Deferred earnings: Apple’s hidden revenue bonus
Last July, Apple (AAPL) announced that revenue from the iPhone would be recorded in an unusual way. Like Apple Care and Apple TV, iPhone sales would not be booked when the device was sold — as they are for a Mac or an iPod — but spread out over the life of the iPhone (set, somewhat arbitrarily, at two years).
More than seven months have passed and nobody — not the analysts, not the investors, and certainly not Wall Street — has quite wrapped their mind around what this bookkeeping oddity means for Apple’s bottom line. That’s in part because it’s complicated, and in part because Apple hasn’t provided all the data you would need to fully assess its impact.
But as we enter the fourth quarter of iPhone sales, those so-called deferred earnings are adding up, and some professional Apple watchers are starting to realize that their impact could be substantial. In fact, if the company hits its iPhone sales targets, these earnings could become a windfall — a revenue bomb that explodes to the benefit of shareholders.
The rules by which Apple records revenue from iPhone sales are spelled out in the 10-Q filed with the SEC on Aug. 8, 2007:
The Company began shipping Apple TV in March 2007 and iPhone in June 2007. For both Apple TV and iPhone, the Company may provide future unspecified features and additional software products free of charge to customers. Therefore, sales of Apple TV and iPhone handsets are recognized under subscription accounting in accordance with Statement of Position (“SOP”) No. 97-2. The Company recognizes the associated revenue and cost of goods sold on a straight-line basis over the currently-estimated 24-month economic lives of these products. Costs incurred by the Company for engineering, sales, and marketing are expensed as incurred. (link)
Sounds straightforward enough. But because of the way Apple reports its earnings and its costs of goods sold, it’s not so easy to track. And to the dismay of Apple shareholders, the fact that these deferred earnings are piling up seems to have gone right over the heads of the institutional investors who have driven Apple shares down nearly 75 points since December.
One Apple investor who has been beating the deferred revenue drum is Stephen Rosenmen at Seeking Alpha. He’s published three articles on the subject since Apple’s Q1 earnings report, including one posted today in which he takes a stab at estimating how big Apple’s hidden revenue backlog has grown:
To date these deferred revenues have become substantial: current quarter revenue deferred iPhones and iTV (Apple doesn’t separate the two) are $816 million with a total of accumulated deferred revenues of $816 million + $624 million, or 1.4 billion dollars in future revenues to be spread out over approximately the next 7 quarters. That doesn’t include the rest of the also substantial AppleCare and other deferred revenues which together with the iPhone/iTV create a total deferred revenue base of 3.288 billion. (link)
As Rosenmen points out, those $3 billion and change are not going away. They are like backordered Boeing jets or offshore oil reserves — the equivalent of money in the bank. Moreover, the quarterly revenue from iPhone reserves climbs exponentially as iPhone sales grow — each quarterly payment consisting of 1/8 of that quarter’s revenue plus 1/8 of the revenue of each of the previous seven quarters.
The participants at The Mac Observer’s Apple Finance Board have been harping on this theme for weeks now, none more vehemently than the investor who calls himself Dawn Trader. He’s looking for the bomb to explode in eight or nine quarters:
As we move into the latter quarters of FY 2010, even assuming modest growth in unit sales, the iPhone may be delivering as much as $1.00 eps per quarter from current and deferred revenue recognition not including the monthly service revenue from AT&T.
Below the fold, Rosenman’s chart showing the growth of deferred revenues over the past five quarters (the exclamation points are his):
I agree with Dave - those analysts are so dumb! Only 93% of analysts covering AAPL do so with a Buy rating, and the average price target is just over $200. I assume Dave from TX is not making the big bucks. Deferred revs is a topic everyone on Wall Street except Dave already knows about. Its taught in entry level financial accounting and is a topic on the lowest level of the CFA exam. Conspiricists should look at Time Warner (TWX), where mgt arbitrarily recognizes revenue from magazine subscriptions over (gasp) the 12 months of a subscription. Extra knowledge for the kiddies: deferred revenues are accounted for as a liability, so as they are recognized on the income statement as revenues, the company’s balance sheet magically de-levers!
So beyond 8qtrs this does not matter? Why was no analysts, real analysts, contacted for comment on this? Better hope that they sell a boat load of these 2 items and don’t ramp up add-ons, upgrades, patches, fixes or what ever. Or that revenue will not turn into profit.
I’ve been pointing this out on Google’s msg board, MDN, and Rosenman’s blog, that the analysts don’t get it. If, they did, they wouldn’t compare last year’s revenue number to this year’s, without mentioning the deferred revenue number. Otherwise, they’re comparing apples to oranges. I figured Apple’s revenue figure for last quarter was not $9.6B but in fact, $10.5B if you included the deferred sales. That was a blowout, but the analysts were too stupid to notice.
This deferred revenue is one of the main reasons I’m so excited about Apple’s future and why Steve Jobs is not worried about earnings anytime soon. When he’s asked about alll the negative news articles, he shrugs as if to say”if they don’t get it, I not going to explain it to them”
The deferred revenue is like a big snowball going down the mountain…it keeps getting bigger as the base stays intact and it keeps growing expotentially as time goes on.
Iphone reported by several outfits to cost $220 so about $180 profit per + $15 per month ATT 180+15(24)=540/24 = $22.5 per unit per month * 14 mil on market at 1/1/09 = $315(3) =$945 mil per qtr PROFIT - close to $1 per share
in 2009 not incl. atv,aplcre etc.. look for $2-3 per in 2010?
BTW MBA is the best selling Mac on the Apple website now
By the time FY10 comes along…. won’t all the deferred revenue for iPhones and contracts already have run its course? (revenue is defered over 24 months).
any bomb that gets dropped by then is based on product sold late this year and next year.
I am not a business school grad. But you guys are just now figuring this out? They announced this when the iPhone came out. Stock was at about $85 then… Went up briefly, day traders, etc… took profits and it settled back to about $87 before last year’s run up past $200.
It will surpass $200 again this year, easily. You all can’t wrap your head around the MB Air. Think it’s a ‘cube’? You have no clue, it’s the laptop of the future. Nobody uses the ports they left off. You think the iPod was a fad? If so, then you are wrong about that too.
The other link to not click is Seeking Alpha “under the radar news”. It seems a few people have figured that if AAPL shows up in their text, their hitcounts go way up. So every article now mentions AAPL, even if it is to say “no news on AAPL today - isn’t that strange?”
another recycled piece of news….
it is your fortune we still click on these .. the big question is why do we still click on Apple2.0 links ???
24 month subscription / contractual obligation / deferred revenue recognition…
Chris is partially correct. The term also has to do with the expected product life. The reason for the “subscription” accounting, though, is the Sarbanes-Oaxley law.
By the time these jokers, called analysts, figure out this gold mine that apple has, the stock will be over 200. They are too busy looking for missing Iphones in the jungles of Africa than doing their homework and their jobs! Apple should never have dropped this low but becuase most analysts are just plain dumb, they sold it off without having a clue as to why. That’s why they make the big bucks!
“…(set, somewhat arbitrarily, at two years)….”
Arbitrarily? Seems that it was set to the subscription plan of AT&T.
Ok, Ive learned my lesson.
Never click on the link for AAPL news if it says “Fortune” next to it. Got it.
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Silicon Valley veterans like to joke that Steve Jobs must be surrounded by a reality distortion field; if you get too close to him, you start to believe what he's saying. Thanks to the success of the iPod, the launch of the iPhone and the renewed interest in the Mac, Apple has made believers out of millions of customers - and made a lot of investors rich. But Philip Elmer-DeWitt believes that an ounce of skepticism never hurts when writing about the company. He should know. He's been covering Apple - and watching Steve Jobs operate - since 1982, first for Time Magazine, then for Business 2.0, and now for Fortune.
“As Rosenmen points out, those $3 billion and change are not going away. They are like backordered Boeing jets or offshore oil reserves — the equivalent of money in the bank.”
Nom, it is not like backordered Boeing jets.
A backorder means a product still needs to be delivered. In the case of the iPhone, there is nothing left for Apple to deliver.
Chris - CO