iPhone: Now Apple's most important product

By Tom Krazit on 22 October 2008, 11:15am

The rampant success of the iPhone has forced Apple and its financial watchers to re-evaluate the value of the company. Saying that Apple's iPhone business "had become too big to ignore," Apple CEO Steve Jobs made a rare appearance on the company's earnings conference call on Tuesday to explain just how much money the iPhone is dumping into Apple's coffers.

For the first time, the company used supplemental financial details to give some colour on the contribution that the iPhone could be making to Apple's bottom line if iPhone sales were handled like Mac sales, and the numbers are astonishing.

The iPhone now accounts for 39 per cent of Apple's business, having generated $4.6bn in revenue from sales of 6.9 million units during the quarter. (Apple TV revenue is lumped in with that number, but let's be real: iPhone sales account for the vast, vast majority of that figure.) Those numbers, however, are not included as part of Apple's official quarterly results because of the way the company chooses to account for the sale of each iPhone -- Apple reported just $806m in iPhone and Apple TV revenue for its fourth quarter in accordance with GAAP (generally accepted accounting principles).

So why the disparity? In order to explain, please permit us to wade through some boring-but-necessary accounting.

Apple uses a subscription-based accounting method to recognise the revenue from the sale of an iPhone or an Apple TV unit. Remember the outrage in January 2007 over Apple's decision to charge certain MacBook customers $1.99 to unlock the faster Wi-Fi chip hidden inside their laptops? The company didn't decide to charge people because it was short on cash -- Apple had to in order to satisfy accounting rules that require a company to establish a value for future upgrades if a decision was made to recognise all the revenue from the sale of a product at the time it was purchased.

To avoid the same situation with its brand-new iPhone customers, Apple announced shortly after the launch of the product that all iPhone revenue would be recorded over a 24-month period, allowing the company to ship software upgrades to the iPhone for free. Note that for whatever reason, it doesn't apply that treatment to its Mac or iPod product lines, meaning that Apple has to charge iPod touch owners a fee for the exact same upgrades that iPhone owners receive.

The problem with this accounting treatment is that it pushes most of the revenue associated with the sale of an iPhone -- ie, the cut it takes from your monthly contract -- out into the future, making it difficult for investors to determine just how much revenue and profit is being generated by the sale of a particular unit until long after that unit has been sold. In addition, Apple has to recognise engineering and marketing costs associated with the sale of those iPhones in the quarter in which they occurred, not over the 24-month period.

Starting on Tuesday, however, Apple decided to open the kimono on its iPhone business in a new way.

Apple revealed the numbers it uses internally to measure the performance of the iPhone business for the first time. Imagine Apple treated the iPhone like it did the Mac and recorded all the revenue from each phone at the time it was sold: it would have recorded an additional $3.8bn in revenue and an additional $1.3bn in net income during the company's fourth fiscal quarter.

Total iPhone revenue of $4.6bn would have represented 39 per cent of Apple's overall adjusted revenue of $11.7bn, and would have ranked it third among all mobile phone vendors as measured by revenue after just 15 months on the market, according to the company. "If this isn't stunning, I don't know what is," Jobs said.

A few words of caution are necessary regarding the use of supplemental results to evaluate a company. Apple posted a lengthy disclosure on the numbers in its press release, warning among other things, "these non-GAAP financial measures may be unique to the Company, as they may be different from non-GAAP financial measure used by other companies. As such, this presentation of non-GAAP financial measures may not enhance the comparability of the Company's results to the results of other companies." (Jobs, of course, did just that in ranking Apple third among all mobile phone vendors as measured by revenue, so there you go.)

But we're still talking about real money. Regardless of how Apple decides to account for iPhone revenue, it's still real revenue, and it provides cash for the company to invest in iPhone engineers (such as the former PA Semi team, for example), market the iPhone, and work on software enhancements to the product.

It allows us to make imperfect estimates on just how much Apple is receiving in subsidies on each iPhone 3G. $4.6bn in revenue divided by 6.9 million units equals $666.67 (£407) per iPhone. That's a little high, since some portion of that revenue has to be attached to Apple TV sales, but even making the unlikely assumption that Apple sold $500m worth of a product it calls a "hobby" during the fourth quarter puts the average cost of an iPhone 3G at $594.20.

And it also underscores that Apple has completed its transformation from a computer company into a consumer electronics company, the only computer company of its generation to successfully pull off that transition. They all tried, but no traditional PC company has managed to shift the bulk of its business from low-margin PCs to high-margin consumer electronics: the iPhone now represents 39 per cent of Apple's revenue using the supplemental metrics, while the Mac accounts for 30 per cent.

The iPhone isn't just the third pillar of Apple's business that Jobs promised it would become back in January 2007, when he introduced the iPhone and changed the name of the company from Apple Computer to Apple Inc. It's now the single largest contributor to Apple's bottom line. -Tom Krazit