Apple Math: Market Share over Margins

Why has the impact of 3G iPhone sales been nonexistent on Apple (AAPL) stock? Because investors are flunking their Apple math exam. The iPhone story grows larger by the day, we are now on day 18 of iPhone mania. Tuesday morning the Santa Monica Apple store had a 2 hour wait by 8:30 a.m. If one million phones sold in the first three days was impressive, then what we've witnessed since then is even more impressive.

It's time for a quick discourse on Apple math. Those, like CNBC's Jim Cramer, who believe this has turned into an event driven stock are completely wrong. It's all about the fundamentals. The lackluster response to unprecedented iPhone demand represents the greatest buying opportunity on Wall Street. Apple math sacrifices a big payday today for an even larger payday tomorrow. There are two components of Apple math creating this buying opportunity:

1.Those who don't understand Apple math look at the recent earnings report and see a meager $419 million of iPhone revenue. This short term dilution of earnings power, caused by the 24-month deferred subscription accounting, has caused investors to ignorantly ignore the long term iPhone impact on earnings per share.

To foresee the real power of Apple math let's fast forward to the December 2009 quarter when it's estimated there will be 58 million iPhones reporting approximately $71.75 per phone per quarter (lonepeakportfolios.com). These numbers produce a profit of $2.5B from $4.16B in revenue for just a single quarter. Compare that to the current Q2 net income of $1.07B on revenue of 7.46B for the entire company! Investors are in store for a 1,000% increase in reported revenue from the iPhone over the next 18 months.

Apple math creates a rolling snowball effect that produces larger and larger returns while at the same time eliminating short term earnings volatility. By June 2009, earnings from the iPhone will reach current net income for Macs, iPods, Apple TV, software and iTunes combined. That is only 10 months away. This growth is happening right before our eyes but most are missing it because they fail to see the future ramp manipulated by Apple math. Apple hasn't reported any revenue from the iPhone since the beginning of March. It's coming.

2. The second component of Apple math that investors have incorrectly interpreted is the pending reduction in gross margins down to 30% in 2009. The incorrect assumption is that the margin erosion will reduce profits. Not so.

According to CEO Steve Jobs, Apple is in the midst of experiencing a market share tipping point with the Mac Computer. Spurred on by the complete failure of Microsoft Vista, Apple has a once in a lifetime opportunity to crack the market share dominance of not only Microsoft (MSFT) but also of their hardware competitors Hewlett Packard (HPQ) and Dell (DELL). The new Apple is all about market share. By lowering the price of their products, Apple stands to further capitalize on the iPod/iPhone halo effect that has led to market share growth 300% better than the overall PC growth rate (IDC data).

This pending drop in margin has nothing to do with a slowing economy; Apple has already proven itself with 41% year over year Mac growth in these tough conditions. The margin decrease has everything to do with their mass market share opportunity. Premium priced products won't topple Microsoft. Apple math means lower margins produce market share madness.

Apple investors should not mistake local cloud cover to be permanent darkness. The future will eventually arrive and reward those investors who understand Apple math. Buying in-the-money January 2010 calls allows you to be out in front of any short term market weakness. Investors won't ignore iPhone sales forever.

Disclosure: Long AAPL

Comments

[Barquish:]

While I have no argument with your math, I do have an issue over consumer sentiment. 58 million iPhones by December 2009 is optimistic. There is also the price erosion and potential competition. I would consider $120 as a good buying opportunity but find it hard to justify a buy in at these levels.

2008 Jul 30 06:52 AM

[mrtaxx:]

Most people don't get it but you do. Here's an example: In Apple's March 2008 quarter Apple reported earnings of $1.16, however if you add in the deferred revenue the earnings become $1.45, a 20% increase. Now that's a blow out quarter.

2008 Jul 30 06:58 AM

[C.Nielsen:]

Very good! $157 is a good opportunity as well - This stock will be at the $200 level by the end of the year, and at least $250 a year from now

2008 Jul 30 07:22 AM

[johnnryou:]

If you are a experienced software developer that have knowledge about what's going on the iPhone software development, you can clearly agree with Jason.

If you have read the book "Being Digital" by Nicholas Negroponte, he have estimated the Ubiquitous computing by a universal computer you always carry around and use for various purposes. Now, suddenly the future is already here in a name of iPhone.

For easy acces to the market, Apple have packaged it as a phone, but it's much beyond a phone.... Just look at the bundled softwares, and Apple iPhone SDK, and thousands of new third party applications pouring out every months, ....

Apple did a great job... They reinvented the Phone.

2008 Jul 30 07:51 AM

[michiganjake:]

Well done article. Patience will pay for those of us that are long.

2008 Jul 30 07:52 AM

[michiganjake:]

Well done article. Patience will pay for those of us that are long.

2008 Jul 30 07:52 AM

[Fedman:]

i think so much of the apple debate has to do with traders versus investors (i.e., what is your time horizon). Barquish raises good points regarding competition and potential price erosion, but I think longer term this is a tipping point for mac where the effectiveness of today's strategies will be seen one year or more going forward. I have Apple as part of my long-term portfolio, google as well, but I have no expectation that apple will be 200 or whatever by year end.

I see a good growth story and we'll see what happens.

But I do appreciate the article pointing out two major concepts that people may overlook when evaluating apple.

Thanks.

2008 Jul 30 07:53 AM

[chplanet:]

Hi,
I sincerely believe that the author has a point as far as the long term is concerned.
The open platform for third party software along with increasing sales of iPhones will extend even further the halo effect (more Apple products out there) thus creating real competition for Dell, HP, Acer and of course last but not least for mobile phone specialists such as Nokia.
On the other hand Apple needs to take in consideration product quality! More quality! The higher sales volumes the higher the exposure to criticism and quality issues (e.g. customer satisfaction handling, product recall problems, etc.).
Cheers,
JC

Disclosure: Long AAPL

2008 Jul 30 08:20 AM

[top_tier:]

Even the current forecast of lower margin is temporary, the back to school season and component costs for new product are consequences for that. Getting past that, and too, folding in ever increasing high margin iPhone sales the margin will be headed back up. Again, Wall Street planting fear, aka boiler room outfits like the Street.com carpet bombing hype about this and Jobs health etc, but all to do about nothing in the end.

People were saying last year this time the recession was going to hurt Apple, hasn't happened, and the long lines at Apple stores are clear evidence that it's still not happening.

2008 Jul 30 08:34 AM

[macglenn:]

This quarter we will not see much revenue from Apple's iPhone leg due to deferred accounting. Peter Oppenheimer guided at 1.00 per share for Q4 2008, his usual UPOD. What he did not say, was, that is also the number for the iPhone division's deferred revenue! ;-)

A conservative estimate of 6 million units this Qtr times 200 bucks in profit equals 1.2 billion in pretax, and i am assuming Apple is making at the very minimum $200 per unit in subsidization from any and all vendors. It will be very easy for Apple to earn a solid $1.00 per share in deferred revenue. That's money in the bank.

2008 Jul 30 08:37 AM

[tom1234:]

like i said aapl sandbags their forecasts and their quarterly earnings--todays income will be reported tomorrow--only todays income will be spread over 24 months which will climb fast ---great article --i hope the lemmings of wall street get this article

2008 Jul 30 08:46 AM

[macglenn:]

In case you didn't get my point above. Next quarter PPS will likely be in the range of 1.40. Add to that the quarters iPhone cash flow of 1.00PPS and we get 2.40 PPS.

2008 Jul 30 08:51 AM

[JB Money:]

Dead on. Been saying the same thing day in day out on Google Finance Boards. The fact that people cannot see what is happening, even though it is happening in a very public way and only requires very basic math skills, illustrates the laziness of many who cover Apple, or just share ignorance as you pointed out.

2008 Jul 30 08:51 AM

[taojones:]

I'm buying all i can afford. the lower prices will mean (in simple math ) we can choose between owning 100% of one apple or 30% of the whole orchard. the fact that in these conditions there are lines for 3 weeks at the stores is PHENOMENAL

2008 Jul 30 09:10 AM

[Shorting Sh...:]

Apple is a traders stock and, unfortunately, the traders will keep bashing it around until the growth story is over.

2008 Jul 30 09:17 AM

[Tom B:]

Micheal Dell once said Apple should closed its doors and return its assets to its investors. Apple rolled over Dell in market cap a few years ago Apple passed IBM (for a time) last year, but AAPL's current low P/E put Big Blue back on top. AAPL will pass MSFT fall, 2009-- my prediction.

Apple:
Made the transition to UNIX
MSFT:
Still waiting. Don't expect modernity in Win7, either.

Apple:
High performance; high security
MSFT:
Low performance; low security.

Apple:
Top notch dev tools for OS X and for the iPhone.
MSFT:
The best they can mange is warmed-over Java (dot net).

Apple: iPod/iPhone--convergen... platform; an iPhone IS ALSO an iPod and uses the same OS, and that OS is a subset of OS X.
MSFT: Zune/Win Mobile. Both different OS's, and not closely related to Windows.

Apple:
Friends with Google
MSFT:
Conducting a futile land war against Google (MSN live, Yahoo attempt)

I could go on: Final Cut Pro. Quicktime. Filemaker. But you get the point.

2008 Jul 30 09:18 AM

[Anonymous W...:]

Well some of us long term investors already know this but I really like your dedicated effort to clearly explain and layout what's really transpiring with AAPL. Thanks for your efforts. You have to understand that technology pushes onward even in difficult economic times and Apple has all the marbles here to double , triple, quadruple...their size in short fashion. Cramer knows nothing about technology, He knows nothing, nothing, nothing !!! Couple into the math the possibilities of the economy turning the corner in 2009 or 2010, etc., and it's to the moon Alice !

2008 Jul 30 09:20 AM

[Network Effect:]

My sense is that big money saw an opportunity to short main street in a very liquid stock. The consumer is a huge Apple fan, and us lemmings are buying their stock. Big Money sells into this and tries to break the backs of everyone and when their back is broken, they buy it back from them at a really low price. I think the problem is that not a lot of main street is selling this time and they can't buy it back at a low enough price to make the trade work as a whole (obviously many people made money shorting apple recently). Rumors were started, people tried to say that RIMM wasn't being affected, and the media machine was doing it's best to get people to give up. I think what happened is that people didn't give up. So what I think is going on now is the calm before the storm - Apple will take off like a rocket when they announce China, or a new product line, etc. No one bought the story and shorts are going to cover and there aren't going to be a lot people selling at these levels. RIMM's delaying the launch of their phone, GRMN is delaying theirs once that kind of news comes out. Big money is now trying to get people to buy into the PALM Centro story ... they are running out of straws to grasp at.

2008 Jul 30 09:34 AM

[FreeRange:]

Good article Jason. Many good comments here. It is amazing how so called analysts are clueless about Apple. There will be no margin erosion. What nonsense. Apple figured out long ago what consumers want, and what makes them passionate. Apple products provide excellent value and will continue to do so at the best margins in the industry. The halo effect from all of the new international consumers, historically Apple's weakest market, will blow the doors off! Agreed though that Apple needs to be very cautious about software and hardware quality, and customer support, so that they don't lose their edge. Hopefully they've learned their lessons with this major launch. And hopefully, Jobs won't beat his people up so bad that his best people bolt. Esprit de corps is critical at this juncture and he needs to keep his people pumped up. Apple, keep up the great work and continue to surprise and delight us with great products people are passionate about! You should all be very proud of what you've accomplished!

Now, for the shorts... I agree that there is much manipulation going on here by the shorts. It is a trading practice that should be banned across the board as it allows too much room for manipulation and outright fraud at the expense of market stability and the average investor.

2008 Jul 30 10:20 AM

[jmmx:]

#1 - Well Jason,

I think you have the basic idea on the iPhone, although I think your numbers quite a bit too high.

Specifically, it looks like you are using iSupply's 56% margin over cost of parts. But even iSupply says this does not include manufacturing costs (if I recall correctly). Also, while Operating Costs (OPEX) ARE being being expensed as they occur (in other words not part of iPhone), there still are some other costs that will go to it - packaging, shipping, distribution, for example.

I like to use for the iPhone a 30% NET Margin. this is 2x their overall net. It might even be a little conservative, but I think it is a good working figure. To most people out there I think it will seem high.

So if you have the figures right for 58 M iPhones generating $4.16 B in revenue, then I put it more like $ 1.25 B in Profit or about $ 1.39 EPS - from iPhone alone!

I know that this is a lot less than your $2.5B - but you know what? I will be satisfied to see this figure. :)

next....

I think you do need to

2008 Jul 30 10:22 AM

[Mr Bill:]

Great article Jason. Please do not make the average investor too smart. Trading Apple has been a money machine. Consider Apple's internal information security. No hint of the switch to Intel chips despite a two plus year transition period. The introduction of the iPhone ready for the market without any hint of its development. However a close watch of their past practices and current actions can give hints to where they are going. We should see an announcement sometime in August.
Disclosure: Apple investor since 1993

2008 Jul 30 10:26 AM

[digivision:]

great article I also agree.. people this is the ipod all over again
I was at a small att store yesterday for some issues with my phone
although there where no long lines 4 people bought iphones in the short time I was there and out of the 4 sales rep only one was available for my issues , he explained me that even though they are not mobbed that is how the whole day goes , it's very steady

2008 Jul 30 10:28 AM

[digivision:]

and can anyone imagine the type of halo effect the iphone can generate all over the world and not only in the US??

2008 Jul 30 10:29 AM

[nine_yarder:]

I would like it if someone knowlegeable would comment on the potential for apple to provide credit card services and micro payments using the iPhone.

I'm thinking of retail sales for everything including clothes, gas and food. Secure payments with bonus awards in apple store points.

2008 Jul 30 10:36 AM

[mollytjm:]

thank you, Jason!! i think even earlier history is part of the problem. today's company is no one trick pony, but it's also not a one man show. a lot of people in business are still tied to their old type pc software. they haven't had a chance to experience products that are better, easier to use and that have wonderful tech support (which is largely not needed). and they remember the company that nearly lost everything. it's painful history to us who love Apple, but we see the future and where it's going and we know Apple is secure and growing. it'll take some time for the herd to figure this out...i think another year will do it. by then, we'll have some really amazing numbers and in an economy that is crummy, they'll look even better! again, thank you for a great article, Jason!

2008 Jul 30 10:42 AM

[jmmx:]

For the second part of your piece...

I am afraid, my friend, that you also have missed the point, as I disagree with you here quite a bit. I do NOT think Apple is going for lower costs in order gain market share.

1- Apple is already gaining market share.

2- What you suggest implies that they will be making a massive foray into market share gains. Personally, I am happy with Mac gains of 40-50 % year over year. I think they may share this view. There is incredible stress and danger on a company that grows faster than that, and Apple has too many new irons in the fire to go for that. Macs are growing at a very good pace. There is no need to commoditize them. Thank you.

3- This just is not Apple's philosophy! As long as they can grow while maintaining their profit margin, this is what they will do. They still give "value for the money" to their customers.

OK - so then why the erosion of gross margin?

It is 1 what they said and 2 what they implied.

1- They are seeing very large start up costs for some new product. Plus the cost of their specials, etc.

2- All the OPEX, advertising and other expenses for the iPhone are being dumped into this quarter with no significant revenue to diffuse it. That is a lot of expense! A real lot of expense! It is typically what 10-20 % of revenue from a product? At 10%, 6 M units sold this Q (just for example) @ $500 / phone = $300 Million, or some 33 cents per share!

That is a big bite into gross margins! I wonder why nobody sees this simple math??

IMHO

2008 Jul 30 10:56 AM

[sgmsg:]

@jmmx

First Apple is gaining market share for lot of reason but not least . windows vista is a bad experience. Microsoft gonna take almost 2 years to fix that. If Apple doesn't hurry his market share gonna stabilize around 10 to 15 % until microsoft give an good alternative to Vista.

Second, Android is coming on mobile phone. Google want to steal all the market. Google has the money, has the visibility. They just need the product. The merge with symbian gonna help them. Lowing the margin should help Apple to take emergent market.

Mobile phone is the next avenue for computer. Apple, Google, Nokia, Micorsoft are playing their futur on it. Apple have to hurry to reach the top, else Apple could die.

2008 Jul 30 11:13 AM

[Appleshuttle:]

Great Article Jason. I've owned Apple stock for a long time and I've never seen a time when there was this much potential to grow earnings and never have future earnings been guaranteed like they are now that Apple defers revenue. I'm glad you get it and glad you write about it.

Even if Apple sells half as many phones as you say they will their earnings will grow rapidly and we will really see this starting this time next year when a full 8 quarters of deferred revenue are realized in one quarter. Even if their were zero revenue from iphones this stock would be a buy based on its rapidly growing mac marketshare, but with it makes this stock a no brainer.

Can you imagine how much revenue Apple will generate when the iphone becomes a mature product with several models to choose from like the ipod? Making a product that is subsidized(by the phone carriers) is ideal for Apple as it takes away the main obstacle those not buying Apple products give for choosing another brand....cost.

2008 Jul 30 11:16 AM

[Dr. Dan:]

I agree, the short-term gross margin reduction is almost certainly due to new products, product upgrades, and marketing for these changes. Any significant new items will cost money to produce, ship, and advertise, while the revenues from them won't be seen until the following quarter.

Given their traditional conservative guidance, one wouldn't expect them to say "after that drop to 30%, we expect the following quarter to jump back past 35% or 40%." Given the high margins Apple likes for new products, I think it's silly to think they'd deliberately lower margins without any expected reversal.

I also agree that the market mentality driving this stock seems inexplicably short-sighted and stupid. How can the same exact scenario - great earnings blasting consensus, conservative guidance below consensus, stock plummets - play out three times in a row? Each time with the earlier fears shown to be unfounded? Where are all the people who were "proving" that iPod sales were flat for good, or that iPhone market was saturating, or whatever fear-du-jour was used to explain the last selloff? It just seems nuts.

2008 Jul 30 11:29 AM

[Randy Fay:]

Good article but number a little optimistic, and there should be thought given to RIMM. However, I'll put on my "possible buy" list.

2008 Jul 30 11:45 AM

[Mikael:]

20 million iPhones in 2008. 100 million in 2009. Mac market share 12% in 2009 and 15% in 2010. Q4 2008 will be much better than predicted, and Q1 2009 (xmas edition) will blow everyone away.

The stock? Someone (Wil Shipley, maybe?) wrote that if Jesus came down and proclaimed Apple his chosen company, stocks would be down $30 in after hours trading. :-)

Long, and loving it.

2008 Jul 30 11:47 AM

[johnnryou:]

The fundamental difference Nokia / RIM / Samsung / Sony phones and Apple iPhone is, every Apple iPhone sold is a money making machine after being sold.

This is happenning because Apple is selling iPhone applicaton software from their shop along with $0.99 songs from iTunes. That's why they opened SDK for third party developers.

So, imagine 10+ millions iPhones out there generating revenues for Apple continuously. It's same like selling Macs out but continue to sell softwares after it's been sold.

This is the fundamental difference between iPhone business and other smart phone makers business.

Apple is selling revenue generating machine, while others just sell one time money.

2008 Jul 30 11:50 AM

[Mikael:]

Yep, it was Wil Shipley. Here is the twit:

twitter.com/wilshipley...

2008 Jul 30 12:13 PM

[jenny:]

Great! Thanks for writing an article on Apple that we haven't seen a thousand times before. It always seemed obvious that subscription and new product revenue played a huge role here except was totally overlooked. After checking sentiment (predictwallstreet.com/...), AAPL shot into the UP territory, reflecting how strong people are feeling right now about AAPL. While I do believe the price is high right now, consumer sentiment for the iPhone will inevitable die down, competition, etc. and the price will most likely follow. I think in the long run AAPL is a good buy if you find the right time in.

2008 Jul 30 12:41 PM

[Tom B:]

"So, imagine 10+ millions iPhones out there generating revenues for Apple continuously. It's same like selling Macs out but continue to sell softwares after it's been sold."

The iPhone is like a casino slot machine, except every pull wins for both the customer and the House.

2008 Jul 30 12:59 PM

[rd4sndk:]

Jason... Although I agree with the general low eval of Apples potential, I totally disagree with your numbers and the time frame inwhich the iphone will be acretive or noteworthy to earnings.

Why disagree with your numbers
1. Munsters predictions are already wrong in that he did not expect expansion of 74 additional countries with initial launch of 22. His numbers included only Japan for 2008. Although I agee with munsters 300% growth over the next 2 years its possible that given Apples momentum, app store and content model, 400% is more probable than 300%.

2. You $71.75 per phone seems too high for my estimates. I estimate a single 8GB phone addes only $65/quarter in sales and using a conservative 40% GM (this number would include royalties, packaging and other mfr incidentals). Much less than your $72/phone.

My estimates

1. The iphone is not just hardware. It includes additional revenue to Apple via the apps store, Mobileme, accessories, repair and itunes. Two of these 5 catagories are new independent multi-billion dollar revenue streams while the others benefit from incremental sales. All total, the iphone represents an initial hardware sale and residual revenue to Apple over the life of the product.
2. The iphone will canibalize the ipod product line. Apple tried to put a good face on this by growing quantity shipped but that was accomplished by halving the price of the shuffle and lowering the ASP for the other ipod line. On the CC, this was reported as being a good thing because the iphone carries a higher GM than the ipod. I agree.
3. In the current quarter iphone sells is $419M lower than all Apple revenue generatine catagories; next quarter it'll be $800M larger than software and peripherals. The 4Q08 iphone sales will be $1450Million larger than desk tops, itunes, sw, and peripherals. By 1Q09 iphone revenue will be 1800Million, the second largest revenue catagory exceeded only by lap tops. Starting in 4Q08, the iphone will be the greatest contributor to cash flow than any other catagory including lap tops.
4. While iphone is moving quickly up the catagory hierchy, apps store and mobileme revenue will approach $250Million per quarter by 1Q09. Although the these catagories will contribute the least the renvenue, added with iphone sales they represent more than 20% of the iphone catagory.

My point is that we don't have to wait until 4Q09, iphone sales and impact to Apples revenue are relevant now and they are substantially significant.

2008 Jul 30 02:30 PM

[Kyle B:]

Great article.
I am not an accountant so I did not understand how phone current revenue would be deferred and be reported in forward quarters. This article gives me a reason to continue to be long for the future reporting. Long investors that bail may not see the rewards of the current sales.
Does invested deferred earnings get invested and reported in a similar manner or does it get into cash reserve?

2008 Jul 30 03:21 PM

[goodjello:]

The iPod story is far from over. With the App Store behind it, the new iPod touch that will be introduced in September will appeal to a massive audience who don't want/can't afford smart phone contracts. The iPod Touch will become a handheld gaming device to beat Sony and Nintendo, an internet/email device for students who have ubiquitous wireless access on college campuses, a brilliant super remote to control home media. If Apple can manage a low end price of $199, it will be unstoppable.

2008 Jul 30 04:53 PM

[Tom B:]

"The iPod Touch will become a handheld gaming device to beat Sony and Nintendo, an internet/email device for students who have ubiquitous wireless access on college campuses"

John Carmack, creator of Doom is interested. He says the iDevices have more power and RAM than other handhelds. I think the accelerometer creates much room for game innovation, too.

2008 Jul 31 08:46 AM

[fishgal53:]

when you change to a apple ... you never go back

2008 Jul 31 09:55 AM

[Ricard:]

Right before the dot-com bust, Cisco was projecting 20-30% yoy earnings for the foreseeable future. Cisco's stock price promptly plummeted 90%. It has yet to recover. It was also not nearly as dependent upon an iconic CEO like Steve Jobs.

2008 Aug 01 05:00 PM

[Yourope:]

iPhone cannot take a decent photo, it cannot handle multitasking, it cannot send MMS, the connection quality is substandard and the plastic shell cracks after only one week. The real price for the product to the consumer is at least $1000.

Seriosly. With that product the iPhone is going to have real big problems to take any market share whatsoever. Yes, it is going to be a flop.

2008 Aug 01 07:21 PM