The Phone Company

Wednesday, 22 October 2008

For a long time — the entire decade of the ’90s and the first few years of this decade — the story of Apple was the story of a company searching for a way to be something other than “the Mac company”. From a financial perspective of revenue and profit, the Mac was Apple, and Apple was the Mac. This was problematic on two fronts. First, it was an “all of their eggs in one basket” scenario. If the Mac had sunk, the company would have gone under. Second, the potential for growth was severely limited by the fantastic success of Windows.

The iPod was Apple’s first breakthrough success after the Macintosh. During some quarters in recent years, iPod revenue has run even with or (in holiday quarters) exceeded Mac revenue. The iPod solved both of the problems Apple faced as “the Mac company”: its eggs were now divided between two baskets, and they’d entered a field with room for significant growth.

Last year, immediately after its debut, Steve Jobs began describing the iPhone as the third leg of the company. The numbers Apple released yesterday for its fourth quarter of financial year 2008 (July through September) back this up.

The main thing you must keep in mind regarding Apple’s reported numbers for the iPhone is that they’re using subscription-based accounting for it. When you buy a Mac or an iPod today, Apple reports the entire sale as revenue for this quarter. When you buy an iPhone today, however, Apple reports the revenue split evenly over eight quarters.

Apple’s interpretation of U.S. accounting regulations is that this is the only way they can provide free feature upgrades over the course of two years. That’s why iPhone OS 2.0 was a free update for existing iPhone owners, but a paid update for iPod Touch owners.

In the long run, Apple doesn’t make any more or less money from this. It’s just a method of accounting for the money they have made. (Indirectly, Apple clearly hopes that it helps sell additional iPhones, on the grounds that people enjoy getting “free” OS upgrades.) But in the short run, Apple’s iPhone revenue and profit are underrepresented in the company’s quarterly results — only one-eighth of the revenue from iPhones sold during the just-completed quarter appear in the quarter’s results. It also makes the iPhone numbers hard to compare against those of the Mac and iPod.

So, Apple is now providing two sets of quarterly numbers. First, GAAP results with subscription-based accounting for iPhones and Apple TV. (GAAP stands for Generally Accepted Accounting Principles.) Second, a new set of numbers — non-GAAP results — which, more or less, show what Apple’s quarterly numbers would look like if they weren’t using subscription-based accounting for the iPhone and Apple TV.

Here’s what Apple CFO Peter Oppenheimer said during his opening remarks of yesterday’s analyst conference call:

As we reported in our press release, iPhone unit sales grew significantly in the September quarter, resulting in a material increase in the amount of iPhone revenue and product costs that had been deferred for recognition in future periods. Specifically, deferred revenue from iPhone and Apple TV sales grew to $5.8 billion at the end of the September quarter, an increase of nearly $3.8 billion from the end of the June quarter. If iPhone revenue was not deferred, iPhone would have represented 39% of Apple’s revenue in the September quarter.

This means, I think, that Apple generated more revenue last quarter from iPhone sales than from either Mac or iPod sales. The iPhone, just 15 months old, is perhaps already the strongest of the company’s three legs. And it’s not like iPod or Mac sales are down — compared to the year-ago quarter, Mac sales are up 21 percent in terms of units and 17 percent in terms of revenue, and iPods are up 8 percent in units and 3 percent in revenue.

And in terms of the momentum of the iPhone OS as a platform, keep in mind that the iPod Touch is put on the books as an iPod, not an iPhone. (And Apple does not break those “iPod” numbers out into specific models; no one other than Apple’s top executives know exactly how many iPod Touches have been sold.)

Steve Jobs rarely appears on Apple’s quarterly analyst calls. I’m pretty sure you can count on one hand Jobs’s appearances on these calls over the last 10 years. Typically, Jobs has appeared when Apple has bad news to announce. (His appearance yesterday seems to have been about addressing Apple’s plans for weathering the current worldwide economic downturn.) Here’s what Jobs had to say in his prepared remarks regarding Apple’s revenue and profit from the iPhone:

As you can see, the non-GAAP financial results are truly stunning. By eliminating subscription accounting, adjusted sales for the quarter were $11.68 billion, 48% higher than the reported revenue of $7.9 billion, while adjusted income was $2.44 billion, 115% higher than the reported net income of $1.14 billion. Adjusted net income that is more than double our reported income — if this isn’t stunning, I don’t know what is, all due to the incredible success of the iPhone 3G.

I would like to now highlight two remarkable milestones resulting from iPhone’s outstanding performance last quarter. The first is that Apple beat RIM. In their most recent quarter, Research in Motion, or RIM, reported selling 6.1 million BlackBerry devices. Compared to our most recent quarter sales of 6.9 million iPhones, Apple outsold RIM last quarter and this is a milestone for us. RIM is a good company that makes good products and so it is surprising that after only 15 months in the market, we could outsell them in any quarter.

But even more remarkable is this — measured by revenues, Apple has become the world’s third-largest mobile phone supplier. I know this sounds crazy, but it’s true — as measured in revenues, not units, Apple has become the third largest mobile phone supplier. Let’s look at the ranking — Nokia is clearly number one at 12.7 billion; Samsung number two at 5.9 billion; Apple is number three at 4.6 billion; Sony Ericsson, number four at 4.2; LG, number five at 3.4 billion; Motorola, number six at 3.2; and RIM number seven at 2.1. Pretty amazing.

So, last quarter: (1) the iPhone was a bigger revenue and profit generator than either the iPod or Mac; (2) Apple sold more iPhones than RIM sold BlackBerrys; and (3) Apple trailed only Nokia and Samsung in worldwide mobile phone handset revenue (and they’re not far behind Samsung).

Jobs followed with this caveat:

Now, both of these things, beating RIM in units and becoming the third largest mobile supplier in revenues are amazing feats but part of this was the result of expanding into over 50 countries and there’s no guarantee that sustained sales will equal initial sales. And who knows what the future results will be, given the worldwide economic slowdown but we actually outsold RIM last quarter and ranked as the third largest mobile phone supplier in revenues. Not bad for being in the market for only 15 months.

He’s right that no one knows what the results will be for the current quarter (which started three weeks ago, and runs through the end of December) — but we can make an educated guess. Because it encompasses the entire holiday season, Apple’s October-December quarter has always been the strongest for iPod sales.

A year ago, iPod sales went from 10.2 to 22.1 million from Q4 (Jul.–Sep.) to Q1 (Oct.–Dec.). Two years ago, they went from 8.7 to 21.0 million. Three years ago, 6.5 to 14.0 million. In terms of a multiplier, that works out to 2.17, 2.41, and 2.15, respectively. I.e., Apple consistently sells a little more than twice as many iPods in the holiday quarter than in the preceding quarter.

We only have one year of data for the iPhone. Last year, Apple sold 1.1 million iPhones in Q4 2007. It went on to sell 2.3 million iPhones in Q1 2008 — a multiplier of 2.09, very much in line with previous years of holiday-quarter iPod sales.

So, it seems quite possible that Apple could sell twice as many iPhones during the current quarter as it did in the just-reported quarter. If they did, that would be 13.8 million iPhones. Even if they fall short of that mark, they seem poised to sell about 20 million iPhones in calendar year 2008 — more than double their oft-stated goal of 10 million. Many analysts doubted that 10 million iPhone goal for the year; Apple might in fact sell 10 million iPhones in a single quarter.

Even if sales are flat in the current quarter, it seems almost certain they’ll sell more than 10 million units in the first six months after the iPhone 3G went on sale.

As for where this growth positions the iPhone industry-wide, recall Microsoft’s projections for Windows Mobile licenses this year:

The warning signs were there. After boldly proclaiming that it would sell “more than” 20 million licenses to its Windows Mobile operating system by the end of its fiscal year on June 30, Microsoft later scaled that prediction back to “nearly” 20 million units. This week, however, the software giant conceded it did not hit its target: The company sold just 18 million units in the fiscal year.

So not only is Windows Mobile growth significantly slower than what Microsoft had publicly anticipated, but the iPhone seems set to surpass unit sales of all Windows Mobile phones combined next year. In fact, given that Apple acknowledged during yesterday’s conference call that, including October sales to date, they’ve already surpassed 10 million iPhones sold for calendar year 2008, the iPhone may well already be outselling all Windows Mobile phones combined.

The entire iPhone platform is only 15 months old. The cheapest model still costs $199. The room for growth in this market is unlike anything Apple has ever seen. So the question is: Despite continuing strong iPod sales and record-breaking Mac sales, how long until the iPhone is undeniably the primary product and platform made by Apple?

My answer: Not long.

And I think Apple’s executive team sees it the same way.