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Margin call update: About those changes in service policies

In the March quarter, our gross margin was 37.5%. It was at the low end of our range. We had a few items that on balance resulted in us reporting at the low end. They included mix, in particular, selling more iPads than we had planned, including getting iPad mini into our four- to six-week channel inventory range, some changes in our service policies that required us to make provisions for prior quarter sales, and we had some unfavorable adjustments.

- Peter Oppenheimer, Apple CFO, FQ2 2013 Earnings Conference Call

[my emphasis]

Thanks to Philip Elmer DeWitt for bringing this quote to my attention in the comments to Margin Call 2.

I was curious about the “changes in service policies” and what that might have meant, especially since they seem to have been retroactive (provisions for prior quarter sales).

The 10Q offers more details:

Accruals for product warranty for the three months ended March 30, 2013 include $414 million associated with product sales in prior fiscal periods reflecting the impact of changes to certain of the Company’s service policies and other estimated warranty costs. Of this amount, $224 million is associated with product sales in the first quarter of 2013, and the remainder is associated with product sales in 2012.

- Apple 10Q, Note 6, Page 17, second paragraph.

These service policy changes were made around April 1st and were in response to editorials in the People’s Daily, the official paper of the Chinese Communist Party. Though seen as a PR issue, their impact goes beyond the company’s image. Changes in warranty policy implies setting aside some of the revenues as an expense, increasing the cost of sales and reducing margins.

The 10Q says that $190 million of the additional warranty set-aside was for prior quarters and that $224 million was for the March quarter.

If we were to subtract the $190 million from the cost of sales the gross margin would increase from 37.50% to 37.93% and if we subtract the full $414 million the gross margin would increase to 38.44%.

The calculations are shown in the following table:

Sales Cost of Sales Gross margin
Q1 $43,603 $27,254 37.50%
Q1 adjusted for change in service policies in 2012 $43,603 $27,064 37.93%
Q1 adjusted for change in service policies in 2012 and 2013 $43,603 $26,840 38.44%

 

If we read 2012 and 2013 as meaning fiscal years then the entire $414 amount is for prior periods (i.e. not for the current quarter) and the gross margin for Q1, excluding one-time items, would be nearly 1 percentage point higher than reported.

The effect of the change in policy would have been very difficult to anticipate when estimating the gross margin, even for Apple’s own team three months ago.

It’s also important to note that this does not say much about the supposed effect of competitive pressures on Apple’s margins. 38.44% gross margin is not as good as last year’s, but they’re pretty good.

  • Chaka10

    And YOY, the impact of mix is more significant, — iPhone revs grew 3% while iPad revs grew 40%, resulting in iPhone share of total revenues declining 4 percentage points and iPad share gaining 4 percentage points (and no iPad mini in year ago quarter).

  • Chaka10

    Horace: Does this analysis affect your view on impact of component costs on COGS in FQ2?

    • http://www.asymco.com Horace Dediu

      Not really. It accounts for 100 basis points out of a shortfall of 250 from what I would have thought a reasonable margin. There is still a question of where the remaining 150 went. On the other hand I think this 100 basis point shortfall explains much better their own guidance miss. I think they would have nailed it if it were not for the adjustment right at the end of the quarter.

      • Chaka10

        Regarding component demand (and perhaps cost), I believe the SIV is DOA, relative to expectations, and that could have broad ramifications, including to extent component expectations factor in robust demand for the SIV.

        Reasons are structural (ie, not so much the consistently tepid reviews, though that doesn’t help) The market segment of high-end first time smartphone buyers is slowed significantly. The SIV’s potential replacement buyer market is highly impaired. (A) Its most obvious replacement buyers already bought (the SIII and NoteII), less than a year ago. (B) The specs focused and complicated SIV is the antithesis of what iPhone users value. High-end Android completion continue their assault.

        Samsung will spend (and spin) like crazy again, when the initial sales disappoint, but that will be pushing on a string — doesn’t solve the structural issues in the market discussed above. It could lower the SIV price significantly — to attract customers who already have a SIII or NoteII or to address the first time smartphone market in the area where there’s growth (the low end), BUT (a) how much would it have to lower prices to be effective and (b) more importantly why? It already has phones that address the low end — why push a more expensive (higher cost) product to the segment?

      • Chaka10

        http://deals.ebay.com/5000250791

        Huh? Such great demand they have to postpone the Sprint and T-Mobile launches (at literally the last minute), but SIV’s are available on eBay at a discount?

      • Chaka10

        Horace, I feel like I may be imposing on your blog with this line of discussion — truth is, I’m very interested in your views…. Nevertheless, please just say so if I’m slipping into “bad form” or worse, with this line here. Thanks.

        (Thanks also to Ben Evans for humoring and engaging in the discussion on his blog, which actually began with his post more than a week ago “A Note On Installed Bases” to which I commented on the implications for Samsung of a 24 mo avg replacement cycle and a maturing high end.)

        It looks like Ben Thompson is jumping on to the bear case on Samsung.

        http://stratechery.com/2013/two-bears/#identifier_1_272

        I obviously disagree with him on the bear case for Apple (I believe Ben Evans is on the fence). As Ben T says “24 percent of Android phone users plan to switch to another platform. Guess where the majority of those professed switchers are going — 18 percent to iPhones.” means there’s growth still. As I noted in a comment on Ben Evans’ post — “given the greater absolute number of Android users, even with the same percentage churn, more absolute numbers of users switching to Apple from Android than the other way around (it’s just math). Compounded with the stickiness, it’s sort of like a lobster pot effect (not very flattering, I know, but I think descriptive).”

      • Chaka10

        Horace, further to my posts below, I’d like to draw your attention to the recent data coming out about disappointing S4 demand, which I’ve been expecting (and which I’m sure you’ve already noticed).

        I think there is a bull case for Apple based on these same structural dynamics affecting Samsung. I say structural, because I don’t think the soft S4 demand is due to market share loss to other high-end Android vendors.

        I think the massive 4S adoption in the holiday quarter 2011 should provide a great tailwind for a 5S launch in the coming holiday quarter. As I’ve been posting for weeks now, I think the key is get past the soft iPhone demand in 2013, by understanding that it is due to the near term structural issues of maturing high end before replacement demand can catchup, and focusing on Apple’s long term prospects — and resumed iPhone growth as soon as the coming holiday quarter, albeit at more sustainable rates. As I said in a post elsewhere, at a 10% market share of CURRENT global mobile phone unit sales, “15% growth in iPhone means it gains 1.5 percentage points (law of small numbers — isn’t that ironic), in fact 15% annual growth sustained means in FIVE YEARS, Apple gets to 20% (vs Samsung’s 33% now)”….

        Meantime, as I’ve previously posted, I think Samsung is poorly placed for a slow down, and is in for a period of negative leverage, one where it’s competitive behavior vs its customers may come to roost. I hope Apple goes for the jugular.

      • http://www.asymco.com Horace Dediu

        I am going to write about this at some point.

      • Chaka10

        Horace, I sought your views in posts in this thread two months ago about my prediction that the S4 would badly disappoint demand expectation. I would ask again, if I may do so, given the news today (Bloomberg: “Samsung Electronics Co. (005930), the largest smartphone maker, faces further profit-outlook downgrades by analysts after posting earnings that missed estimates as sales of its flagship Galaxy S4 handset fell short of expectations.”)

        I was (and am) particularly interested in what that might say about the iPhone going forward. To me this is fairly strong support for my view that the perceived underperformance of the iPhone relative to expectations is NOT due to competitive issues but rather a market dynamic, which I expect to resolve itself for Apple in the coming holiday quarter. Again, interested in your thoughts.

  • Alex Garner

    Horace, don’t forget to stick an “m” after those $414 amounts!

    • http://www.asymco.com Horace Dediu

      Thanks. Fixed.

  • http://twitter.com/artman1033 artman1033

    Horace:

    The 8-K that the SEC listed yesterday (25th), covers Greater China. http://www.sec.gov/Archives/edgar/data/320193/000119312513170623/0001193125-13-170623-index.htm

  • MOD

    GAAP requires that when a product is sold, a warranty liability (provision) account be set up, and the corresponding warranty loss be taken immediately. This amount is based upon the estimated (or historical) expenses of repairs for the product just sold. When the warranty expenditures are incurred later (say in one year), that will just clear the liability; it will not affect the Gross Margin any further, because the loss has already been already taken (in the present). This is the matching principle: the expenses of selling a product are matched to (the time of) the revenues from that product.

    If the warranty expenditures come in more (or less) than what was allocated, then the company has to recognize a loss (or gain) at the time the estimate is corrected.

    If Apple underestimated the warranty liability (provision) of prior quarters, GAAP requires an immediate adjustment (correction) of the liability/provision accounts, when the error is discovered. The increase in liability (credit) must have a corresponding increase in the loss (debit), in the current quarter. Per the 10Q notes this is what happened.

    If the new estimated expense is accurate then why back-out that expense and make a new Gross Margin? And I would use the wording “Q1 with service polices expense adjustment backed-out”. An “adjustment” is accounting terminology for correcting wrong to right.

    So this is really the question. Was Apple wrong to take the additional charges? Was it just a matter of PR in China, and the warranty expenditures will never materialize? If so then the Gross Margin can be adjusted back to what it should have been.

    But if the new charges are correct, because the warranty expenditures will really be incurred, (for the products sold thus far), then those expenses should be included in the Gross Margin. In this case, an argument can be made that what should be adjusted is the Gross Margin of all quarters, not cram all the charges in the Gross Margin of this quarter. The expenses should be spread out over the corresponding quarters’ sales, in order to compare profitability.

    So there are two questions: (1) Are the expenses valid and realistic? (2) How should they be spread out?

    If the expenses are valid, they should be spread out to the corresponding sales. If the expenses are not valid, they should be backed-out of this quarter.

    I hope this helps.

    • http://www.asymco.com Horace Dediu

      There was no “error”. There was no “wrong” or “right”. The company changed its policy in China and extended the warranty on devices already sold. Because of the policy change some customers may very well take advantage of the change and ask for repair/exchange on their iPhones. It could have possibly re-stated previous quarters to reflect this but it probably makes more sense to roll them up into the current quarter as a one-time expense. The point is that this is a one-time hit on the margin and not likely to repeat in future quarters.

      • MOD

        The “change in policy” is quantified in the financial statements. If you are saying the quantification is completely accurate then Q1 2013 should include the corresponding warranty charges, not exclude them. And if this “change in policy” is permanent, then every quarter from now on will include them too.

        If you are saying some people will not take advantage, etc. and this percent is not quantified in the warranty liability estimate (even though is should be), then Apple was wrong to take the charge, and you are right to exclude it.

        As far as 2012 charge, yes, that is a non-recurring charges. But its validity should likewise be questioned. If no one will take advantage of the warranty, etc, then Apple will likely reverse those charges.

        There can be a lot of bs (and politics) in accounting estimates, and they should be scrutinized.

      • http://www.asymco.com Horace Dediu

        There is no question that the charges will be higher in the future. My point is that the one-time charge was due to the retroactive application. Phones sold in the first quarter should be be “more expensive to make” because there is a warranty expense for phones sold last year. The analysis is on gross margin on current phones shipped. The market looks at a drop in margin and reads an ominous sign. The point is that an entire percent of that margin does not reflect the operations or market conditions of this quarter.

      • MOD

        I think you meant to write that phones sold in the first quarter should NOT be “more expensive to make” because of a warranty expense last year. This is correct. But that is the $190m. The $224m for the March quarter phones should stand. So the real margin, going forward, would benefit by only 1/2 a percent.

        But one should really question the whole warranty game. What if Apple placated the Chinese govt. with exactly this: a charge (provision) to their financial statement as proof that they are “kowtowing” to them. If these charges will not really be incurred, and they are just numbers, then they will be reversed in future quarters, which will result in an equal increase in the margin. This is the feel I got from the conference call — an accounting whitewash on the ignorant Chinese govt.

      • Sacto_Joe

        So? Either way, the market initially over-reacted negatively, which is Horace’s point. The question of whether or not this was a sop to the Chinese govt is going to be reflected in the future. It might bear watching to guard against a future positive over-reaction.

        BTW, there is a LOT of money being set aside by Apple that isn’t showing up as earnings….

      • http://www.asymco.com Horace Dediu

        Indeed. Earnings are an opinion. Cash flow is a fact.

  • http://financial-alchemist.blogspot.com Turley Muller

    Interesting that Apple reported GM exactly at low end of range of 37.5%. Probably no coincidence given these warrany accruals are what every Apple wants them to be. So, it could choose a number (within reason) that would result in GM coming at 37.5%.

  • Horatiu

    Horace, this warranty accrual was as one of commenters above noted, Apple’s pure estimate. Since they changed the policy in China recently, it is arguable that there is a history of returns which, as per my experience, should be used when making such an estimate.
    I think that most accurate warranty/ return provison could be booked by Apple at a least one year from the implementation of this policy.

    Congrats from Romania for your work and blog!