By John Gruber
Procreate is a beautiful, fast, and powerful painting app made for creative professionals.
Joe Wilcox published a piece Friday titled “Apple was NOT more profitable selling cell phones than Nokia in Q3” (caps emphasis his). It’s in reference to the widely-cited (and linked from DF here) report last week by Strategy Analytics which concluded that Apple generated more profits than Nokia from mobile phone handset sales last quarter.
Wilcox was skeptical — nothing wrong with that — and conducted his own investigation into the numbers:
Well, hell, that sounds reasonable enough, right? Wrong. Apple and Nokia SEC filings tell a different story. Both companies announced third calendar quarter results a few days apart in mid October. For devices and services, Nokia reported profits of €785 million, which is about US $1.1 billion. Apple reported total profits — that is for all products — of $1.67 billion in its earnings press release, and later the 10-K filing. I searched the 10-K, and, as I expected, Apple doesn’t breakout iPhone profits.
But it doesn’t have to for purposes of this discussion. I don’t doubt that Apple is more profitable per handset, since iPhone is a smartphone, than Nokia. But the numbers don’t add up to Apple’s overall handset profitability exceeding Nokia’s during third quarter, unless someone is making the bold assumption that all, or nearly all, Apple profits came from iPhone. They surely do not. What? Apple made only $700,000 on iPod, Macintosh, retail and software — $1.6 billion — on iPhone. No way.
The disturbing lack of fact checking seems to be a trend when it comes to Apple these days.
This is disturbing. Either Joe Wilcox has uncovered a massive, widely-reported error, or, he has made a fool out of himself. (That Wilcox thinks $1.67 billion - 1.6 billion is $700,000, rather than $70,000,000, offers a clue.)
What Wilcox is arguing is that Apple only reported $1.67 billion in total profit for the quarter, so how could they possibly have made $1.6 billion from the iPhone alone? But that’s not what Apple reported at all. Perhaps if Wilcox had actually read more than just the first paragraph of Apple’s press release announcing the company’s earnings, he’d understand. Apple’s announcement stated:
Apple today announced financial results for its fiscal 2009 fourth quarter ended September 26, 2009. The Company posted revenue of $9.87 billion and a net quarterly profit of $1.67 billion, or $1.82 per diluted share. These results compare to revenue of $7.9 billion and net quarterly profit of $1.14 billion, or $1.26 per diluted share, in the year-ago quarter. Gross margin was 36.6 percent, up from 34.7 percent in the year-ago quarter. International sales accounted for 46 percent of the quarter’s revenue.
In accordance with the subscription accounting treatment required by GAAP, the Company recognizes revenue and cost of goods sold for iPhone and Apple TV over their estimated economic lives. Adjusting GAAP sales and product costs to eliminate the impact of subscription accounting, the corresponding non-GAAP measures for the quarter are $12.25 billion of “Adjusted Sales” and $2.85 billion of “Adjusted Net Income.”
As everyone who follows Apple should be aware, Apple is accounting for iPhone sales over eight quarters. This practice is unusual, but it’s not complicated. This is how they’re able to give software updates to iPhone owners free of charge, and, conversely, because iPod sales are not accounted for on a subscription basis, why iPod Touch users must pay for the same updates. When Apple sold an iPhone last quarter it only accounted for one-eighth of the revenue and profits for that quarter. The remaining seven-eigths will be accounted for over the next seven quarters.
Subscription-based accounting does not mean that Apple doesn’t pocket the cash from iPhones all at once. They do — at least since June 2008 when they switched to the model of being paid an up-front subsidy from the carriers, rather than the per-month revenue-sharing model they used with AT&T for the first year. It’s all just a matter of accounting. What Apple calls “non-GAAP measures” are its way of saying “this is how much money we actually made this quarter”. The “adjusted net income” of $2.85 billion is effectively what Apple would have reported as profit for the quarter if they weren’t using subscription based accounting for the iPhone and Apple TV.
This is how Apple’s cash on hand has grown by $21 billion in the last three years, from $14.5B on 30 September 2006 to $36.2B on 26 September 2009. (Click “Balance Sheet” and “Annual Data”.)1
It is true that Apple does not specifically break out the revenue or profits from iPhone sales. But unless you think Apple is selling a lot more Apple TVs than most of us do, it’s pretty safe to say that the iPhone accounts for nearly all of the difference between Apple’s GAAP and non-GAAP reported profit, which difference came to $1.18 billion for the quarter. That suggests Strategy Analytics’s numbers are in the ballpark. It’s also worth noting that Nokia does not account for its handset sales as Apple does — Nokia accounts for them “normally”, up front, in the quarter in which they were sold.
Even if Strategy Analytics’s $1.6 billion figure is a little high, they’d have to be wrong by over $500 million for their overall conclusion (that Apple made more profit than Nokia selling phones) to be wrong. Here’s another back-of-the-envelope calculation. Apple does release the total number of iPhones sold during each quarter. Last quarter it was 7.4 million. So take Strategy Analytics’s estimate of $1.6 billion in profit, divide by 7.4 million iPhones, and you get $216 in profit per iPhone, which, again, sounds like it’s in the ballpark. (Unsubsidized 16 and 32 GB iPhone 3GS models — the most popular iPhones — sell for $599 and $699 respectively, and Apple’s reported gross margin for the quarter was 36.6 percent.)
As for Wilcox’s would-be exposé, I’m almost embarrassed to quote his concluding paragraph:
As for Apple’s overall phone profits being higher than Nokia’s, don’t believe it. Just because dozens of Websites report something as true doesn’t make it so. Because of the extent of misreporting, I can’t say where the fault lies. The Strategic Analytics report, which again I haven’t seen, might have gone no further than present numbers showing that Apple makes more profit per phone than Nokia. That absolutely makes sense. But to assert that iPhone generated $1.6 billion profit during a quarter when all Apple products generated $1.67 billion is simple stupidity.
Simple stupidity indeed.
If you subscribe to the Market Share gospel, it’s perhaps very hard to wrap your head around the idea that a company with 2.5 percent unit sale market share generates more profit than a company with 35 percent market share. But the numbers aren’t complicated. The iPhone really is that big a deal.
That Wilcox is so utterly befuddled by Apple’s iPhone accounting — convinced that Apple is generating far less cash than they actually are — makes me wonder how many analysts and investors are likewise confused about this. Probably many. So it’s worth noting that a recent accounting rule change may change the way Apple reports these numbers in the near future, such that Apple could report revenue from iPhones the way casual observers expect — in the quarter the sales occurred. Here’s what Henry Blodget wrote about the rule change in September:
The new rule will allow Apple to recognize the iPhone hardware revenue and profit at the point of sale, while an estimated value for the software will be recognized over the life of the device.
A change in accounting shouldn’t make a difference, but I’m guessing it will. Look for Apple’s stock to jump up if they make this change. ↩︎