Piper Jaffray: Apple Poised To Report Strong Quarter

Posted by: Arik Hesseldahl on October 15, 2009

Apple look poised to report another set of strong quarterly results on Oct. 19, according to a research note out this morning from Piper Jaffray analyst Gene Munster.

Munster writes that retail sales research firm NPD is showing Apple unit sales tracking above the consensus estimates of Wall Street analysts. Domestic Mac sales for July and August show growth of 7%, which he says implies overall Mac sales of 2.8 million units.

On the iPhone side of the business Munster says checks of Apple’s supply chain are showing that production constraints on the iPhone 3GS suggest that demand is so high for the phone worldwide that Apple and its manufacturing partners can’t seem to make them fast enough. This implies, he says, sales of about 7.5 million units in the quarter. He cites comments by the CEO of Italian wireless carrier 3 Italia, saying the company is selling 20,000 iPhones per month, but could sell twice as many given adequate supply.

For the quarter he expects Apple to report per-share earnings of $1.37 on sales of $9.1 billion, boosting his estimate from an EPS of $1.24 on sales of $8.9 billion. He expects gross margins to hit 36%, up from 34.5%.

Looking ahead to the all-important holiday quarter, ending in December, Munster expects Apple do what it always does: Issue conservative guidance. Over the last 12 quarters, he reminds that Apple has given revenue guidance that averages about 4% below the consensus estimate, and for EPS that is 12% below the consensus. But actual results always beat the consensus by an average of 3%, and by a whopping 24% on the EPS.

What will be especially interesting however is how Apple’s guidance is affected by the change in certain accounting rules by the Financial Accounting Standards Board that will affect both the iPhone and AppleTV business segments. More on this after the jump…

Remember that Apple has since 2007 treated both products as subscription services. The revenue from the sale of every iPhone and AppleTV has been booked not all at once, the way it is for a Mac, but in eight equal pieces.

Since Apple has been issuing software updates during the two-year life of each iPhone or AppleTV box, the accounting treatment of that revenue has helped cover the costs incurred from issuing software updates, which it does regularly. This is one of the reasons that major iPhone OS updates aren't free for iPod touch owners.

The benefit is that the deferred revenue created a stable annuity-like stream of income that would insulate Apple against the more volatile movements of the PC market. (Though in Apple's case, that movement has been steadily upward in recent years, and less subject to the ups and downs with which the other PC companies struggle.) But it also created this oddly skewed picture of Apple's operations.

The company went to great lengths to report its GAAP results, which took the subscription rule into account, and then to report its non-GAAP results, which showed what Apple would have been reporting were it not for this rule, and the difference between them was impressive. It was such an important matter, that when Apple took the unusual step of having CEO Steve Jobs speak on a earnings conference call to explain it all, which is something he rarely does.

The argument about subscription accounting goes like this: If you offer free upgrades over a specified time on a device like an iPhone, the FASB required you to treat the product like a subscription for accounting purposes, and then defer the revenue from the up-front sale over the time of that "subscription."

But the case can be made most of the value you get from an iPhone, you get right away at the time of the purchase. Under the new rules, Apple will be able to decide how much of that value is realized at the time of purchase, and then book revenue accordingly. So if you derive 90% of the value of the iPhone when you first buy it, then only 10% of the revenue gets deferred. It's not clear how Apple is going to treat each product, but the rules are now much more flexible.

On Sept. 23, the FASB announced changes to its rules that let the company decide how much of its revenue from the sale of a product gets deferred. It's not clear how Apple is going to execute this change, but you can expect some time time to be spent on the conference call going over the intricacies.

In a note on Sept. 24, Munster discussed the implications for this change, which he expects Apple to implement into its accounting during the December quarter, which is Apple's first fiscal quarter for 2010.

What it means is that Apple's earnings, will on paper, appear to soar. For Apple's fiscal year 2009, the company would with the change in place, have Apple reporting $8.21 per-share earnings on a GAAP basis instead of the previously expected $5.71. And for fiscal 2010, he expects Apple's GAAP earnings to go from $6 per share to $8.90.

Under the previous rules, he says, Apple would report a difference of about 35% between its GAAP and non-GAAP results. With the new rule in place, he expects that difference to narrow to 5% or less. It's notable that in that same research note Munster raised his price target on Apple from $186 a share to $235.

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