Monday’s “Applevine” post on Metue summarized some of the current Apple (AAPL) reports and rumors circling the news world. One of the elements included was a recap, and light review, of newly reported data on how the new iPhone supporting “App Store” is doing. The numbers were impressive and there is clearly great potential but the take here was cautionary; a bias toward pragmatism with predictions. One month seems too slight a sample to use for accurately forecasting revenue growth or impact on EPS. A few raised flags of dissent.
One comment speculatively said the store could be a 80 to 85 percent gross margin business. Another said that the store could add as much as ten or twenty cents to quarterly earnings per share. Those numbers weren’t supported. They were just “pie in the sky claims,” but still they are out there and they beg a question: what’s the App Store potentially worth – not qualitatively, not from a behavioral analysis, not from a zealous Apple fan, nor from a detractor - simply by the numbers. If we set aside the opinion that one month of data is too little to be meaningful and use it anyway, if we break out the Graham & Dodd, fire up the spreadsheets, how much of a contribution could the App Store make to Apple’s bottom line if the current levels are annualized? It’s got a great revenue story but how much for earnings?
How much might the App Store contribute to earnings per share if the store’s revenue grows to $500m, or passes $1 billion?
What might it mean to Apple shareholders on a standalone basis that disregards the store’s greater contribution as a driver of iPhone (and iPod Touch) sales?
There are no easy answers, but in this post we’re going to try and set out a framework for looking at it – a way of adding numbers to wild speculation.
SETTING UP THE MATH
To start, there a few certainties we can throw in the mix: we know Steve Jobs reported 60m downloads and about $30m in revenue for the first full month. We can annualize that easily enough, or project even higher to compensate for more countries getting iPhone “host nation” status in the coming weeks. Other facts: we also know Apple only keeps about 30% of the store’s revenue. From that 30%, Apple handles credit card processing, bandwidth, server management and other expenses related to the service. Last, we know Apple’s Q3 numbers: we know their revenue, gross margin, income, outstanding shares etc. (The complete earnings are here via the 10Q).
To apply it all, we need a model. Because Apple’s a global company and its sales results are influenced by currency fluctuations, cultural patterns, product supply limitations and more, and because the iPhone’s only available in select markets (and waiting to come online in other countries), starting from scratch would be difficult. There are too many variables. Besides that, the App Store’s performance is going to be influenced by the quality of the products available and their pricing.
Unlike iTunes, where prices are fixed and music and video are known quantities such that consumer choices are a matter of tastes, the App Store is something else. Evidenced by among other things, the withdrawn “I Am Rich” application which was supposedly a joke, the App Store offers more variability in both the quality of its offerings (amateur and professionally developed applications), and the price ranges in which they are sold.
A comprehensive model with a chance at accuracy would need to account for many of these factors. There’d be a lot of “if” and “then” elements; a lot of variables. That’s not only a lot of work, it’s probably impossible to render with the existing public data. There’d be too many random guesses.
Fortunately, there seems to be another way – we can compare iTunes to the App Store. Even though the two services are different, they share two important similarities:
The first is the revenue sharing ratio with content creators:
• Most estimates say Apple takes approximately 29-31 cents per song sold on iTunes. The music label and artist split the remaining piece of the 99cent fee. If, for the sake of calculation, we round that out and say Apple draws 30 cents, or 30 percent, that’s the same share they’re taking from the App Store.
The second factor is costs:
• Both ventures are online commerce services that share some of the same expenses – credit processing, hosting (bandwidth) and server management. The numbers and scale are clearly different, but the relationships among them (cost per sale, margin etc.) may be similar enough to warrant comparison, at least as place to start. (Some could even try and argue that on a “per unit” basis, the App Store might carry more expense because many of the applications are free which translates to a form of subsidy from Apple – e.g. these applications have costs (bandwidth, hosting) but generate no income to repay them.)
By comparing to iTunes, if shared cost structures and similar earnings to revenue relationships are accepted for the sake of argument, then if we can estimate what impact iTunes had on the current quarter at a per share level, we can also make some educated guesses on the App Store’s future contributions.
CALCULATING THE iTUNES EPS CONTRIBUTION FOR Q3
Some general numbers to start with: Using results from Apple’s Q3 10Q filing, Apple had net sales of $7.4b. The Cost of Sales was reported at $4.86b. Net Income was $1.072b. Gross Margin, which as a percentage is equal to Revenue minus the Cost of Sales, then divided by Revenue, was 34.8%.
From the data we can also calculate Apple’s Net Margins. They are the reported Net Income (after taxes) divided by Net Sales (=$1.072b/$7.464b). For Q3, Net Margins were 14%. We’ll be able to use that number and equation in a second.
We’ll also need to know Apple’s outstanding shares. They were 883,738,000 on a basic level or 903,167,000 on a fully diluted level.
The numbers: iTunes revenues are counted in a category Apple reports as “Other music related products and services.” This category includes iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. Apple doesn’t break out the differentiation for the different components. That has to be estimated. For the purposes of the model we will by estimating iTunes accounts for almost the entire category, 97.7% to be exact. For the quarter ended June 28th, the category sales were $819million. If iTunes represented 97.7%, it yielded $800.2m in revenue.
SIDEBAR: EXPLAINING THE ITUNES SHARE
Before moving forward, some will attack the 97.7% number as too high. It may be, but it’s not arbitrary. We derived that number by applying some known sales data to the mix. First, it’s reported that Apple sold approximately 1 billion iTunes songs between February 26, 2008, when 4 billion was reported by the company, and June 19, when the 5 billion threshold was reported. That’s a period of approximately 16 weeks - which means 62.5m songs per week. (Note: The exact day the numbers were hit is unclear but the report days are being used as if exact for the sake of modeling).
There were 13 weeks in Q3 (approximately March 30 to June 28) so if growth continued at the same rate, it would equal 812.5m songs sold (62.5 X 13). That is equal to $804.3m in revenue at 99cents a song for the quarter. Factually, that’s too high. The number doesn’t account for video sales and rentals, and adjusted to incorporate video, it would be too high a result for the June quarter’s actual revenue. For Q3, Apple reported $819m for “Other Music” revenue. The song total and revenue number has to be lower. To guess how much so, we’ve compared the quarterly category grosses between Q2 and Q3.
For the second quarter, Apple reported “other music revenue” of $881m. For the third quarter, it was $819m. If I can do the math, that’s a sequential quarterly slowdown of about 7%. If the weekly song total also dropped off by the same 7% rate, it would yield 58.13m songs sold at iTunes per week (from the 62.5m song number used above). For the 3rd quarter, with its 13 weeks, that would mean total song unit sales of 755.6m. At 99cents per song, that’s $748m in revenue. Add to that an arbitrary $52m for video sales and rentals through iTunes and the iTunes store sold about $800m for the quarter. At $800.2m, that’s 97.7% of the reported “Other Music Revenue” category. The remaining revenue of near $19m accounts for Apple branded accessories and other iPod services.
(Note: $52m for video sales is an arbitrary number but it tracks loosely to Apple’s June announcement that they were seeing 50k downloads a day. Specifically, at an average sales price of $12.50 to accommodate pricing for new and library titles (not rentals), 50k per day over 13 weeks would equal $56.8m. If that is knocked down a little to discount for the share taken by rentals, which are priced from $2.99 to $4.99, $52m would seem to be in a fair range.)
SO WHAT DID APPLE EARN PER SHARE FROM iTUNES?
As noted, it’s estimated Apple takes 29 to 31 cents a song at iTunes and the remainder of the 99 cent price is shared between the artists and labels. If we call it an even 30 cents, or approximately 30%, it matches Apple’s share of the App Store’s revenue.
Even though that iTunes rate doesn’t necessarily reflect the distribution of income from video sales, it’s a starting point: 30% of the $800.2m we’re guessing iTunes grossed for Q3 is $240.05million. That’s Apple’s take before applying costs.
Nobody knows what those costs are. The variables include credit processing, which might be as much as 3% of each transaction plus a fixed minimum of a few cents, then there is bandwidth (hosting), server costs and more.
It would be unusual to see a report of expenses at that level of detail from a company, let alone within operating categories/segments like “Other Music,” so we’re left to guesstimate again. Net Margins, which are calculated here as Net Income divided by Net Sales (using Q3 data), seems a reasonable spot. Admittedly, that choice can be debated given how much of Apple’s income comes from hardware (the hardware businesses having a different cost structure than Internet services), but it’s something tangible to work with.
With revenues and Net Margins, we have two of the three parts of the equation. That’s workable to back into earnings.
For Q3, Net Margins were about 14% (Gross Margins were 34.8%).
With about $800.2m attributed to iTunes, income for Apple’s thirty percent share calculated at a 14% Net Margin would be $33.6m for Q3 (e.g. =$800.2m * .30 * .14). Per share that’s 3.8cents at a basic level, or 3.7 cents fully diluted. (Based on 883.738k and 903.167k shares outstanding.)
Summed up: Using this model, $800.2m in revenue amounts, at iTunes, to a rounded-up 4 cents a share of Apple’s total earnings.
BACK TO THE APP STORE: POTENTIAL EARNINGS?
Monday’s report said Apple drew $30m in revenue from the App Store for the first full month. Annualized that would be $360m. Steve Jobs further predicted that the number could be as high as $500m or even $1 billion down the road.
Using the exact model we’ve set for iTunes, that is, taking 30% of the draw as Apple’s share, then assuming net margins of 14% as a way of subtracting expenses, the picture of per share income becomes more clear. At the current float of outstanding shares listed above, the numbers lay out as follows:
Earnings (14% Net Margin)
So there it is. By this model, if the App Store’s current sales are annualized to $360m in revenue, it might add about $.017 cents a share. At half a billion in revenue it would be good for about two and half cents. At a billion, just under five cents a share.
And what if margins are higher? Since it’s all wild speculation, to provide a counterpoint, we looked at the result if we more than doubled Net Margins to a unrealistic 30%. (That is a number that would presume operating expenses are way below what seems realistic.) $360m in revenue would translate to about 3.6 cents a share come earnings. At $500m in revenue, it would yield about five cents a share. At a $1b revenue number, EPS would be boosted by about 10 cents.
CAVEAT EMPTOR – THE GUESS FACTOR
Financially, Apple only breaks out some data. As a result, revenue modeling, or cost modeling, at this level of detail invariably relies on guesses. The assumptions can always be challenged. The basic arithmetic can go astray too (though hopefully it hasn’t). And even where assumptions are accepted and calculations are accurate, there are still lots of different ways the numbers can be applied.
Here, several assumptions have been made. Complex elements have been simplified. There is no doubt, some will be quick to point out shortcomings and challenge them.
One glaring fact sure to get called out is the fact that iTunes sells more than music. The video business with sales and rentals is growing soundly. Nobody knows its share, nor how Apple splits the revenue with content owners. Projections here could lean too heavily toward music and be off.
Other issues that could be called out: using Apple’s reported 50k movies a day number doesn’t distinguish between rentals and sales. We have to guess. Similarly, using the time lapse from Apple selling 4billion to 5billion songs is inexact too. We don’t know the exact day Apple hit those thresholds and even if we did, growth isn’t a constant.
Last, the applicability of the Net Margin rate to Apple’s content sales could easily be challenged. It surely may not fit. Apple makes its money from hardware and software. Each of those businesses has different expenses and profit margins, and they also differ from the Internet commerce component. Using a Net Margin percentage taken as an average from the entire business can’t possibly reflect the differences in the different divisions. 14% works for the sake of putting something together but it’s a guess that could be off in either direction.
For these shortcomings and more, modeling iTunes EPS contribution, or projecting what the App Store might contribute, is arguably a science project; an abstract hypothesis. That leads back to the original take – it seems with the App Store, pragmatism in predictions is warranted until more information is released.
But if breaking out the numbers is the goal, this at least creates a factual framework for looking at it.