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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Monday, November 17, 2008

Calculating Gross Margin for Apple's iPhone (4Q08)

APPLE INC (nasd:AAPL) According to my calculations, deferred revenue booked from Q4 iPhone sales carries a 55.5% gross margin. Gross margin on the deferred revenue (DR) booked from the first generation model averages about 29%. The average gross margin for total booked DR is 47.8%.

I derived this number from the “deferred expense under subscription accounting“ that Apple disclosed in its annual filing (10-K) in conjunction with the deferred revenue (under subscription accounting) also reported. I used some rather extensive math to come up with the 55.5% number which I discuss below.

Apple’s ”Non-GAAP“ figures it provided for Q4 implies that 3G iPhone GM was 47.8%. According to the 10-K, GM for iPhone deferred revenue not yet recognized in income is also 47.8%. Coincidence? Not likely. Since the deferred revenue carried on the balance sheet includes both the original and 3G models, that GM should differ from the GM implied by Q4 Non-GAAP numbers that solely comprise of 3G unit sales. We know that the GM on the 3G model is much higher than the first model.

So why is the GM according to Apple’s Non-GAAP figures the same as the GM derived from the 10-K? Apple included estimated future warranty expenses in the adjusted cost-of-goods sold (COGS), which inflates Non-GAAP COGS and understates GM. The amount of estimated expense is at Apple’s discretion. In my opinion, Apple overstated the Non-GAAP COGS adjustment for the sake of conservatism, but also to obscure the true iPhone GM. Normally, under GAAP accounting (subscription), Apple recognizes iPhone warranty expenses as incurred. However, Apple added its estimates for future warranty liability into the COGS adjustment, and I believe management was very conservative.

The gross margin on the iPhones sold in Q4 that will be recognized over the coming seven quarters is 55.5%. There will be some warranty expense incurred, yet I expect it to be relatively small. It’s likely that most of the warranty liability is incurred during the period sold. If a unit is defective, the problem usually surfaces shortly after it’s purchased.

I estimate the normalized gross margin is even higher, possibly north of 60%. Thus, iPhones sold in 1Q09 and beyond will carry higher GMs, assuming ASPs remain constant. iPhone GMs for Q4 were abnormally compressed due to elevated shipping costs, adapter recall, and other various expenses related to the global introduction of the new 3G model.

Gross Margin- Non-GAAP Reported Q4:
For the first time, Apple provided adjusted figures showing the actual iPhone sales/income earned in the quarter. Until Q4, Apple always gave the GAAP numbers that uses subscription accounting for iPhone sales. Instead of recognizing the actual revenue earned for the quarter, it is spread over 24 months and amortized on a straight-line basis. Using normal accounting methods, total revenue would have been 3.787B higher, or 11.682B. Cost of goods sold (COGS) increases 1.975B to 7.161B. Overall gross margins improve from 34.7% (GAAP) to 39.0%, which equates to a 47.8% GM for the iPhone adjustment ([revenue adjustment - COGS adjustment] / revenue adjustment).

However, the 47.8% figure is not the true iPhone GM. First, the adjustments include AppleTV sales, yet that amount is believed to be quite small relative to the iPhone, thus the effect is probably very minimal. Second, and most important, is that Apple included the estimated warranty costs for over its full life in the COGS adjustment.

iPhone Gross Margin- Deferred Revenue/Costs Reported in 10-K:
Without knowing the amount of deferred iPhone cost booked in a quarter, it’s impossible to calculate iPhone gross margins. Apple’s quarterly filings discloses the iPhone portion of deferred revenue which is reported was a liability on the balance sheet, but Apple never broke out the iPhone related deferred costs that is included in an asset account. The actual amount of iphone revenue earned in a quarter can be determined by adding the change in DR account (+) the amount of iPhone revenue recognized in income. To find the actual product costs, we need the change in deferred costs. In its annual filing, Apple disclosed the amount of iPhone related deferred cost on the books at the end of Q4, but we don’t know the Q3 number.

Using the DR & DC at year-end, an average GM (of all iPhone sales) can be found. At year-end, Apple had $5.78B in DR and $3.02B in DC on its books, which translates into a 47.8% gross margin for all the iPhone sales still be amortized. Since Apple gives the figures for current (less than 1yr) and long-term accounts, we can gain additional insight into iPhone margins. For the iPhone sales that will be recognized within a year, the average GM is 45.1%, and for the non-current portion, the GM is 51.9%.

The reason for the 7% difference is due to 3G sales, which carries a much higher margin than the original iPhone. Almost all the non-current DR & DC is related to the 3G, since iPhones sold in 4Q07 & 1Q08 have moved from the non-current to current bucket. Only a small portion of Q2 sales would be left in non-current, and Q3 sales were low, thus the figures classified as non-current are almost entirely associated with 3G sales. The actual percentage of 3G models can be estimated from the change in DR from Q/Q compared to the actual ending balance. Current DR increased 2.129B to 3.518B, which means 60.5% of current DR is from 3G. Long-term DR increased 1.63B to 2.62B, but the actual amount of 3G classified as non-current is higher because of the portion of legacy iPhone revenue recognized for the quarter. I estimate that 320M of DR was recognized in Q4. Roughly 86% of non-current DR is from 3G sales.

Actual 3G iPhone Gross Margin Calculation:
With the figures for (1) average GM for both current and long-term [45.1% / 51.9%], and (2) the percentage of units which are 3Gs for both classifications [61% / 86%], I solved for the “true” 3G iPhone gross margin by setting up 3 simultaneous equations. The goal is to find the GM number (for both the 3G units and the legacy units) that produces the same combined gross margin for all three classifications (current, non-current, total). As I mentioned above, I solved for the percentages or “weights” of each model represented in the amount of deferred revenue reported on Apple’s balance sheet. Using those weights, the solution I found was 3G gross margin of 55.1% and 29.2% GM for the original model units. When the 3G & legacy gross margins are multiplied by the percentage weights for all three classifications (Total, Current, Non-Current), the products equal the same gross margin extracted from Apple’s 10-K.

(1) Total deferred: 47.8(all)= .71(MGN[3G]) + .29(MGN[2.5G])
(2) Current Deferred: 45.1(all) = .61(MGN[3G]) + .39(MGN[2.5G])
(3) Non-Current Deferred: 51.9(all) = .86(MGN[3G]) + .14(MGN[2.5G])

If my math is correct, the gross margin on the DR booked from 3G iPhones sold in Q4 (Sep 08) is 55.5%. This means over the next seven quarters, Q4 iPhone sales that will be recognized in current earnings contribute 55.5% GM. Yet, gross margins on units sold going forward will materially exceed the 55.5% generated on Q4 sales.

The rationale for thinking the normalized GM will be higher is due to excess product expense related to the roll-out. Shipping costs were abnormally inflated due to pressures created by supply shortages. The elevated expenses were due to more shipments of smaller lot sizes expedited at quicker delivery times. In short, distribution costs weren’t optimized, yet it’s better to spend a little more to make a sale, than to try to contain costs and forego a sale. For example, iPhones ordered through AT&T direct fulfillment were being delivered individually by FedEx. In addition, Apple stores were receiving smaller shipments but more frequently, on an as-needed basis, so that some stores don’t get too much stock leaving others short. Now that demand and supply factors are in balance, Apple is able to reduce distribution expense by shipping larger lot amounts, less regularly at non-expedited speeds.

Another item inflating product costs was the power adapter recall. Not only does this cause material costs to increase, shipping and packaging costs were likely unfavorably impacted as well.

Going forward, I foresee rising margins resulting from efficiency gains in distribution along with lower product costs resulting from falling component prices and scale benefits. Another item of note, the end of September Apple began selling unlocked iPhones online to Hong-Kong for roughly $685/$799 (free shipping). These prices are quite higher than what Apple receives on other iPhone sales. It’s possible that Apple can do decent volume through the Hong-Kong channel given the propensity for iPhones to find their way into grey markets, such as China, Thailand, Vietnam and others. It’s interesting that Apple decided to sell unlocked, open carrier iPhones only to Hong-Kong which makes one wonder if this is a direct response to the stubbornness of Chinese carriers.

Massive iPhone margins provide Apple with the ability to reduce selling price and still earn a generous profit. Apple has a key advantage over other mobile handset makers that don’t have nearly as high GMs. I expect Apple to eventually lower iPhone prices, but given the iPhone’s superior value proposition, a price cut shouldn’t be needed for some time. However, that doesn’t preclude Apple from doing so just to make competitors life difficult.

Apple could use the colossal iPhone margins to subsidize price reductions on other products if needed. Given the difficult economic environment, this is a very beneficial arrow for Apple to have in its quiver to draw upon.

Disclosure: Long AAPL


Anonymous said...

Superb. Great work, and much appreciated. The high end estimate on GM could be derived by taking teardown estimates for bill of materials and labor from Portelligent and iSupply. They range between $170 and $190. This, together with the ~$650 ASP, yields a GM limit of 70% if no warranty and minimal shipping is assumed. Your estimate of 55.5% growing to over 60% makes a lot of sense given this upper bound.

Anonymous said...

Turley, there is an error in your logic. You are assuming all the deferred revenue is attributable to the iPhone. Remember that revenues related to AppleCare and Apple TV's are also included in that number.

Margins on AppleCare are likely well in excess of 55% (some similar warranty providers recover 90% margins). Given the growth in Mac sales AppleCare revenues have likely increased significantly as well.

If you are on Sanity take a look at my comments to your post.

Grouch said...

Great job.
In your first of three equations the article gives a .21 factor where the table from which it is derived shows it should be .29. Which did you use in your calculation? Typo or calculation error?

Grouch said...

Great job.
In your first of three equations the article gives a .21 factor where the table from which it is derived shows it should be .29. Which did you use in your calculation? Typo or calculation error?

Turley M Muller said...

Good catch- that's a typo in the equation I gave- should be .29 not .21 (.29 + .71 = 1)

The tables have the actual match underneath them- I just took screen shots, but I was careless, I guess, typing out my explanation.

i"ll correct that.

Thanks for pointing that out.


Turley M Muller said...

The deferred revenue I used was just attributable to ATV and iPhone. AppleCare is broken out separately, thus It's not in my numbers.

From Apple's Q4 report:
DR- current:
iPhone & ATV = 3518
AppleCare = 599
other = 736
TOTAL = 4853

As you can see in my calc I used the 3518 number, not the 4853 figure for total current DR.

The same is true for non-current DR

Thanks for broaching the subject, I'm sure others have wondered the same thing

wallstreetking said...

Nice work. I'd like to say that revenues from AppleCare should be substantial and should not be ignored. When it cost me $75 bucks to call in and ask a question, I'd say thats margin...

Anonymous said...

Hong Kong is no longer unique with unlocked iPhones. Apple has recently commenced selling unlocked iPhones in Australia and New Zealand. Of note is that Australia has five Carriers selling the iPhone, so it's not due to a lack of competition.

Refanel said...

Turley, could you kindly indicate where did you get the following DR breakdown from? I couldn't find them on any of the Ks/Qs:

iPhone & ATV = 3518
AppleCare = 599
other = 736

Turley Muller said...


Those numbers aren't in the Q's, but are in the quarterly press releases. If you go to Apple's IR site, there is archive all press releases and accompanying tables.

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