Apple 2.0

Covering the business that Steve Jobs built

Deferred earnings: Apple's hidden revenue bonus

February 11, 2008: 2:07 PM ET

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):

deferred-revs.jpg

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About This Author
Philip Elmer-Dewitt
Philip Elmer-DeWitt
Editor, Apple 2.0, Fortune

Philip Elmer-DeWitt has been following Apple since 1982, first for Time Magazine, and now on the Web for Fortune.com.

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