How the iPhone and Poor Management Contribute to Apple's Downfall

| About: Apple Inc. (AAPL)

In April of 2007, Peter Oppenheimer (Apple’s (NASDAQ:AAPL) CFO) announced that Apple will be using what is commonly referred to as the “subscription method of accounting” for sales of the iPhone where the sales revenue from the iPhone is deferred and recognized over a 24-month period instead of at the point of sale. Both that decision and the underlying reason in support of the decision would go down as being one of the worst in Apple’s history. In his opening statement of the Q2 2007 earnings call, Oppenheimer made the following alarming comments:

Since iPhone customers will likely be our best advocates for the product, we want to get them many of these new features and applications at no additional charge as they become available. Since we will be periodically providing new software features to iPhone customers free of charge, we will use subscription accounting and recognize the revenue and product cost of goods sold associated with iPhone handset sales on a straight line basis over 24 months. So while the cash from iPhone sales will be collected at the time of sale, we will be recording deferred revenue and costs of goods sold on our balance sheet, and amortizing both of them into our earnings on a straight line basis over 24 months. We will continue to expense our iPhone engineering, sales and marketing costs as we incur them. This accounting policy will have no impact on cash flow or the economics of our business.

This was the first time the financial community learned about Apple’s plans to defer iPhone sales revenue. Until that moment, everyone was expecting some dramatic blow-out growth rates for 2008. Such hopes were dashed when Oppenheimer decided to give iPhone customers free $9.95 software upgrades at the inevitable sacrifice of Apple’s stock price. In August, I made several arguments on why such an accounting treatment would lead to the eventual manipulation of Apple’s financials both by analysts and the media. I warned that the market would be overly focused on Apple’s P/E ratio instead of its price-to-free cash flow and that such a result could lead to disastrous consequences.

A year and a half later, Apple is trading at the same price it was before the iPhone even existed, is portrayed as a company that struggles to grow and as a company that faced major financial headwinds in 2008 despite the fact that it grew its earnings 125% in Q4 alone. While the recent financial turmoil, the 2008 recession and serious concerns over Steve Jobs’ health is much to blame for the loss in share value, Apple could be trading at much higher levels if the revenue from the iPhone were recorded when received instead of how it’s treated under the current accounting regime.

Newton was Wrong: iPhone Deferred Revenue makes Apples Fall

The underlying problem with the subscription method of accounting is that it makes Apple’s financials appear radically weaker than they actually are. And as any experienced market participant knows, the market rarely trades on reality. Stocks trade on appearances, they trade on fluff, they trade on generalities regarding the health of the economy—what they do not trade on, is reality regarding fundamentals. Especially if teasing out that reality requires anything more than looking beyond the surface.

This accounting treatment of the iPhone hides Apple’s true financial value under the shroud of adjusted earnings to which almost no one seems to pay much attention. It puts Apple at a significantly uneven keel when compared to other similarly situated stocks in the sector. As a matter of fact, it is quite possible that Apple could be trading at $140 a share today if it never introduced the notion of subscription accounting. Here’s why…

If Apple decided against deferring its iPhone revenue, Apple would have reported some truly staggering numbers and growth rates for most of 2008. Notice, this is all an issue of investor and market confidence. Had Apple reported the blow-out numbers portrayed in its adjusted earnings, investor confidence would have both led to greater advances in Apple’s stock price and put up some considerable support during the inevitable collapse in equities this past October of which almost no stock was immune. Instead, investor confidence in Apple has been shot for the majority of 2008 and even the slightest inkling of bad news has led to a dramatic nose-dive in Apple’s stock price.

Just to get an idea of how much of an impact the subscription method of accounting had on Apple’s earnings in 2008, one need only compare Apple’s 2008 GAAP-based earnings with its adjusted earnings which backs out the amortization of the iPhone. When disregarding the deferred revenue mechanism of subscription accounting, Apple actually earned $7.48 in EPS on $38.041 billion in revenue. That compares to the $5.36 in EPS on $32.479 billion in revenue that Apple reported on a GAAP-basis.

This means Apple would have reported an average of $0.53 more in EPS and $1.4 billion more in revenue each quarter in 2008 but for Apple’s decision to give free $9.95 software upgrades to iPhone customers—upgrades of which have only been released twice in the history of the iPhone. That is roughly 40% more in EPS!

That added revenue and EPS would have painted a completely different picture of Apple’s financial health and thus its stock price in 2008. Concerns over Apple’s growth rate would have been non-existent as investors would have been focused on the dramatic increases in sales revenue, earnings and cash on the balance sheet. Yet, because Apple decided it wanted to arbitrarily offer free software upgrades to iPhone customers while making iPod Touch users pay for those very same upgrades, Apple has become a sanctuary for the bear to roam free causing massive damage to Apple’s stock price, investor confidence and historical market favoritism towards Apple in general.

Table 1.1: 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
-
Click to enlarge

Even now Apple’s management seems to regret using the subscription method of accounting for the iPhone. In its most recently reported fiscal quarter, Steve Jobs all but begged the market and investors to focus more on Apple’s newly introduced adjusted earnings rather than simply looking at Apple’s GAAP-based results. Here’s just a small portion of what Jobs had to say about the iPhone’s impact on Apple’s business, the use of subscription accounting, and Apple’s decision to provide adjusting earnings for the first time ever:

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.

Too big for Apple management or investors to ignore? Really? If Steve Jobs actually believed that the market will all of a sudden begin to act rationally, then he obviously has no clue as to how the market actually functions. Since Jobs released his adjusted earnings showing that Apple reported 115% higher net income than indicated by GAAP-accounting measures, Apple is down over 15 points. As a matter of fact, Apple has gone absolutely nowhere since it reported adjusted earnings back in October. If Jobs and Co. really wanted the market to focus on Apple’s true earnings results and fundamentals, they should have thought about that before foolishly deciding to sacrifice reporting 40% of its revenue just so that iPhone customers can get a free $10 upgrade. This is clearly one of the dumbest financial decisions made by a company that had it all.

As infallible as the market makes Jobs out to be, he is nothing short of massive failure in being able to manage his own stock price. Any normal company would have simply made its customers pay the nominal $9.95 fee associated with its extremely rare software upgrades or held a press conference to clear up any uncertainty regarding the health of its chief executive. With Apple, however, the “we don’t negotiate with terrorists” stance towards the media has led to deleterious consequence. Apple cannot so much as hold a press event to release new products and services without the focus of the event being about Steve Jobs’s health.

The “It’s All Priced-In” Delusion

Many will undoubtedly argue that Apple’s adjusted earnings is simply priced into the stock, that investors and analysts have already figured it into the fundamentals and that everyone already knows about Apple’s adjusted earnings. Nothing can be further from the truth.

First, very few analysts provide adjusted earnings estimates, value Apple on a price-to-free cash flow (which backs out the negative impact of adjusted earnings) or provide GAAP-based earnings estimates which fully consider the impact that deferred revenue will have in 2009. Analyst 2009 consensus estimates have been criticized as being outrageously low due in part to analyst inability to comprehend the impact that deferred iPhone revenue will have on 2009 results. Even bullish analysts such as Charlie Wolf from Needham & Co. analyze Apple’s fundamentals in terms of forward P/E. If 40% of Apple’s revenue is not being released under GAAP-accounting, then how one can truly analyze a company on a forward P/E basis is beyond reason. And these are bullish analysts who fall victim to this obvious error.

Secondly, it’s a stretch to assume that momentum traders, hedge fund managers, and average investors know that Apple is even using subscription accounting. The average trader, hedge fund manager or investors looks to the basic GAAP-based financial ratios to quickly determine whether a company is over or under-valued – a practice that is pretty much full-proof most of the time, but will invariably fail when it comes to Apple. Every time a fund manager or analyst mentions Apple and P/E ratio in the same sentence is yet another indication that the market has failed to value Apple on its adjusted earnings, and this sort of behavior occurs on a daily basis.

Thirdly, when using Apple’s adjusted earnings as a basis of financial ratio comparisons to other tech companies, Apple is far more undervalued than every other similarly situated tech company in the sector. On an EPS to trailing P/E basis, EPS to forward P/E basis, price-to-free cash flow, price to cash, price to operating cash flow, cash per share, total net cash, and EPS growth basis, Apple presents with the best value in the tech sector.

This is largely the result of the market completely discounting Apple’s adjusted earnings. When looking at Apple’s adjusted earnings-ratios, one can accurately conclude that the market is valuing Apple ex-iPhone. If the market was truly “pricing-in” adjusted earnings as some would have us believe, then Apple’s GAAP-based P/E ratio should obviously represent a sizeable premium to others in the tech sector.

Yet, such is definitely not the case. The opposite is actually occurring. Apple has a GAAP-based P/E ratio that is in-line or lower than others in the tech sector which suggests that the market has more than completely priced-out both the actual and potential financial impact of the iPhone. Actual in that the adjusted earnings ratios are pricing Apple significantly lower than its peers and potential in that Apple’s forward P/E fails to contemplate deferred iPhone revenue due to analyst failures in drawing a fairly stated consensus.

Yet, the single biggest indication showing that the market has failed to priced-in Apple’s adjusted earnings is expressed in Apple’s adjusted-based trailing P/E ratio. Apple’s adjusted-based P/E ratio should be in-line with its peers because the adjusted P/E ratio is based on the elimination of subscription accounting. But such is not the case. Apple’s adjusted-based trailing P/E ratio is far below its peers. RIMM’s P/E is at 15.26, GOOG is at 19.02 and AMZN is at 38.07 while Apple boasts a mere 12.11 P/E. In order for Apple to be priced in with its peers, it would have to be trading between $119.82 and $142.12 a share.

What I find to be interesting is that Apple outgrew both Amazon and Google on an adjusted basis but holds a P/E ratio that is far below that of Google’s and one-third that of Amazon’s. This can be explained by the mere fact that the amount of bearishness prevalent in Apple’s stock price far exceeds that of RIMM, AMZN, GOOG, MSFT, CSCO and others.

Even Apple’s outrageously low price-to-cash ratio indicates that there is either an extreme level of pessimism built into Apple’s stock price, more so than almost every other tech company, or that the market has failed to price-in Apple’s adjusted earnings. Apple is currently trading at only 3 times its net cash position which is far lower than every other tech company (see Table 1.3). The ratios in the table below are dated as of closing prices on January 9, 2009 which backs out the confounding variable of selling pressure placed on Apple’s stock as a result of the quasi-resignation of Steve Jobs.

Table 1.2: P/E Ratios & EPS Growth Comparisons within the Tech Sector as of Jan. 9, 2009

Stock Price
Trailing P/E
12-Month EPS
EPS Growth

AAPL (Gaap)

$90.58
16.90
$5.36
36.40%

AAPL (Adj.)

$90.58
12.11
$7.48
78.50%
RIMM
$47.46
15.26
$3.11
100.65%
GOOG
$315.07
19.02
$16.56
31.33%
AMZN
$55.51
38.07
$1.46
67.82%
MSFT
$19.52
10.32
$1.89
20.13%
CSCO
$16.70
12.60
$1.33
16.42%
IBM
$84.70
9.98
$8.48
27.52%
INTC
$14.15
11.27
$1.25
18.87%
HPQ
$37.49
11.55
$3.25
25.91%
Click to enlarge

Table 1.3: Balance Sheet Item Comparisons within the Tech Sector as of Jan 9., 2009

Total Cash
(Bn.)

Total Debt

Net Cash
Per Share

Price to
Cash

AAPL
$24.49 Bn.
$0.00
$27.57
3.28
RIMM
$1.68 Bn.
$5.82 Mil.
$2.75
17.26
GOOG
$14.41 Bn.
$0.00
$45.87
6.87
AMZN
$2.32 Bn.
$435 Mil.
$4.40
12.62
MSFT
$19.71 Bn.
$1.98 Bn.
$1.99
9.81
CSCO
$26.76 Bn.
$6.87 Bn.
$3.39
4.93
IBM
$9.76 Bn.
$34.41 Bn.
$0.00
84.70
INTC
$12.20 Bn.
$2.36 Bn.
$1.77
8.00
HPQ
$10.25 Bn.
$17.85 Bn.
$0.00
37.49
Click to enlarge

The iPhone’s Double-Edged Sword on the iPod

Even without considering the damaging implications of subscription accounting, the iPhone itself has acted as a destructive double-edged sword regarding the appearance of Apple’s financial health. On the one hand, the handset market is significantly larger than that of the MP3 market. And so it makes a whole lot of sense for Apple to have entered that market, especially since Apple is in the business of making elegant, revolutionary well-designed software and consumer electronics. Yet, on the other hand, it would be incredibly naive for one to believe that iPhone sales aren’t cannibalizing iPod sales to some degree. While not everyone who is in the market for an iPhone is in the market for an MP3 player, iPhone purchasers who are in both markets have little need to own both an iPod and an iPhone.

The main problem with the iPhone cannibalizing iPod sales is that it makes iPod unit sales growth appear significantly weaker than it actually is. The iPhone is basically an iPod with a phone. One who decides to buy an iPhone over an iPod touch is essentially buying an iPod. Yet, analysts, traders and the media don’t portray it that way. Instead, the financial community tends to view any apparent weakness in iPod unit sales growth as being attributed exclusively to either market saturation or weakness in the consumer.

Rarely, if ever, does anyone consider the breadth of iPhone unit sales when evaluating iPod growth rates. For example, in Q1 2008, the focal point of Apple’s earnings results, aside from guidance, was how iPod unit growth contracted considerably. Analysts and the media had a field day with the “slowing iPod growth story” shortly after Apple reported its fiscal Q1. Apple reported sales of 22 million iPods in Q1 of 2008 up a mere 5% from the 21 million units sold in the year ago period.

Yet, if one were to combine iPod and iPhone sales, he or she would get a drastically different picture regarding iPod unit growth. In Apple’s most recently reported fiscal fourth quarter for example, iPod sales taken alone grew at a pace of only 7.7%. That is in spite of the severe recession and collapse in consumer spending in calendar Q3. Yet, when combining iPod and iPhone units together, the growth rate skyrockets to 58.5% on a year-over-year basis. One could see how easily these numbers can be manipulated to portray Apple as a company that is struggling to grow, as a company that is the perilous victim of dismal consumer spending or as a company that is collapsing under the weight of recession.

The decision to use subscription accounting for the iPhone compounds this problem even further. Because not only do iPod sales appear weaker due to cannibalization by the iPhone, each iPod that is cannibalized as an iPhone sale sees very little revenue recognition in the quarter the sale is cannibalized. This means that Apple’s revenue takes an immediate and drastic hit on each iPhone sale that might have otherwise been an iPod sale.

Thus, what we have here is a perfect recipe for media misrepresentation, analyst confusion and market disorientation regarding Apple’s fundamentals. Because not only do iPod sales appear weaker due to iPhone cannibalization, Apple’s revenue does not reflect this fact because of the subscription method of accounting. These two problems taken together paint a very nasty picture of Apple’s fundamentals when the reality is Apple grew its adjusted earnings from $4.19 in 2007 to $7.48 in 2008 (78.5%) and grew its revenue from $24.637 billion in 2007 to $38.04 in 2008 (58.5%).

Adjusted Earnings for Apple, Inc. (FYE 2007-2008)

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%
Click to enlarge

What Apple Should Do to Fix this Problem…

While there is little to nothing Apple could do to fix the current market perception regarding its fundamentals in the short term, Apple can take certain defensive steps that could potentially alter the market’s views in the long term.

First, 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. By doing this, Apple would benefit in both the short and long term.

It would benefit in the short term because there are no adjusted-earnings “guidance expectations” that Apple would have to meet because there are no adjusted-earnings consensus estimates at the present moment. Thus, near-term strong earnings results would not be hampered by Apple’s excessive conservatism in guidance because Apple would not be guiding below any expectations. In other words, Apple would limit near-term headline risk regarding its guidance because it would simply not be providing any.

Yet, the major benefit Apple would gain from offering only adjusted-based earnings guidance is that analysts will be forced to comment and give estimates on Apple’s adjusted earnings which will eventually shift the market’s focus in that direction as well.

Another more drastic measure Apple should really consider is doing away with subscription accounting altogether. It could do so in tandem with its next iPhone refresh by stating that third-iteration iPhone purchasers will have to pay for future software upgrades as they become available. All previous 3G and EDGE iPhone revenue would be amortized under subscription accounting while next generation iPhone revenue would be recognized at the point of sale in the quarter in which the sale occurs.

Both of these actions taken together would likely fix market perception regarding Apple’s fundamentals by the end of 2009 as sales of the new iPhone cause Apple’s GAAP based revenue to skyrocket in the latter half of the year. Such a proposal is so obvious that even Apple’s management can't mess this up. Or can they…