unemployment only go as high as 10%. Any reference higher than that is pure speculation without supporting logic.

    Also, the US is RIMM’s largest market, so they are in no way immune to a US “recession”. They will fair just as does AAPL in a US market turndown.

    My personal belief is that RIMM will fair worse than AAPL because the Mac market is nowhere near mature (and is growing 3X faster than the PC market), and the same is true of the iPhone. iPhone you ask? Absolutely, please note that iPhone unit sales exceeded Blackberry by 13%, yet was available in only 50 countries (vs Blackberry 130+) and for far less than a full quarter.

  14. Great work but — your Table 2 percentage figures are very misleading. The differences are compared to the non-GAAP numbers when they should be compared to the GAAP numbers. No one in the analyst communities had the non-GAAP figures until you provided them. Your percentages show how much GAAP accounting REDUCES the actual figures. The important point they should get and you should adjust your percentages to show is how much MORE non-GAAP is than GAAP. All your percentages will go up and give a much clearer picture of how much GAAP accounting is UNDERVALUING all numbers. Most impressive is the increase (when you do this) of Gross Margin from your 19.5% to 24.3%.(By the way this really shows that the iPhone is a really high gross margin item even compared to the Macs. When you compute gross margin % itself the iPhone sales increase the non-GAAP number by over 2% for ALL sales.) Reply |Report abuse

  15. The 14.6% not recognized should be of Total Sales? The iPhone % not recognized would be much much higher.

  16. Doing the math using numbers supplied by Apple, iPhone Gross Margin percent is 48+%.

    The obvious point about Gross Margins of this magnitude, is the flexibility Apple has in unit pricing. I see the next round of iPhone upgrades creating a third iPhone model, and that model will cost $99 (down from the current $199). Apple will then have three separate models priced at $99, $199 and $299 respectively, The major differentiator between models will be memory/storage. iPhone applications from the App Store will positively influence the purchase of higher memory models, effectively supporting higher ASP’s.

  17. Won’t this huge jump in revenue be recognized with GAAP numbers eventually as the iPhone numbers stack up quarter by quarter?

  18. nice analyis.
    keep it up
    frnd i want iphone locker, can anyone provide me?

  19. Eventually GAAP and non-GAAP numbers will virtually merge, but that is going to take 10 years+ before we start to see that happen.

    The world is divesting itself of land lines in favor of wireless. That means wireless handset growth of at least 10% until land lines are essentially business lines only.

    Add to that the fact that iPhone is a late comer, and has a lot of territory to make up before its sales curve flattens appreciatively.