Reconstructing Apple Earnings, Including iPhone

by: Andy Zaky October 28, 2008 | about stocks: AAPL    

Andy Zaky

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Now that Apple (AAPL) has reported its earnings for the full 2008 fiscal year, I think it's important for investors to focus on how Apple would have performed if it fully recognized the revenue and earnings from its sales of the iPhone. Apple's true 2008 financial results have been hitherto veiled under a shroud of financial secrecy that I set out to finally irrevocably uncover, since Wall Street analysts apparently cannot do their jobs. Someone needs to put an end to this nonsense and if not the analysts, then it's up to the investment community to make such determinations on their own.

The Apple earnings confusion has largely been the result of Apple's relatively (un)complicated subscription method of accounting for sales of the iPhone. Most analysts seem to be either thoroughly lazy, or genuinely perplexed by this fairly simple concept; and so I thought I might make their jobs a little easier by reconstructing Apple's 2008 earnings results to reflect what Apple actually earned in 2008. After reviewing several research notes by analysts for the months of September and October, it doesn't surprise me one bit that "the analysts are at the bottom of the s**t heap" or "at the lowest level of the investment banking hierarchy" as described by John Rolfe and Peter Troob in Monkey Business.

While the broader market is down well over 40% this year, Apple's stock has been significantly more deflated than others in the tech sector due in large part to Apple's decision to give iPhone customers free "once in a blue moon" software updates rather than having them pay a $10.00 nominal fee. Who would have thought that a simple decision to waive a small $10 fee would cause so much destruction to shareholder value and billions in losses in market capitalization? Apple should have determined that analysts would simply be too stupid to give their investors a full and accurate picture of Apple's true fundamentals. But that is neither here nor there. The table below lays out what almost no analyst has dared to show their clients regarding the reality of Apple's earnings results in 2008. The method used for determining adjusted earnings is relatively simple and straight forward, and could be found here for those who are interested in the inane details. The table below lays out the adjusted earnings results for each of Apple's fiscal quarters in 2008, which includes full revenue and earning recognition for sales of the iPhone and Apple TV.

Table 1: Breakdown of Apple, Inc., Non-GAAP Adjusted Earnings for FYE 2008

 

Q1 2008

Q2 2008

Q3 2008

Q4 2008

FYE 2008

Revenue

$10,802

$8,005

$7,552

$11,682

$38,041

Cost of Goods Sold

$6,859

$5,283

$4,917

$7,131

$24,190

Gross Margin

$3,943

$2,722

$2,635

$4,551

$13,851

Operating Expenses

$1,206

$1,159

$1,208

$1,297

$4,870

Operating Income

$2,737

$1,563

$1,427

$3,254

$8,981

OI&E

$200

$162

$118

$140

$620

Net, Before Taxes

$2,937

$1,725

$1,545

$3,394

$9,601

Taxes

$941

$505

$448

$957

$2,851

Net Income

$1,996

$1,220

$1,097

$2,437

$6,750

Earnings Per Share

$2.22

$1.36

$1.21

$2.69

$7.48

Diluted Shares

900,054

899,329

903,167

904,786

902,406

Table 2 (below) lays out just how much of a difference the subscription method of accounting had on Apple's financial results by comparing Non-GAAP earnings (which includes full recognition of revenue from sales of the iPhone) with GAAP-based earnings results which employs the deferred revenue mechanism of subscription accounting). There are a couple of key points that investors should take away from analyzing this comparison. First, that Apple didn't record nearly 14.6% of the revenue it actually received from sales of the iPhone throughout 2008. In fact, for each quarter in 2008, Apple reported an average of $1.391 billion less in revenue than it should have reported but for the obtuse and unrealistic requirements of the Generally Accepted (Asinine) Accounting Principles (GAAP).

Secondly, one should also notice how Apple reported $2.12 or 28.4% less in EPS than what it actually earned in the "real world." This is particularly troubling because Apple's trialing P/E reflects a much higher multiple than what reality dictates. On a GAAP "fantasy" basis, Apple is trading at 17.19 times 2008 GAAP-based earnings. Yet, under adjusted-earnings, which contemplates actual "reality," Apple is currently trading 12.31 times last year's earnings. GAAP accounting principles actually makes Apple's stock price appear significantly less attractive from a valuation perspective than it actually is.

Thirdly, one should notice how Apple reported 30.1% less in Operating Income than what it actually earned. This means that Apple is reporting only two-thirds (2/3) of the actual results from its primary operating activities. Operating Income is supposed to be a reflection of the health of Apple's core business. OI&E, the tax rate, and diluted shares are malleable from one quarter to the next. But operating income tells the investor how Apple's business is really doing. EPS is for show, while operating income is for the serious analyst. I have to question an accounting measure that requires a company to simply "leave out" 30% of its primary business from earnings reports because that company decides to give its customers a "once in a blue moon" free $10.00 software update. I thought Sarbanes-Oxley and the accounting measures imposed after Enron were suppose to makes companies more transparent, not less!

Table 2: 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

-

Table 3 below compares 2008 adjusted earnings with 2007 adjusted earnings, which is useful in analyzing the various trends in Apple's growth rate. Since Apple started selling the iPhone in the final days of fiscal Q3 2007, adjustments to Q3 and Q4 of 2007 were necessary to make the data comparable from one period to the next. It would be silly to compare 2008 Adjusted Earnings with 2007 GAAP based earnings. The methods used in making the adjustments from GAAP to Non-GAAP earnings can be found here.

Right away, one ought to notice the staggering growth rate in both revenue and earnings that Apple displayed in 2008. Apple's real revenue grew 54.5% from $24.637 billion in FYE 2007 to $38.041 billion in FYE 2008 – a full $13.4 billion growth in revenues. Even more impressive is Apple's 81.2% growth rate in adjusted net income. For a company that is trading at 12 times 2008 earnings, it doesn't take a genius to conclude that Apple is severely undervalued. Especially since Apple currently trades at about 3.37 times its cash position – which is objectively and significantly lower than every other large cap tech company.

Google (GOOG) trades at 7.18 times its cash position, Research in Motion (RIMM) at 15.51 times cash, Amazon (AMZN) at 9.15 times cash, Microsoft (MSFT) at 9.13 times cash, Cisco (CSCO) at 3.62 times cash, IBM at 10.96 times cash, Intel (INTC) at 6.54 times cash, and Hewlett-Packard (HPQ) at 5.15 times cash. What is more, only GOOG, AAPL and MSFT have no debt of the companies mentioned above. Apple has the largest net cash position than any of those companies and Apple has more net cash than RIMM, GOOG, AMZN and IBM combined.

I will take up the issue of valuation later on this week where I'll give a comprehensive analysis of several large cap tech companies. Preliminary research indicates that Apple is extensively more undervalued than every other large cap tech company at current levels and this is due almost exclusively to the subscription method of accounting. In order for Apple to be trading at the same current valuation as GOOG, RIMM, AMZN, MSFT, CSCO and IBM, Apple would have to be trading at $206.25 – and that's after this current correction in the market place.

The fact of the matter is, Wall Street never valued Apple properly prior to the beginning of this bear market. Apple should have been trading at $300 before this recent downturn and even after this excessive sell-off, Apple should be trading at $158.92 at current S&P levels. I leave it to my readers to make their inferences about where Apple might be headed in 2009 and 2010. Much more to follow.

Table 3: Comparison between 2008 Adjusted Earnings and 2007 Adjusted Earnings

 

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%

Disclosure: Long AAPL, GOOG, and RIMM.

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This article has 25 comments:

  •  
    Oct 28 01:57 PM
    These calls for fundamental analysis showing the ridiculously low valuation for Apple will go unheeded until there is more clarity about the macro picture. Until then the stock is held hostage by mutual and hedge fund liquidations. Provides a great longer term investment but it seems like no one cares for now.
    Reply | Link to Comment
  •  
    Oct 28 02:11 PM
    ... apple cooks the books! C'mon people, no real company could be doing this well in this economy!
    Reply | Link to Comment
  •  
    Oct 28 02:12 PM
    You just made one part of the case for why Wall Street is currently undergoing the biggest transformation in its history. The investment banks, and especially the analysts, are seeing just how replaceable they are.

    The analysts have held a level of power that is at odds with their competence. Are you trying to tell me that a star analyst, with a staff of a dozen people and a fat budget, cannot design market research and financial models that uncover the unique truth about Apple's business case? Or are they just too lazy or backward-looking that they don't recognize the changing landscape? In either case, why are they paid to destroy value for Apple shareholders, unless there is big profit for the shorts?

    At some point the stars will align and Apple will be fairly valued. Until then, keep up the good articles Andy.
    Reply | Link to Comment
  •  
    Oct 28 02:14 PM
    Yeah, Apple cooks the books. And every Mac user at the cafe, jogger with the iPod, or person talking on their iPhone is a corporate shill. Good one Steve!

    I love this company!
    Reply | Link to Comment
  •  
    Oct 28 02:21 PM
    The voice of one crying in the wilderness!!

    As I am sure you are aware - there are many readers of the Apple financial blogs (my self included) who have also been trying to point this out for a long time.

    Thanks for the dedicated financial analysis.
    Reply | Link to Comment
  •  
    Oct 28 02:32 PM
    Here's the problem. The stock market has ALWAYS come down to what P/E ratio are people willing to buy? In this market, it seems people are only willing to buy PE ratios of 10-15. In a normal market, 15-25 is the usual number. So until investors are willing to buy higher P/E ratios, Apple stock is stuck. The good news is that the stock will skyrocket very quickly once the mindset changes.

    see:

    www.comstockfunds.com/...
    Reply | Link to Comment
  •  
    Oct 28 02:32 PM
    Here's the problem. The stock market has ALWAYS come down to what P/E ratio are people willing to buy? In this market, it seems people are only willing to buy PE ratios of 10-15. In a normal market, 15-25 is the usual number. So until investors are willing to buy higher P/E ratios, Apple stock is stuck. The good news is that the stock will skyrocket very quickly once the mindset changes.

    see:

    www.comstockfunds.com/...
    Reply | Link to Comment
  •  
    Oct 28 02:58 PM
    Unfortunateley, there is a lot of BIG money out there that does not want to hear or accept this evidence. I mean hedgefunds! Hedge funds dont want to be found out selling off a mid term ATM machine like aapl for
    their investors and having known it. Hence my suspicion of a cabal among certain analysts and funds. Even worse than lazy bottom of the s**t heap quality that you mentioned.
    I find it hard to separate big funds connected to big banks connected to analysts. I think it's nieve to think that there's a kind of neutral journalist like tradition among them. Hedge funds need to liquidate NOW, and aapl still has juice to squeeze. That kind of Hedge power out there is the real GA(A)P in reality right now. Strong enough to make analysts say strange things.
    Until we see another bootom take shape and wipe out a majority of hedgefunds -who have been steering aapl for over a year now - though i think there will continue to be a tragic disparity between aapl and Apple Inc.
    Reply | Link to Comment
  •  
    Oct 28 03:11 PM
    Again, good stuff, Andy.
    Reply | Link to Comment
  •  
    Oct 28 03:43 PM
    Amen brother. Andy, I hope you stick around. Nice to have someone who doesn't talk out of both sides of their mouth. Keep screaming this stuff from the mountaintops. That said, I think a lot of the comments here are correct though - corruption is rampant on wall street. It's the reality, but it's not right, and it's not sustainable. Fortunately, it appears that regulators might be opening thier eyes to this underhanded crap that's been going on in the markets for the last couple years (a lot longer I know, but the last 2 years have been ridiculous). When a market is dominated by traders rather than investors, and those traders are connected to the media, it's not a market, it's a scam. If this kind of activity keeps up, there will be no market. Fortunately, that's not an option, so something tells me that analysts and "wall street journalists" are going the way of the dodo bird (or at least they will become a lot less influential over the market). They nailed Blodget to the cross for saying "let's put some lipstick on this pig" 10 years ago - they will do the same for the manipulators on the downside this time around as well.
    Reply | Link to Comment
  •  
    Oct 28 04:36 PM
    Hi Andy - Thanks again for the analysis and the clever swipes at analysts - you're preaching to the choir in my case.

    One thing that should be pointed out is that while revenue is recognized using the subscription model, over 8 quarters, the cash from iPhone sales hits the Apple balance sheet IMMEDIATELY. You have pointed this out in previous articles but it's always worth reiterating. That is why Apple posted a net increase of $3.8 Billion in the Q4 just ending, if I did the math correctly. Their cash and short term investments ended Q4 at $24.5 billion. Sweet!

    To paraphrase Fake Steve, this iPhone is a cash gusher the likes of which the planet has not seen. fakesteve.blogspot.com...
    Reply | Link to Comment
  •  
    Oct 28 04:42 PM
    Sooner or later the analysts will see the forest through the trees. At that point the real valuation for apple will be played out for all the longs (and the shorts hahaha). One thing that bothers me though, in light of the recent decay in stock price, and the significant cash position apple has, why isn't APPLE BUYING AAPL? If they spent $10 billion of the $24+ billion in the bank and bought apple over the next several months even paying $100 a share (which was a premium up till i started typing) apple could reduce the float by almost 100 mil shares or more then 10%. Doesn't sound like a bad thing if you think the stock is going to rebound to the extent talked about.
    Reply | Link to Comment
  •  
    Oct 28 05:09 PM
    Andy, once again, brilliant!
    Reply | Link to Comment
  •  
    Oct 28 05:42 PM
    Most companies grow in earnings and price with growth in the economy and the population served. An earnings per share model is a reasonable estimate of comparative value for such companies. However there are companies such as Apple that don't fit in this category. Look for these outliers and you will do well in the market.
    Years ago my dad told me if you are in a poker game and you notice someone cheating, politely cash in your chips and leave the game. Good advice in the current market until the rules are changed.
    Reply | Link to Comment
  •  
    Oct 28 06:29 PM
    Hi Andy,I hope you can endure long in this website,I like to express mi congratulations for the excellent job that you did with your recent analysis on apple earnings,you really make outstanding job,moreover Wall Street analysis where so out of range,that don't deserve any credibility.
    Reply | Link to Comment
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