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How many iOS devices will be produced in the next 12 months?

Apple’s capital expenditures for product tooling, manufacturing process equipment, corporate facilities and infrastructure has followed very closely their production of iOS devices. The pattern is shown in the graph below.

Screen Shot 2013-10-30 at 10-30-2.12.28 PM

Note that although reported expenditures did not match forecasts for 2012 and 2013, the differences nearly cancel each other.[1] The company’s forecast for fiscal 2014 is shown as well.

The orange line shows iOS unit production[2] with the scale on the right-side axis. Note the correlation with forecasts on CapEx. The relationship can be seen more clearly in the following scatter plot.

Screen Shot 2013-10-30 at 10-30-2.33.26 PM

I added the 2014 Forecast ($10.5 billion from the latest 10-K filing). If the relationship holds into next year then the iOS unit shipments should be between 250 million and 285 million.[3].

Notes:
  1. I suspect that the difference might be caused by a payment being brought forward in 2012. []
  2. Technically, shipments []
  3. The equation for the trend line shown suggests 285,908,000 units []

iTunes users spending at the rate of $40/yr.

In the latest quarter the iTunes top line grew by 32%. Additional newly reported items:

  • Quarterly revenues topped $4 billion (a new high) and the company suggests that this rate is maintainable by stating it has a “$16 billion annual run rate”. The pattern of revenues is shown below.

Screen Shot 2013-05-12 at 5-12-8.12.30 AM

  • The content portion of iTunes revenues was $2.4 billion, up from $2.1 billion sequentially. Growth into Q1 is not unusual as many holiday iTunes gift cards are redeemed during January.
  • Revenue growth has been surprisingly steady, averaging 29%/quarter for more than six years.

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.

Margin Call 2

I expected Apple’s margins to improve  last quarter. They didn’t and so the question I needed to answer is why. Here is a history of Apple’s gross margin and operating margin as reported since late 2005:

Screen Shot 2013-04-25 at 4-25-9.26.53 AM

For a company selling hardware these are extraordinarily high margins. They are higher than those of Google and have narrowed the gap with Microsoft,  neither of which has a high proportion of hardware sales:

The cost of building Galaxies (and iPhones)

Although Samsung and Apple are acclaimed as the leaders in profit capture for smart (and otherwise) phones, what is not lauded is how much they spend on capital equipment used in the making of these phones.

In 2012 Samsung spent around $20 billion while Apple spent about $10 billion (excluding leasehold improvements or Apple stores but including real estate).

Compare these figures with Intel at $11 billion, Google at $3.2 billion, Microsoft about $2.8 billion and Amazon $3.8 billion (including presumably new distribution centers.)

Screen Shot 2013-04-04 at 4-4-5.51.15 PM

What each company spends on differs depending on its business model, but as the graph above shows it’s easy to see that there is a class of “big spenders” who spend so much that it makes it hard to imagine just what $10 billion/yr could actually buy.

To get an idea of just how big that figure is consider that

The cost of selling Galaxies, updated

Thanks to @jtk0621 via twitter I was able to obtain a quarterly view into Samsung’s SG&A expenditures by cost category.

The value of this data is in being able to understand why Samsung SG&A as a percent of sales remains fairly constant. To recap, the discrepancy with Samsung’s SG&A is that it has grown in proportion to rapidly rising sales. Normally, when sales grow, SG&A grows but when sales grow very rapidly, SG&A grows a bit more slowly since it’s primarily a function of headcount and hiring is necessarily organic and hence slower as a process.

The contrast is shown in the following comparison between Apple’s SG&A and Samsung’s SG&A as a percent of sales. [For more detail on Samsung revenue composition see: The Cost of Selling Galaxies].

Screen Shot 2013-04-02 at 4-2-3.09.39 PM

Apple’s SG&A has declined as a percent of sales, as one would expect, but Samsung’s hasn’t.

I have hypothesized that the reason for this might be in the practice of “outsourcing” many marketing functions. As Samsung expands promotional efforts, it does so partially by hiring people but even more so by farming out a lot more work. In this way, if and when sales subside, it can pare costs. This practice ensures that it’s not exposed to a huge cost structure that is hard to control. The downside to this approach might be obtaining “quality” marketing as oversight is still depending on inside teams who still have limited resources.

To test this hypothesis, I looked at the types of costs it reports and divided them into two categories:

Category 1 are what might be considered “internal” costs which are in function of employees or operations. These costs are:

  • Salaries
  • Retirement Benefits
  • Commissions
  • Depreciation
  • Amortization
  • Freight

I graphed these costs over time below:

Screen Shot 2013-04-02 at 4-2-3.12.09 PM

Category 2 costs are those which can be “outsourced” and are in function of budget items. These are:

iTunes Segment Revenues in Context

In the last few posts I estimated the iTunes economy in some detail. In absolute figures, the revenues and cost structures of iTunes are substantial:

  • 6.3 billion transactions in the last quarter
  • $4.6 billion consolidated revenues (including software & services)
  • $3.3 billion in content payments
  • $650 million in operating income

However, as a part of the entire Apple revenue model, iTunes appears to be a small contributor. The following diagrams shows where revenues came from and where they were spent during the last quarter

Sankey-Income1

A few notes:

So long, break-even

The following is another excerpt from a report titled “iTunes Business Review” which will soon be available for purchase through the Asymco Store. If you are interested in the product please get in touch.

iTunes store will be 10 years old next month. From its inception Apple has stated that it aims to run the store “at break-even”.  The business has grown so rapidly however that its profit-free nature has come under severe pressure.

The reasoning goes that as more media types have been added costs have increased but revenues have increased even faster. Consider the estimated gross revenue base as shown below:

Screen Shot 2013-03-22 at 3-22-2.39.55 PM

What is known as iTunes today has quintupled in seven years. Although cost of content sales are likely to have been preserved as a ratio (about 30%) the vastness of transaction volume (estimated at 23 billion item transactions in 2012 alone) implies that there are some significant economies of scale.

This implies that the operating costs are spread more evenly and that therefore the possibility exists for some operating margin.

The Conundrum of iTunes' Recognition of Revenues

An excerpt from a report titled “iTunes Business Review” which I’m currently writing:

Revenue Recognition

Before proceeding it’s also important to understand one more detail: The company does not report all transactions through iTunes as revenue. To quote the 2012 Annual Report (10 K):

For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations.

What this means is that App revenues are only reported at the 30% level that is retained by Apple. The 70% paid to developers is excluded from Apple’s financial reports. The same is true for other products for which it considers to be acting as an agent. The difference seems to be mostly in cases where Apple does not define the end user pricing. This is mostly true for ebooks however that may not be true for all book titles.

This distinction between “gross” revenues and “reported” revenues is maintained in this report but both are presented for consideration. Gross revenues are needed for comparing the media businesses against each other and for competitive assessment but reported revenues are needed to test assumptions against ground truth.

This can be explained with an example:

If a song sells for 99c then Apple reports all 99c as Revenue and then pays the record company about 70c and uses 30c to operate the store and pay for transaction costs. In the case of music it means the Gross Revenue is 99c and the Reported Revenue is also 99c.

However, if an app sells for 99c then Apple reports only about 30c as Revenue. It does not consider the portion paid to developers as revenues for itself. It spends a portion of the 30c to pay for transactions, hosting, and the time testing and accepting the apps. In the case of apps and books it means the Gross Revenue is 99c and the Reported Revenue is 30c.

So if Apple sells one song and one app then the Consolidated Gross Revenue is 2 x 99c or $1.98 but the Consolidated Reported Revenue is only $1.29 (99c + 30c).

The difference in accounting is sometimes called “agency” vs. “wholesale” and it applies in some retail businesses. Another term sometimes used for used goods is selling items “on consignment“.

The reasoning for why some media are treated one way or another is cited in the Annual report as “the Company does not determine the selling price of the products and is not the primary obligor to the customer”. In the case of Apps, the price is set by the developer and the developer is obligated to deliver on the promise. Apple acts as transaction processor and they don’t consider that they ever owned (and hence never sold) the app. Note that this accounting is probably discretionary. They decided to do it this way and it’s not clear that it was necessary to do it this way by any regulation.

This distinction between two treatments of revenue makes it difficult to understand the complete story behind iTunes.

If you’re interested in the full report, contact me directly.

UPDATE:

Apple’s rationale can be partly justified from a reading of a Financial Accounting Standards Board statement titled “Reporting Revenue Gross as a Principal versus Net as an Agent” (Emerging Issues Task Force Abstract EITF 99-19 http://www.fasb.org/pdf/abs99-19.pdf) a portion of which is quoted below.

“Indicators of Net Revenue Reporting

15. The supplier (not the company) is the primary obligor in the arrangement— Whether a supplier or a company is responsible for providing the product or service desired by a customer is a strong indicator of the company’s role in the transaction. If a supplier (and not the company) is responsible for fulfillment, including the acceptability of the product(s) or service(s) ordered or purchased by a customer, that fact may indicate that the company does not have risks and rewards as principal in the transaction and that it should record revenue net based on the amount retained (that is, the amount billed to the customer less the amount paid to a supplier). Representations (written or otherwise) made by a company during marketing and the terms of the sales contract generally will provide evidence as to a customer’s understanding of whether the company or the supplier is responsible for fulfilling the ordered product or service.

 

Tim Cook's comments on Apple Stores, illustrated

Yesterday Tim Cook spoke at the the 2013 Goldman Sachs conference:

There’s no better place to discover, explore and learn about our products than in retail. It’s the retail experience where you walk in and you instantly realize this store is not here for the purpose of selling. It’s here for the purpose of serving. I’m not even sure “store” is the right word anymore. They’ve taken on a role much broader than that. They are the face of Apple for almost all of our customers

Last quarter, we welcomed 120 million people in our stores.

Screen Shot 2013-02-13 at 2-13-1.46.24 PM

We only have a little over 400 [stores]. Last year, we welcomed 370 million into the stores.

Screen Shot 2013-02-13 at 2-13-12.51.57 PM

We’re closing 20 of our stores and moving them and making them larger this year. And in addition to that 20, we’re adding 30 more. Those 30 will be disproportionally outside the U.S. That gets us in 13 countries.