Apple's 'Real' Earnings: Up Almost 125%

by: Andy Zaky October 23, 2008 | about stocks: AAPL    

Andy Zaky

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In its recently reported fiscal fourth quarter, Apple's (AAPL) adjusted net income grew approximately 124.6% from $1.085 billion in Q4 2007 to $2.437 billion in Q4 2008—an extraordinary number when fully accounting for iPhone sales in both periods. Just as impressive is Apple's 75.1% grow rate in sales. Apple's adjusted revenue grew from $6.673 billion in Q4 2007 to a whopping $11.682 billion in Q4 of 2008. Earnings per share grew 123.0% from $1.21 in Q4 2007 to $2.69 in Q4 2008. This begs the question? Where are the analysts and why aren't they quick to point this out? Only on Wall Street can a company grow earnings 124.6%, sustain bouts of analyst downgrades and see its shares decline 55% (while boasting a 14 forward P/E on a GAAP-basis).

I was both shocked and very disappointed to see no analyst comment on the fact that Apple's business grew an astounding 124.6% on an adjusted (real) basis. What's even more troubling is that no one seems to emphasis the significance of the fact that Apple grew its cash hoard from approximately $21 billion in Q3 to $25 billion in Q4. That's a $5.00 increase in total cash per share from $23.45 in Q3, to $28.22 in Q4. At this pace, and assuming Apple makes no big acquisitions, Apple could very well have nearly $48 per share in cash and cash equivalents by the time we hit November 1, 2009. So I ask again: Where are the analysts and why aren't they making mention of this?

The Obvious but Rarely Mentioned Problems with GAAP Accounting Measures

In many ways, the idea of GAAP accounting fails miserably at its intended purpose—to give a "fairly stated" picture (as my accounting professor would often say) of a company's earnings results. Yet, under GAAP accounting measures, Apple is forced to use what is called the subscription method of accounting for sales of the iPhone by amortizing the revenue received from the device over a 730-day period (2 years). When Apple reports its GAAP earnings results, it only accounts for an infinitesimal portion of the revenue it ACTUALLY receives from sales of the device in any given quarter. This is particularly troubling for Apple and its investors due to the fact that Apple draws nearly 44% of its revenue and an unbelievable 63% of its net income from iPhone sales! What is more realistic and fairly stated: an accounting measure that requires a company to leave out 63% of its net income or an accounting measure that forces a company to be transparent by including what it has actually earned in the quarter?

This should infuriate the informed investor because it means that Apple is quite literally trading on P/E ratios that do not reflect more than half of its business. When one compares Apple to Google (GOOG), Research in Motion (RIMM), Amazon (AMZN) and others similarly situated in the tech sector, one should notice that they all have very similar P/E ratios. All of their P/Es have contracted significantly because of the markets overblown fears of the United States entering the second great depression. Yet, Apple's stock has obviously been the hardest hit in this contraction. This is because if one accounts for the 63% in EPS that Apple isn't reporting as a result of GAAP accounting measures, Apple's trailing P/E is probably closer to 11 and its forward P/E is closer to 7 (under the conservative assumption that Apple will earn $12 in adjusted EPS in 2009—not on analyst hallucinations).

Moreover, such an accounting measure opens the door for bearish news reporters such as Eric Savitz at Barrons to continuously publish bearish analyst opinions by the likes of Kathryn Huberty, Travis McCourt, Toni Sacconaghi and Mike Abramsky who only tend to focus on less than half of Apple business. Yesterday, Mike Abramsky cut both his earnings outlook and price target on Apple despite the fact that Apple beat his EPS estimate by $0.11. I have yet to see one analyst or even one news reporter mention the fact that Apple is trading at a mere 3.4 times its cash position, which is significantly lower than its counterparts. Google is trading at 7.8 times its cash, Microsoft at 9.29 times its cash, Research in Motion at 17.8 times, Amazon at about 12 times, Cisco (CSCO) at about 4 times cash, and IBM (IBM) at about 11.5 times its cash. Most of these companies have significant debt and thus net cash per share could be significantly lower.

This general sense of unjustified bearish surrounding Apple over the past six months is a directly result of GAAP accounting. If Apple were able to fully account for sales of the iPhone, almost no analyst would have any ammunition to justify a downgrade the stock as they have over the past two months. Kathryn Huberty is probably the exception because her downgrades are so comical that her EPS estimates continue to be the worst on Wall Street. She needs no excuse to downgrade and I expect another one any day now. While analysts such as Huberty were downgrading Apple in September, Apple was busy growing at 124%. Yet, due to the backwards accounting measures in place today, Apple could only boast a 23% growth rate in GAAP earnings. The table below compares Q4 2007 adjusted earnings to Q4 2008 adjusted earnings. Notice that Apple grew its operating income at a pace of 149.2%. This is a direct result of the revenue growth rate and gross margin percentage growth rate significantly outpacing the growth rate of operating expenses.

Non-GAAP Based Adjusted Earnings Comparing Q4 2007 with Q4 2008

Line Item

Q4 2007
(non-GAAP)

Q4 2008
(non-GAAP)

Growth Rate

Revenue

$6,673

$11,682

75.1%

Cost of Goods Sold

$4,337

$7,131

-

Gross Margin

(35.0%) $2,336

(38.96%) $4,551

396bp

OpEx

$1,030

$1,225

18.9%

Operating Income

$1,306

$3,254

149.2%

OI&E

$170

$140

-17.6%

Net, before taxes

$1,476

$3,394

130.0%

Taxes

(26.5%) $391

(28.2%) $957

170bp

Net Income

$1,085

$2,437

124.6%

Earnings Per Share

$1.21

$2.69

123.0%

Diluted Shares

895,666,000

904,786,000

-

Method for Arriving at Non-GAAP based Adjusted Earnings for Q4 2007

Since Apple didn't start releasing adjusted earnings results until this past Tuesday, I had to reconstruct Apple's fiscal Q4 2007 to account for iPhone sales in order to be able to more accurately compare Q4 2008 with Q4 of 2007. The two most difficult adjustments to determine were gross margins and total revenue. Both of these numbers required a small degree of guesswork and so I was conservative in the guessing. It's quite likely that Apple would have reported a lower adjusted earnings number in Q4 2007, which suggests a larger growth rate in 2008 than indicated in the table above. Yet, the revenue number can at least be stated with a relatively high degree of precision.

Revenue Adjustments

In order to account for the full revenue Apple received from sales of the iPhone and Apple TV, one must reverse the current period's amortization of deferred revenue derived from the devices. At the end of Q3 2007, total deferred revenue (current and non-current) derived from sales of the iPhone and Apple TV was $180 million. Total deferred revenue derived from sales of the iPhone and Apple TV at the end of Q4 2007 was $636 million. In order to reverse Q4 2007's amortization of deferred revenue derived from the devices, one need only subtract Q3's total deferred iPhone and Apple TV revenue from Q4 2008. The difference between these numbers is what Apple actually added to the quarter's deferred revenue pile and is what Apple would have reported in adjusted earnings.

It is important to notice that in order to get a full and accurate picture of revenue; one would also have to subtract any contribution of the previous quarter's deferred revenue that Apple added in its Q4 2007 GAAP-based results. This number is both quite small, likely $23 million, and quite difficult to determine with full accuracy. Thus, for the sake of conservatism, I simply left in the contribution, which makes the growth rate in 2008 slightly better than stated in the table above. The offset between deferred revenue at the end of Q3 and at the end of Q4 results in a $456 million adjustment to Non-GAAP revenue. Thus, Apple would have earned about $456 million more in fiscal Q4 if it didn't employ the subscription method of accounting or if it provided adjusted revenue.

Gross Margins, COGS

Determining adjusted gross margins is a slightly subjective inquiry. Since there is no way to determine what the iPhone and Apple TV's gross margins were in fiscal Q4, and since we know they were better than overall gross margins, I bumped overall gross margin up 139 basis points. This more than adequately accounts for the better than overall gross margins enjoyed by the iPhone. Even if the gross margin percentage estimate is off by a 50 basis points, it would only account for a plus or minus one to two pennies in EPS. The 125% growth rate as stated above is a very realistic depiction of Apple's actual growth rate.

Operating Expenses & Operating Income

No adjustments are necessary for operating expenses as Apple fully recognizes any and all operating expenses when incurred without regard to any of its deferred revenue mechanism. If one looks at Apple's published adjusted earnings for Q4 2008, no adjustment is made to operating expenses in arriving at adjusted earnings. Since no adjustments needs to be made to operating expenses, operating income is simply the difference of subtracting operating expenses from gross margin.

No adjustments are necessary for OI&E as Apple fully recognizes any and all OI&E without regard to any of its deferred revenue mechanism. See Apple Q4 2008 adjusted earnings results for example.

Tax Rate

No adjustments need to be made to the tax rate, as a uniform rate is determined on a quarter-by-quarter basis. The effective tax rate in Q4 was approximately 26.5%. See Apple's Q4 2008 adjusted earnings for example.

As a result of the $181 million addition to net income based on the adjustments noted above, exactly $0.20 is added to EPS based on the published diluted share calculation of 895,666,000 shares. The table below is an unaudited reconciliation of Non-GAAP to GAAP results of operations for Apple's fiscal fourth quarter for the fiscal year ended in 2008.

 Q4 2007 Unaudited Reconciliation of Non-GAAP to GAAP Results of Operations

Line Item

As Reported
GAAP Earnings

Non-GAAP Adjustments

Non-GAAP Earnings

Revenue

$6,217

$456

$6,673

Cost of Goods Sold

$4,127

$210

$4,337

Gross Margin

(33.61%) $2,090

$246

(35.0%) $2,336

OpEx

$1,030

-

$1,030

Operating Income

$1,060

$246

$1,306

OI&E

$170

-

$170

Net, before taxes

$1,230

$246

$1,476

Taxes

(26.5%) $326

$65

(26.5%) $391

Net Income

$904

$181

$1,085

Earnings Per Share

$1.01

$0.20

$1.21

Diluted Shares

895,666,000

-

895,666,000

Disclosure: Long Apple.

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This article has 28 comments:

  •  
    Oct 23 09:48 AM
    Excellent article! You understand accounting. It seems there is a negative bias to Apple in several of the Analysts you mention. Kathryn Hubert and Mike Abramsky especially seem to time their negative comments and downgrades so they can inflict maximum damage to any upward movement in Apple shares. One wonders if they have some motive other than the pefromance of their jobs. Apple continues to outperform and the stock continues down. I guess the Hedgefunds and Day Traders are still shorting every move upward.
    Reply | Link to Comment
  •  
    Oct 23 09:49 AM
    Keep up the good work Andy - I don't understand why people aren't talking about this either. The conspiracy theorist in me thinks that everyone else is sweeping it under the rug because they aren't long yet and don't want the stock to get away from them before the market turns. Apple's underlying fundamentals are literally off the charts, and you are one of the few who are actually talking about it. Analysts are continuing to lose credibility and if they don't watch out, they may make themselves completely irrelevent, if they're not there already.
    Reply | Link to Comment
  •  
    Oct 23 09:54 AM
    Remember... We're dealing with Wall Street, here.
    Reply | Link to Comment
  •  
    Oct 23 10:07 AM
    FINALLY, SOMEONE WHO HAS DONE HIS HOMEWORK AND UNDERSTANDS THE TRUE APPLE MARKET. I HAVE TO BELIEVE THE HEDGE FUNDS ARE THE REAL CULPRITS IN THIS. I KEEP TELLING MYSELF THAT MARKETS REALLY ARE RATIONAL AND TRUYH WILL PREVAIL.
    Reply | Link to Comment
  •  
    Oct 23 10:09 AM
    Great article. Jobs rolled out the 'adjusted' numbers and you filled the picture out very well. Thanks.

    I'm wondering if this will be the last quarter where aapl adjusted numbers are ignored by MSAs (mainstream analysts).

    I'm guessing some of them will ignore these adjusted numbers for several years hence.

    What passes of for analysis is astounding! Ain't it?
    Reply | Link to Comment
  •  
    Oct 23 10:26 AM
    Finally, an honest intelligent person stating the facts...they won't be able to hide it much longer... I believe apple will have another blowout 1st Quarter,...Santa Claus is coming to the Apple Store....
    Reply | Link to Comment
  •  
    Oct 23 10:55 AM
    Great, great, great,....

    this article explains everything about Apple business and future. I am total belliver in Apple and having almost every dollar I have in their stock. Your writings here and on TMO board, together with similar friends like Dawntrader and Tommo, are my main source of true informations about Apple position.....

    I am from Croatia, and if there is no articles from you Andy, I will probably never invest in Apple...

    Dont forget another fact nobody noticed: Apple is 3rd mobile phone manufacturer by revenue.... After Nokia,Samsung only 15 months on the market, with just ONE PRODUCT !!!!!!!

    Thank you Andy
    Reply | Link to Comment
  •  
    Oct 23 11:08 AM
    I have said it before, but it is worth repeating, Andy Zaky is the premier financial analyst for any number of reasons. He is careful, thorough, does his homework. He is the #1 financial analyst when it comes to Apple. He makes so many brilliant points that it is overwhelming. His editorial comments regarding mainstream analysts is spot on.

    We are witnessing the birth of a great financial analyst. I am appreciative and value his work.

    dr.a
    Reply | Link to Comment
  •  
    Oct 23 11:12 AM
    I also wondered the same thing. I can't believe an item indicating that when including deferred income, the profit is well over TWICE of what was reported can be treated as mere footnote. It would seem that as this revenue comes trickling (flooding?) in, it will more than make up for even the most conservative estimates regarding sales drops during the recession. All this cash gives Apple a HUGE advantage to innovate and grow (purchase Adobe, e.g.?) and eventually shoot through the roof once people start spending again.

    I can understand investors fleeing even an excellent company in a bear market, but why is it that more analysts aren't trumpeting these same qualities that Mr. Zaky notes? These factors were whispered about occasionally before this earnings report, but now Apple is providing actual numbers and positioned them prominently in their call. They're doing it for a reason, people! Pay attention!
    Reply | Link to Comment
  •  
    Oct 23 11:15 AM
    I admit to being a neophyte as far as accounting but: Under your theory, if I sold products at $10 apiece, but did not manufacture them until next year at a cost of $11 apiece, it sounds like you are saying I could claim a profit of $10 a unit this year. Is it not to prevent potential scams like this that GAAP was mandated?

    Once companies start deviating from the standard, how is the investor supposed to know what to believe? Is the company an Apple, or is it an Enron?
    Reply | Link to Comment
  •  
    Oct 23 11:15 AM
    I admit to being a neophyte as far as accounting but: Under your theory, if I sold products at $10 apiece, but did not manufacture them until next year at a cost of $11 apiece, it sounds like you are saying I could claim a profit of $10 a unit this year. Is it not to prevent potential scams like this that GAAP was mandated?

    Once companies start deviating from the standard, how is the investor supposed to know what to believe? Is the company an Apple, or is it an Enron?
    Reply | Link to Comment
  •  
    Oct 23 11:22 AM
    As I understand it, the deferred revenue doesn't involve the selling of manufactured products. It involves continuing income committed after a product is sold, such as subscription revenue. Here, ATT has to pay Apple a monthly cut of the subscription dues it collects from plans entered into by iPhone customers. When it sells an iphone, Apple gets a profit from the item itself (or ATT provides it because it subsidized the price). The, it sits and waits for the monthly check ATT sends to Apple which is that portion of the iPhone subscriber's dues that ATT agreed to pay Apple for the privilege of attaching its services to the iPhone.

    Thus, deferred revenue is an actual, contractual revenue commitment, not a hope and a prayer that a manufactured item willa ctually sell.
    Reply | Link to Comment
  •  
    Oct 23 11:23 AM
    As usual, spot on. All you need to know is Apple generated $9.1B FCF in 2008, has $25B cash in the bank and currently is valued at $90B. Subtract $25B from $90B to get to the value of the business and divide by $9.1B to get a true historical cash earnings multiple and you get about 7X. 7X? Really, 7X earnings? YES. What a joke. This shows how ridiculous the markets are right now. BUT you have the opportunity to invest here and participate in the normalization of the multiple in time.
    Reply | Link to Comment
  •  
    Oct 23 12:45 PM
    You're mistaken. Apple doesn't get monthly shares of revenue anymore. They used to, but now they get all the iPhone revenues from AT&T as soon as the devices are sold. That is why AT&T had to post such a bad profit for the last quarter. They sold a hell of a lot iPhones and had to give the subsidies to Apple.
    The monthly revenues will then go to AT&T to make up for this. Apple accounts for the iPhone sales as they do for service contract revenues like Apple Care. The customer pays all the revenue in September (example) but it will be accounted for the next couple of years (depending on the lengths of the plan).
    Btw that is the reason why major iPhone-firmware-update... cannot be charged for while updates for the iPod Touch (which is accounted for in the month it is sold like every iPod) have to be charged for. Apple actually mentioned that when they first offered a firmware-update last year.

    Excuse my messy english. I'm not a native speaker.
    Reply | Link to Comment
  •  
    Oct 23 12:51 PM
    outstanding analysis and opinion
    Reply | Link to Comment
  •  
    Oct 23 01:38 PM
    A good article Andy. You are honest enough to show us the figures that underlie your opinions about AAPL and that is an admirable quality. It demonstrates a level of courage and conviction in being transparent as to the basis of your claims. Other analysts would not dare to publish the workings that underlie their absurd opinions and downgrades and the reason is clear. They are dishonest and have a selfish agenda which cannot help them in the long run. It's cynical and very dishonest.
    If I may suggest one change. Your point would be made much more powerfully if you expanded your worksheets to include the same stats for a few competitors and for the sector as a whole.
    Excellent.
    Reply | Link to Comment
  •  
    Oct 23 02:36 PM
    Any thoughts on what an adjusted non-GAAP guidance might be for next quarter?

    Apple might consider providing that number. Some sort of realistic estimate might go a long way to relieving fears about a slowdown at Apple and put their GAAP based future guidance into perspective.

    How can anyone take the forward, conservative GAAP guidance seriously, when this last quarter they guided down and beat by over 100% (when looking at the non-GAAP numbers).

    I can see how even my last paragraph is confusing. The term GAAP and the concept of non-GAAP earnings being more accurate is sure to confuse many investors, and it seems to have confused most professional analysts to date, as you mentioned.

    Perhaps the analyst community will formalize around the non-GAAP metrics for Apple and attempt to provide comparative P/E's using the non-GAAP numbers. This might improve the understanding of the investment community. It would certainly highlight the disparity in valuations you mentioned.
    Reply | Link to Comment
  •  
    Oct 23 03:20 PM
    Apple still gets the revenue on outstanding 2.5G contracts still in place. 3G phone doesn't have the revenue sharing, instead the upfront subsidy. I bet the 2.5G contracts are dwindling away fast. Most everyone I know who had a legacy iPhone bought a new 3G so those contracts were replaced with the non-sharing revenue model of the upfront subsidy. There were probably only 50% of 2.5G phones that were on an authorized carrier network. (3M) My guess is that there probably 1.5 - 1.75 M that haven't upgraded yet.
    Reply | Link to Comment
  •  
    Oct 23 04:01 PM
    Even if all of this is true, and it probably is, AAPL could still be trading at $70 in a week. The risk is all systemic here - Apple could have sold 20 million iPhones and it wouldn't have made a difference...
    Reply | Link to Comment
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