Are Apple's Economic Reassurances Believable?
News Analysis. Apple CEO Steve Jobs turned on his famed "reality distortion field" during the Oct. 21 fiscal fourth-quarter earnings call. His performance reminds me of a story. |
My uncle tells the story of a Houlton, Maine, bank that survived the runs that closed countless institutions during the Great Depression.
Mainers are known for their cunning and ingenuity, which the one bank manager demonstrated with gusto. He placed security guards outside the main window, which he filled with stacks of 100-dollar bills. People could walk up to the bank and see their money, know that it was safe. The tactic prevented the kind of run that closed most other banks in Maine during the early 1930s.
Of course, nobody would really stack thousands of dollars in a bank window. The bills were ones in denomination with hundreds only on top. The bank manager only needed to create the perception that people's money was safe, which it probably was as long as they believed it so. Their disbelief would have led to a run that would have eventually closed the institution and taken their savings with it.
The positive-perception-making tactic probably allowed the bank to profit from its competitors' misfortune. My uncle claims that only one other Maine bank survived the Depression. Those two banks built up new business from the wreckage of others. The Houlton bank is located about 50 miles from my hometown.
All this assumes that my uncle wasn't repeating some urban legend—folklore spread around the state and farther. But the story is good, nonetheless, and it's an appropriate allegory for Steve's unexpected participation in yesterday's Apple earnings conference call.
Dividing by the fear factor.
Everything about yesterday's conference call was about managing perceptions, acknowledging that tough, uncertain economic times are ahead but the bank won't close.
Fiscal responsibility and U.S. Securities and Exchange Commission rules compelled Apple Chief Financial Officer Peter Oppenheimer to give muted guidance. Apple forecast for its 2009 fiscal first quarter $9 billion to $10 billion in revenue and earnings per share between $1.06 and $1.35. Margins could drop from 34.7 percent in the fourth quarter to between 30 and 31 percent in the first quarter. That's unusually broad guidance for any company. It bodes uncertainty about what's ahead, so the company put forth a show of strength, which the CEO also conveyed.
But there was some misdirection during the conference call, too. Not deception, just something akin to putting hundred-dollar bills on stacks of ones and placing them in the bank window. Here's how Apple massaged perceptions:
Non-GAAP accounting. This is about as close as it gets to those stacks of bills in the bank window. Apple has done something not typical for a public company: announce separate earnings that include subscription revenue. Based on GAAP (Generally Accepted Accounting Principles), companies defer subscription revenue. Because services are delivered over time, their revenue is realized by X percentage every quarter. Microsoft has done this for years because of annuity volume-licensing contracts. Microsoft states the total unearned revenue and how much more was gained each quarter.
Yesterday, Apple stated revenue and income as it should, but then offered a separate number with the included deferred revenue and income. That's the stack of money in the bank window. Apple quarterly revenue reached $7.895 billion, with $1.14 billion net profit or $1.26 earnings per share. The non-GAAP adjusted revenue would be $11.68 billion and adjusted net income $2.44 billion. The figure includes $4.6 billion deferred revenue from iPhone 3G.
During the conference call, Steve said the non-GAAP results "eliminate the impact of subscription accounting." That's a helluva understatement. "Subscription accounting is the solution we adopted to let us provide free software updates to iPhone users under GAAP accounting rules." Following GAAP rules, Apple will realize iPhone revenue over a period of two years.
"As long as our iPhone business was small relative to our Mac and music businesses, this didn't really matter much," Steve continued. During the quarter, the iPhone grew to be "39 percent of Apple's total business, clearly too big for Apple managers or investors to ignore," he asserted.
Steve described the non-GAAP results as "truly stunning." Right, so were those stacks of bills in the Houlton bank. They're called "accounting principles" for a reason. The non-GAAP stacks up Apple revenue—those bills in the bank windows—48 percent higher than the real reported revenue.
There is some small justification to Apple reporting non-GAAP revenue and income: comparison with other mobile phone manufacturers. For example, Nokia reports non-IFRS (International Financial Reporting Standards) results. The significance should be apparent in a few paragraphs. Read on.
Apple beats RIM. For the partial fiscal fourth quarter, from July 11, Apple sold 6.9 million iPhones. It's a stunning number. Earlier in October, there was wild speculation that Apple had sold as many as 9 million iPhones in the quarter—adjusted for inventory—down to 7.6 million. I estimated 6.3 million, which was slightly closer to the real number.
"Apple beat RIM," Steve exclaimed, referring to Research In Motion. In the second quarter, RIM was second to Nokia in smart-phone shipments, according to Gartner. Steve observed that during its "most recent quarter" RIM "reported selling 6.1 million BlackBerry devices. Compared to our most recent quarter's sales of 6.9 million iPhones, Apple outsold RIM last quarter." But comparison is inexact. For good reasons, analysts compare calendar quarters. RIM announced fiscal second-quarter results on Sept. 25. So the comparison isn't for the same time period.
Now Steve probably is right that for third calendar quarter, Apple shipped more iPhones than RIM did BlackBerrys. I did my own analysis, based on Gartner quarterly data, in mid-September. I generously assumed that 7 million BlackBerrys would ship during the quarter (my expectation then and now is more like 6.5 million). Such a feat would place Apple in the No. 2 spot for smart-phone device and operating system shipments.
But no matter what happens with RIM, Apple beat Microsoft. In second quarter, Windows Mobile ranked third for smart-phone operating system shipments with 3.8 million units. Apple has pushed Microsoft to either third or fourth place. During yesterday's conference call, Steve described RIM as a "good company." He didn't acknowledge Microsoft.
Steve wasn't done touting the iPhone. "Measured by revenues, Apple has become the world's third largest mobile phone supplier. I know this sounds crazy, but it's truly [the case]." Yeah, absolutely nuts, Steve. According to Steve, Nokia's revenue was $12.7 billion; Samsung, $5.9 billion; Apple, $4.6 billion; and Sony Ericsson, $4.2 billion. Steve couldn't have made this comparison, or third-place assertion, using GAAP results.
The mobile platform. Steve took some time to tout the iPhone App Store, and for good reason. App Store is the iPhone's killer application, but on Oct. 22 Google launched the rival Android Marketplace with official release of the T-Mobile G1 smart phone.
Yesterday, Steve said the 200 millionth application would be downloaded today. Some 5,500 applications are available through App Store. "We are far along in creating the virtuous cycle of cool applications begetting more iPhone sales, thereby creating an even larger market, which will attract even more iPhone software development," he said.
This statement is hugely boastful but important. All successful platforms must achieve this virtuous cycle, where there are enough users to justify third-party commitment, which in turn generates more users—then the cycle repeats like a perpetual motion machine. Windows is by far the best example of this cycle in action.
Steve's presentation emphasized the importance of iPhone and its future success, even as the company, like so many others, stands on the precipice of economic gloom. The insinuation: The iPhone will carry Apple through, even if Mac sales slow.
iPod's great non-holiday quarter. Apple sold 11.052 million iPods in what the company claimed as its best non-holiday quarterly results. Sounds good, right? But Apple sold 11.011 million iPods in the previous quarter. Nearly identical sequential sales are good, but not as great as insinuated by Apple. During both quarters, Apple ran its annual back-to-school promotion, where students got a free iPod Nano with purchase of a new Mac.
"In the final weeks of September and the early weeks of October, we were running flat year over year on a worldwide perspective," Tim Cook, Apple's chief operating officer, said in the conference call. That change could as easily be the end of the promotion as the economic gloom, which came about the same time. The economic slowdown could foreshadow slower gadget sales ahead, particularly to someone considering an iPod or iPhone.
What about the economy? Steve dismissed the gloomy macroeconomy the way someone might pull a torn fingernail. "We are not economists," Steve quipped. "Your next-door neighbor likely can predict what is going to happen as accurately as we can." Really, now. Maybe that explains the prices of the new MacBooks, which are audaciously higher than their predecessors.
Steve turned around the subject of larger economic woes and the credit crunch by bragging that Apple had $25 billion in the bank and no debt. That's more cash than Microsoft, last time I checked.
"This downturn may also present some extraordinary opportunities for companies that have the cash to take advantage of them like Apple does," Steve claimed. The insinuation: Apple may acquire some companies or technologies on the cheap.
In its fiscal 2008 first quarter, Apple reported revenue of $9.6 billion and net quarterly profit of $1.58 billion, or $1.76 earnings per share. Assuming Apple revenues fell between fiscal 2009 first-quarter projections, Apple is at best looking at flat year-over-year growth.
"There's a lot of prudence in there," Steve said of Apple's first-quarter guidance. "But it's also October, and October has always been a little bit of a foggy month for us. We're always biting our nails wondering whether we ordered too many iPods or this or that for the holiday quarter because sales often don't really take off until November sometime."
The prudence doesn't stop with guidance. Apple started and ended the fourth quarter with between three and four weeks of inventory, which is about a week less than is typical. I read that as Apple protecting itself against slow holiday sales. No company wants to exit the holidays with lots of unsold inventory. There is risk. Apple would be more exposed than, say, Microsoft should consumers close up their wallets for the holidays.
Steve imbued confidence, which is what he should do as chief executive—be a leader. "We may get buffeted around by the waves a little bit, but we'll be fine and stronger than ever when the waters calm in the future."
[Please send your tips or rumors to watchtips at gmail.com.]
Comments (10)
Perhaps you should rename your column to "Apple Envy".
Posted by joe the envious | October 23, 2008 8:22 AM
Are Apple's Economic Reassurances Believable? Excellent question, I hope you aren't expecting an answer. That question can't be answered until we find an answer to you last question: What about the economy? The fudsters will have a field day with that one.
My take is that the Mac numbers weren't as good as they have been in recent quarters. Still ahead of the industry, but not as good as they have been. I've been tracking PC shipments for a while and have compiled a google spreadsheet, but the eWeek police rejected the post that included that link. The truly remarkable number to me was the blowout quarter that Acer had.
Is this something Apple needs to worry about? I don't know. They've been using this three legged stool analogy for their business; Mac, iPod, iPhone. I thought they were using it to show that the maturing iPod market was not a serious problem. Perhaps the Macintosh is reaching the same status, hence the focus on the iPhone.
The true value of the iPhone depends on how you measure it, GAAP, or non-GAAP. Subscription accounting is new to Apple. I'm sure there is some sentiment within Apple that is thinking, hey, we sold all those phones, is this all we get credit for? The difference between $7 billion and $11 billion is huge, unless of course, you're the government. Down the road it will act as a free lunch, but for the moment, it's gotta hurt.
Let me end with a twist. Acer's success has been attributed to their early entry into the netbook market. Apple disappointed many by not announcing a cheap notebook last week. At the earnings anouncement this week, Steve Jobs said, "We don't know how to make a $500 computer that's not a piece of junk, and our DNA will not let us ship that". What if you consider the iPhone a netbook? That changes everything. And I need to start tracking revenue in addition to units. This is not black and white, it is shades of grey.
P.S. I was going to include the link in the spreadsheet dot google dot com format, but I don't want to make waves. Can someone at eWeek explain why this link was rejected? I have seen others.
Posted by Dave Lindhout | October 23, 2008 9:08 AM
Interesting analysis J.W. The reporting of "non-GAAP results" stuck me as being a bit fraudulent, for lack of a better term.
Posted by JohnJ | October 23, 2008 10:16 AM
The "non-GAAP" results were given because none of the rest of Apple's business is accounted for as subscriptions, including the ipod touch. It allows people to gauge how much of Apple's business is in the iphone.
Yes there is risk, there always is. But a company with zero debt, $25B in cash, high profitability, and popular products is well placed to ride out the storm.
Posted by Jim Stead | October 23, 2008 10:42 AM
I think the analogy to the stacks of bills is faulty.
The difference is that Apple actually received the cash, they just are going to report it coming in over the following quarters. Banks don't have the cash on hand that they represent, while Apple does have the cash that it can not represent.
I think the larger question is can Apple sustain the level of iPhone sales that they had in this quarter. There was a lot of pent up demand since iPhone stocks had dwindled through the Spring so they had a burst of sales right out of the gate.
Next quarter will have an asterisk as well because of holiday time.
The quarter to watch will be their 3rd, Jan-Mar '09.
Posted by Alan | October 23, 2008 4:26 PM
Talking about stacking bills in the window:
1. Apple continues to use GAAP reporting. A business segment using subscription accounting is rapidly growing and evolving the company's cashflow so the company, which rarely gives up the smallest details, is providing an alternative picture: a datapoint for comparison. Evil.
2. Will RIM beat Apple in some quarters over the next couple of years? Maybe. But the question reminds me when Apple surpassed WalMart in music retail-- Apple reported it as quarterly and likely temporary, and everyone said it was a blip. Not anymore.
Microsoft hopes to grow annual shipments of 16-19 million now by 10 percent over the next few years. RIM can grow somewhat aggressively from 18-22 million annually for several years. Apple is easily capable of jumping from 12-14 million into the 20s and much higher in one year. Some analysts estimate 30-45 million. In a year, it will be easy to see Apple as the third or second largest phone supplier.
3. You're comparing consecutive quarters for Apple? ... for Apple? Seriously, Apple?
Apple's fiscal Q4 used to be strong for Macs because of annual educational contract purchases. Apple is resurging in education again, but with teenagers buying computers at home for college, not so much K-12 contracts. A good thing really. But Q4 is always the low point for seasonal iTunes, iPod, and iPhone sales. Not only is it a low point but Apple's media and consumer electronics products are usually sequentially flat from Q3 and Q4. Featuring a huge holiday surge, followed by a post-holiday bump, beginning-of-the-year and spring product releases, and price reductions. Comparing sequential quarters? Sequential?
4. How is saying they cannot predict the economy, that they are preparing for the worst, and are being overly prudent pretending or ignoring the economy? And how can you not see Apple as extremely well prepared for a recession: no debt, more cash than anybody but MSFT and ORCL and a couple others (by the way, at least 5 of those bills aren't cash; it's unrealized revenue that will be accounted over 2 years -- maybe you could use some non_GAAP-type reporting figures to help you out)... They can BUY all ut one competitor out of pocket: they could buy Adobe, or a NAND manufacturer, RIM, etc... and they don't even want to.
Uncles teach interesting lessons, but they're all a little shady.
Posted by Tim F. | October 23, 2008 8:20 PM
About that Maine bank, would that be the one Andy Dufresne ran?
About Gross Margins: Oppenheimer only repeated the numbers from last quarter, when he talked about the "product transition" pushing GMs down to 30-31% in FY2009. There was NO reference to macroeconomic pressures. If there were, it would have been reflected in sales, not GMs.
About, Calendar Years. It's not Apple's fault that RIM has an oddball calendar year, ending their quarter in August. They'll always be out of sync with the rest of the companies in the world. Reading your comment, it seems to me that perhaps you don't realize that there WAS a 2-month overlap in Steve's comparison. Apple has a traditional July to Sep quarter, while RIM has the odd June to August quarter. Have you been getting it wrong all this time, or is that Gartner's fault?
About acknowledging MS, Steve referred to handset mfrs. MS does not mfr handsets. I'm getting the feeling that you sense Steve prevaricating. So, far, of your three points, none of that was the case. I think you are looking for something that doesn't exist. You do realize that Steve is legally responsible for what he says in these conference calls?
Using the GAAP results would have made a NONSENSICAL comparison. Apples to oranges. What would you have Steve do?
Yep Google launched its Marketplace with 13 apps; while Apple has over 5000.
About the Nano, if so many of the 11M were "free", then why were GMs so high at 34.8%? Joe, when are you going to make some sense?
About the macroeconomy: if you follow Steve and Oppenheimer, it has been a mantra of theirs to state that they are not economists, and that they make no predictions of where it's going. This was routine, boilerplate.
Wow, you had an angle, and you stuck to it. I'll give you that. Unfortunately, I have to disagree with your premise. You think Steve was on the CC to spin away any doom or macroeconomic gloom.
I think Steve was on the conference call because he's frustrated that analysts don't understand deferred revenues, and that's why he spent so much time explaining non-GAAP numbers. Look at their press release, it's mostly about non-GAAP.
While you have it in your head, that this is somehow wrong. What you don't understand is that up to now, since the iPhone's debut, analysts have been comparing Apple's revenues and income from pre-deferred quarters, to post-deferred quarters. A total apples to oranges comparison.
You know Apple could get rid of subscription accounting, and report $11.7B in sales, $2.4B in profit, and $2.69 in eps. All they have to do is charge $5 every time they add a feature to the iPhone. Would that make you happy? Recall Apple took alot of grief for charging $2 to enable wifi-N on Macbooks and MBPs. They decided to use subscription accounting instead to avoid these $2 charges. The upshot is that dumb analysts were not clued into Apple's TRUE sales and profits per quarter.
I ran my own analysis this year, and calculated that last Xmas Apple sold $10.5B, but reported $9.6B. That's a HUGE difference, and yet not one analyst made any comment upon deferred revenues. Those are REAL sales, not some fabrication. That money is in the bank, have you even looked at the free-cash flow? Talk to a financial expert, because you are really barking up the wrong tree with your notion that non-GAAP info is somehow obfuscating the true picture, when in fact it's the exact opposite. It's an attempt to bring some clarity to the less-than-sharp analysts.
Posted by KenC | October 24, 2008 1:39 AM
Joe, usually I agree with what you've written, but for some reason, we're on a different page today. BTW, I'm from Maine.
I re-read what you wrote, and now I get the sense that perhaps, when you saw Steve spell out the non-GAAP figures which look at Apple's figures without subscription accounting, were you thinking he took all the prior deferred revenue from the last year, and lumped it into the $11.7B?!? Because, that would be outrageous, and that would make sense for why you seem to think this is about putting $100ss on sacks of dollars. If that is what you think, then let me tell you, that's NOT what Steve did. He only counted those sales from this past quarter. Prior deferrals from previous quarters were NOT included in the $11.7B. Steve just spelled out, this past quarter's TRUE sales, as if he were selling iPods and not iPhones. This is the way 95% of companies would report sales and earnings. What Apple is doing, using subscription accounting is the oddity.
Posted by KenC | October 24, 2008 1:53 AM
I hate to add another comment, but it occurred to me that the problem here, is the transition from one form of accounting to another. After 8 quarters, subscription accounting will tend to smooth out revenue streams. The GAAP figures will converge with the non-GAAP. The problem is that in the transition, if analysts are not sharp, they will underreport a company's true sales and profits. That's what Apple is addressing.
Posted by KenC | October 24, 2008 1:57 AM
You can give this a negative spin by making it akin to "stacking bills in the window," but it seemed as though every quarter, the so-called "analysts" were asking the same questions about how Apple accounts for it's iPhone revenue, and Tim and Peter would go to great lengths to explain it, and next quarter they'd ask the same questions again, and Apple would give out the same answers, ad infinitum. I think they finally said hey, since this seems to be going over their heads every quarter, lets give out some theoretical numbers that are simple enough for them to digest.
And no, there was nothing said during the conference call which should be applied to an explanation of the "audaciously higher" cost of the Macbook. You get a tremendous upgrade in build-quality and features for what used to be the price of the mid-range (and most popular) plastic Macbook model, and yet you feel that the price requires some sort of justification. They even left the intro level model on the market at a lower entry point to satisfy the price screamers and that still is not good enough for you. Jobs reiterated something during the call and I'm very glad every time he does so, because no one ever seems to hear him: they do not choose to compete in the sub-$1000.00 market.
When a company continues to demonstrate that their chosen business model is very successful for them, why do you insist upon questioning how they operate that model or how they measure that success? How many more stories will we see about why they should license OS X to third parties, or why they don't sell $400 laptops? Give it a rest.
Posted by Steven | October 24, 2008 5:37 AM