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The iPhone Quarter

When Apple Inc. (Nasdaq: AAPL) reported its fourth fiscal quarter the other day it was a watershed event for the company and the wireless industry in many respects. Granted, the revenue was a little on the light side at only $7.90 billion (+27 percent year-to-year; +6 percent quarter-to-quarter) but earnings per share were well above street expectations at $1.26. The earnings gain was essentially a function of the company’s gross margin being significantly above guidance (34.7 percent versus guidance of 31.5 percent) due to lower component costs.

While Macintosh units hit record levels (2.6 million) with 21 percent growth versus last year and 5 percent sequentially, the company continues to gain market share. Macbook unit growth slowed to about 24 percent in the period, but there is some suggestion that the anticipation of the recent Macbook introductions may have had a limiting impact on demand.

The clear star of the show was the iPhone, which had a huge quarter. Apple sold approximately 6.9 million units, generating $4.6 billion, making it the No. 3 handset company in the September quarter on a revenue basis. iPhone 3G customers have downloaded more than 200 million applications from the App Store, which today contains more than 5,500 unique offerings. There are now 30,000 distribution points for the iPhone 3G worldwide, with more to come by the end of 2008.

Unfortunately, the impact of the iPhone gets buried in Apple’s financial reporting. Those wonderful folks at the Securities and Exchange Commission (SEC) only accept financial statements based upon generally accepted accounting principles, or what’s known as GAAP accounting. Under GAAP rules, when you are going to provide software updates to a product for free to your customers over a period of time, you are required to use subscription-based revenue recognition. So if you sell an iPhone for $200 (makes the math easy) in July, you don’t get to recognize the $200 when you report the September quarter. You only recognize $25 in September and “defer” the remaining $175 over the next seven quarters recognizing $25 in each.

This may sound like a great idea to the accounting professors at the SEC, but it makes running a company on a day-to-day basis rather difficult. It also short-changes investors who may be considering buying or selling the stock. Consequently, for internal control purposes the company has been maintaining pro forma (as if) results, and they made them available to investors in the press release. Keep in mind that there are no rules for pro forma reporting. A company can include or exclude anything it deems appropriate, so it is always important to understand what you’re dealing with.

In this case, Apple simply reversed the impact of the subscription accounting procedures and recognized the revenue up front as a one-time sale as a means of showing the impact on the P&L of the company. What you see rather quickly is that iPhone revenue is now 39 percent of revenue in the September quarter. Pro forma revenue in the quarter would have been $11.68 billion and EPS would have been $2.69. Quite a difference from the GAAP results!

While GAAP accounting rules may mask the strong iPhone results on the P&L, they can’t hide it on a cashflow statement. Even though you can’t recognize the revenue, you’ve been paid for the phones so your bank account is bulging. In Apple’s case, in the September quarter the company generated $4.3 billion in cash from operations. That translates into roughly $552 per second during the 90-day period, and it is virtually all being driven by iPhone. Talk about the proverbial cash cow!

There are those who will argue that the very successful launch of the iPhone 3G was simply addressing pent-up demand and that sales will likely plateau going forward. Hey, anything’s possible, but I’m not in that camp.

For some time I’ve argued that the iPhone is not like other devices, nor are their users like other cellphone users. They treat their iPhones as portable computers. Despite operating on relatively slow 2.5G networks, the original iPhone’s made an impact upon its carriers. The CEO of wireless carrier Telefónica UK Ltd. , Matthew Key, told the Financial Times in December 2007 that iPhone customers have “a big appetite for data.” About 60 percent of O2’s iPhone subscribers use around 25 megabytes (equivalent to about 7,500 emails) of data per month vs. only about 2 percent of the company’s other wireless subscribers reaching that mark. In an interview with Unstrung, Deutsche Telekom AG (NYSE: DT) CEO Rene Obermann noted that iPhone subscribers use data at a rate 30 times that of the average T-Mobile International AG wireless customer.

It’s not just anecdotal either. In the table below, I’ve shown the wireless data revenue growth (year-year) for AT&T Inc. (NYSE: T) and Verizon Communications Inc. (NYSE: VZ). Both are quite strong, although I’d really like to know why the big decline takes place in 1Q08 for Verizon. But AT&T also breaks out the wireless Internet data growth, and, while we don’t have the absolute number, the growth rate remains huge. That’s being driven by the iPhone. And this data does not even track the data usage via WiFi!



Apple’s App Store is only going to get larger because of the success of the hardware platform as well as the developers thus far creating a far more attractive experience for the user. And it is a virtuous circle in that regard.

Our illustrious editor posed a question as to whether or not “folks are still going to have money to buy expensive phones in a few months.” Economic downturns hit everything to one degree or another, so I would never say "never." However, when the perceived value of a product or service is high, even in the worst of times individuals find ways around the hurdles.

Maybe the best example of that is back in the early 1980s when we were mired in stagflation: no economic growth, double-digit inflation rates, and interest rates at 20 percent (think about that if you think things are tough now). In the middle of what was the worst economic environment in many decades, along comes the IBM Corp. (NYSE: IBM) PC in 1981. It – and virtually everything associated with it – flew off the shelves at astonishing rates for years, despite the economy.

Can that happen again? Who knows, I do know an iPhone costs a lot less than an IBM PC did.

Position: The Telecom Connection model portfolio is long AAPL.

— Bob Faulkner, Special to Unstrung. Apple is one of the many technology and telecom companies that Bob Faulkner writes about weekly in The Telecom Connection.

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