My Photo
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.

Thursday, October 28, 2010

Warranty Expense Crimps Apple's Margins in 4Q10



Apple Inc (nasd:AAPL) reported a 36.9% gross margin for Q4 2010 which ended in September. This caused worry among investors especially since management stated on the earnings conference call that the decline was due to higher cost structure of iPad and iPhone and the exceptional value it is delivering to consumers. However, a considerable portion of the decline was due to warranty expense which there was no mention on the call.

At the time Apple recognizes revenue for the sale of a product, it also records its estimate warranty expense in costs. It is just an estimate, thus actual warranty costs may vary. When there is an actual warranty cost incurred, it is not recorded to expenses on the income statement since Apple already accounted for warranty expense at the time of sale. Instead, actual cost incurred are recorded as reduction to the warranty expense reserve.

Apple’s warranty accruals had been averaging around 1% of revenue for the first three quarters of FY10, or roughly ~$150M. In Q4, warranty accruals ballooned to $457M, or 2.3% of revenue.

If estimated warranty expense had remained constant in absolute dollar terms ($150M), GM would have been 38.4% vs 36.9%. If If estimated warranty expense had remained constant in as a percentage of revenue (1%), GM would have been 130bps higher at 38.2%.

The silver lining is often estimates of warranty costs are overly conservative resulting in much smaller accruals going forward. This could potentially happen with Apple if actual costs incurred fail to materialize, Apple would make much smaller accruals going forward, hence boosting gross margins. 


6 comments:

Horace Dediu said...

Nice catch!
I posted: http://www.asymco.com/2010/10/28/turley-muller-warranty-expense-crimps-apples-margins-in-4q10/

I wonder what the chances are that we might see a surprise on the upside in margins this Q.

Turley Muller said...

I expect we will. I don't think the cost of claims, (charges to the reserve) will catch up, thus Apple will have more that sufficient reserves allowing them to book lower warranty expense to earnings in the periods ahead.

Senith @ finance tutor said...

Turley,

Excellent find. But I think we cant be sure if the charges to the reserve will bounce back to normal levels. The last qtr is ~85% more than the previous qtr which itself was the highest charge in the last 7 qtrs. So it could be the beginning of a trend. Not sure if it has got to do with the iphone4 teething issues or the ipad.

Ted Cranmore said...

Superb work as always Turley! This is real insight that makes a significant impact to the body of knowledge.

Did we see similar trends during the introductions of other devices? Or, does the sheer scale and number of new products help differentiate what we are seeing today?

Burney said...

Any idea why Q4 cost of claims were so high, possibly the antennae fix/refund? Hopefully not IPad. I would assume AAPL is looking to carry a higher reserve going forward and that they expect a big number next quarter also.

Turley Muller said...

The antenna issue was covered with giving away free cases wouldn't be included in warranty expense n

Share it

Contact Financial Alchemist



Email: gmail-turley.muller
Phone: (901) 213-8875