Calculating Apple's 2010 EPS

Apple (AAPL) has not specified when they will implement the GAAP subscription accounting change recently approved by FASB. The change will eliminate the need for Apple to use subscription accounting for the iPhone and AppleTV, and also allow them to provide free software upgrades for the iTouch. They must implement the new accounting rule by their first quarter (December) 2011, but may implement before that. During their 2009 Q4 conference, Apple was non-specific on timing. Below, I will run through the possible scenarios of implementing the new FASB rule beginning in either of 2010 Q2, Q3, Q4 or 2011 Q1 and the effect on end of year 2010 GAAP EPS.

If this is all about GAAP financial reporting and Apple’s cash flows are unaffected, then why do I care? The answer is about expectations and perceptions on how the company is being measured and priced by the street against the “consensus estimate”. Apple is priced by the street based on consensus EPS. It should, but isn’t, based on cash flows. Why? I don’t know. Amazon (AMZN), with its relatively high P/E, appears to be priced on cash flows (subject for a future article). For Apple, I want to know what to expect in GAAP EPS and how the street will react to it and to what degree the street is underestimating Apple’s performance (which they always do).

Below is an Apple EPS calculator for 2010. It will provide 2010 EPS estimates based on which quarter of 2010 Apple chooses to implement the subject FASB change. The snapshot of the calculator shows the scenario of implementing the accounting change beginning in Q3 2010. A table of all results is shown just below the calculator.

Some explanations and assumptions:

• The first table shows the iPhone units sold, by quarter, which I have assumed for 2010. There is not a whole lot of science behind these numbers. They may be conservative given the global sales reach achieved, but given the recession and potential competition from Verizon, I felt comfortable with these numbers. For reference, Apple sold 20.7M iPhones in FY 2009.
• The blue section of the first table shows what portion of the sales per quarter will be recognized in 2010 based on which quarter the FASB change is implemented. Under subscription accounting, iPhone revenues are recognized over 2 years, so an iPhone sold in Q1 2010 will have half of its revenues recognized in 2010 and half it 2011. A phone sold in Q2 2010 will have 3/8^th of its revenues recognized in 2010 and 4/8^th in 2011 and 1/8^th in 2012. The longer the FASB change is pushed off, the less iPhone revenue will be recognized in 2010. The “Total” line is calculated by multiplying across and adding down to the equivalent total iPhone sales recognized in 2010.
• iPhone ASP and Accessory $ per iPhone were calculated from my Apple financial model and are based on reported financial data from Apple.
• Non-iPhone revenue was flat from 2008 to 2009 at about $30B. Due to the recession, I extended this to 2010 and assume no growth. I hope this will be proven to be unnecessarily conservative. The 33% gross margin on non-iPhone sales is consistent with the trend over the last 8 quarters.
• iPhone Revenue is calculated from the ASP of $600/iPhone times the equivalent total iPhone units. In the example, iPhone Revenue = 20,875 units x $600/unit = $12,525M.
• iPhone accessory revenue is based on actual total iPhone sales x $34/iPhone, or in this example, 27,000 units x $34/unit. The $34 per phone is a weighted average over the last 5 quarters from my Apple financial model.
• The “Sub-Total” column is based on revenues that can be attributed to sales in 2010. In other words, past (pre Q1 2010) deferred revenues have not included.
• Finally the deferred revenues to be recognized in 2010 (current deferred revenues as of Q4 2009 financials) are added to provide total revenues and profits for 2010. The deferred iPhone Gross Margin is a weighted average of the actual gross margins over the 8 quarters ending Q4 2009.

The final table displays possible estimated EPSs for 2010 based on when the FASB change is implemented. Q1 2010 is grayed out since we already know this scenario did not happen. The longer the change is delayed, the lower the GAAP EPS due to increased deferral of iPhone revenues into future years.

I find this exercise useful for bracketing the range of possible EPS. So, if Apple implements the FASB change starting in January 2010 (Q2), I estimate their 2010 EPS at $13.56. If they wait till 2011 Q1, which I think all current analysts' estimates are based on, then I estimate 2010 EPS at $9.06. I feel pretty confident in this model. I plugged in 2009 actual revenues and iPhone units, and the output is within pennies of actual 2009 earnings. I think the revenue estimates for 2010 are reasonable, yet $9.06 EPS is 18% above the street consensus of $7.67. By the way, the revenue which produced the $9.06 EPS is $44.01B. The street consensus EPS of $7.67 is based on revenues of $44.2B. I suspect the street is underestimating the effect that iPhone has on gross margins.

If you really want to be bold, plug in RBC Capital Markets' estimate of 82.1M iPhone sold in 2012. Ignoring deferred earnings (because they won’t exist in 2012) and holding all other inputs constant, the 82.1M iPhone unit produces an EPS of $26.56. This also assumes that Apple will be able to hold iPhone margins at 60%.

And of course, don’t forget about cash. I estimate that Apple will have $45B in cash by the end of 2010. This is equivalent to nearly $50 per share.

One last note: This model assumes nothing about future Apple products.

“All models are wrong; some are useful” – George Box.

I hope this model is useful for investors. I find it unhelpful when analysts throw out estimates while providing no basis or assumptions. I have provided enough information here for readers to reproduce this calculator in Excel.

Full disclosure: The author is long Apple stock.

Comments

[olddoc74:]

The figure for iPhones sold in 2009 (20+BILLION) is patent nonsense, since it exceeds the world population by a considerable margin

Oct 25 09:30 AM

[User 352274:]

He meant million not billion?

Oct 25 09:52 AM

[Stefan Sida...:]

I also mis-labeled the first table. The units for "iPhones Sold" is thousands, not millions.


On Oct 25 09:30 AM olddoc74 wrote:

> The figure for iPhones sold in 2009 (20+BILLION) is patent nonsense,
> since it exceeds the world population by a considerable margin

Oct 25 10:31 AM

[User 480222:]

"Non-iPhone revenue was flat from 2008 to 2009 at about $30M." is also off by three orders of magnitude. Shouldn't an analyst be familiar enough with the differences between thousands, millions, and billions that such mixups wouldn't happen at least three times in a single article? (I said "at least" because I skipped the rest of the article after finding the first three mistakes).

Oct 25 12:17 PM

[Wade Slome:]

Good piece. For cash flow valuation, check out: investingcaffeine.com/.../

Oct 25 04:19 PM

[Stefan Sida...:]

I apologize for the typos. I know how they can turn off a reader.
Yes, it should be $30B, vice $30M.
The EPS calculations are still sound.

Stefan


On Oct 25 12:17 PM User 480222 wrote:

> "Non-iPhone revenue was flat from 2008 to 2009 at about $30M." is
> also off by three orders of magnitude. Shouldn't an analyst be familiar
> enough with the differences between thousands, millions, and billions
> that such mixups wouldn't happen at least three times in a single
> article? (I said "at least" because I skipped the rest of the article
> after finding the first three mistakes).

Oct 25 04:48 PM

[jmmx:]

WOW - a lot of work!

Just one caveat - be careful of gross margin when they go to non-deferred accounting. I seem to remember that several items that typically come out before g.m. are pushed to operating expenses on iPhone - e.g. Advertising, etc. (That came from some early conference call.)

Oct 26 03:38 AM

[jmmx:]

Stefan

As for typos - you really should be very careful. It looks so unprofessional - you lose credibility.

Oct 26 03:41 AM

[Stefan Sida...:]

Typos have been corrected.

Oct 26 09:14 AM

[Stefan Sida...:]

I agree with your comment. Right now iPhone SG&A and warranty expense/cost are all expensed, so when they do switch from subscription accounting, I would expect some SG&A to move into the CGS line.

Thanks for the comment. Don't want people to panic and point at lower iPhone GM after the switch and attribute it to Apple getting squeezed.


On Oct 26 03:38 AM jmmx wrote:

> WOW - a lot of work!
>
> Just one caveat - be careful of gross margin when they go to non-deferred
> accounting. I seem to remember that several items that typically
> come out before g.m. are pushed to operating expenses on iPhone -
> e.g. Advertising, etc. (That came from some early conference call.)

Oct 27 01:46 PM