Wednesday, October 17, 2018

Impact of Licensing Revenue on Apple's Services Segment

Apple’s revenue from its Services segment has consistently exhibited growth. It’s the only area of Apple’s business not to have a down quarter over the past 6 years. It has accelerated in the last two quarters reported to over 30%/ While sales growth for iPhone, iPad, and Mac has been all over the map, Apple promotes its Services as a high-margin growth engine for the future. The Services segment includes revenues from Apple Music, Apple Pay, AppleCare. iCloud, iTunes, App Store, and licensing. On quarterly conference calls, management touts the success of its Services business and goes on to mention the unparalleled popularity of the App Store, Apple Music, iCloud, and so on. It reviewing transcripts dating back 10 years, I couldn’t find a single mention of licensing other than a couple instances where the CFO was explaining what was reported in the Services segment. 

"we refer to as services and this will encompass everything we report under the heading of iTunes software and services today including content, apps, licensing and other services and beginning this month it will also include Apple Pay."



Goldman Sachs estimates that the licensing revenues have been growing over 40%, and currently amount to almost $2.5B per quarter, and they expect it to continue to grow almost 30% next year. This appears reasonable. We can dissect revenues the other Services components- App Store, AppleCare, iCloud, etc. and we are left with a $2B+ shortfall, most of which must be licensing related revenue. The bulk of this licensing is revenue from Google for search in Apple’s Safari browser. Since this is a confidential agreement Apple makes no mention it exists other than alluding to it in quarterly SEC filings. In the Management Discussion section of the Form 10-Q, Apple states licensing as a primary contributor to the growth of the Services segment. Contrary to earnings calls, where it’s never been mentioned.  Below is a table displaying the quarters licensing was named as a growth contributor and the excerpts of those statements. All but 2 quarters since 2014 has licensing been included. Apps are mentioned for every quarter and AppleCare in more than half. AppleCare, however, is not a significant growth contributor. Unit sales for Apple Products that AppleCare is available for have been flat for past several years. Attachment rates have likely increased modestly. Since AppleCare revenue is deferred over life of the contract (usually 2 years), it does not have an immediate effect on the quarter in which it was sold since only 1/6 (at most) is recognized.It does affect revenues over the next 8 quarters if Apple continues to sell more contracts than previous quarters.
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Below are the excerpts from the 10-Q



2013 Q3
iTunes, Software and Services Net sales of iTunes, software and services were $4.0 billion and $11.8 billion in the third quarter and first nine months of 2013, respectively, increases of $787 million or 25% and $2.4 billion or 26% compared to the same periods in 2012. These increases were primarily due to growth in net sales from iTunes, AppleCare and licensing

2014 Q1
The increase in net sales of iTunes, Software and Services in the first quarter of 2014 compared to the first quarter of 2013 was due to growth in net sales from the iTunes Store, AppleCare and licensing. 

2014 Q2
The increase in net sales of iTunes, Software and Services in the second quarter and first six months of 2014 compared to the same periods in 2013 was due to growth in net sales from the iTunes Store, AppleCare and licensing. 

2014 Q3
The increase in net sales of iTunes, Software and Services in the third quarter and first nine months of 2014 compared to the same periods in 2013 was primarily due to growth in net sales from the iTunes Store, AppleCare and licensing


2015 Q1
The increase in net sales of Services in the first quarter of 2015 compared to the first quarter of 2014 was primarily due to growth from iTunes and licensing.

2015 Q2
The increase in net sales of Services in the second quarter and first six months of 2015 compared to the same periods in 2014 was primarily due to growth from licensing and iTunes, 

2015 Q3
Net sales of Other Products increased solely due to the launch of Apple Watch, and net sales of Services increased primarily due to growth from iOS app sales and licensing. 

The increase in net sales of Services in the third quarter and first nine months of 2015 compared to the same periods in 2014 was primarily due to growth from iTunes and licensing

FY2015
The increase in net sales of Services during 2015 compared to 2014 was primarily due to growth from Internet Services and licensing. 

2016 Q1
The remainder of the year-over-year growth in net sales of Services was due primarily to higher App Store and AppleCare sales.

2016 Q2
The year-over-year increase in net sales of Services in the second quarter and first six months of 2016 was due primarily to higher App Store, licensing and AppleCare sales. 

2016 Q3
The year-over-year increase in net sales of Services in the third quarter and first nine months of 2016 was due primarily to growth from App Store, licensing and AppleCare sales.

FY2016
The year-over-year increase in net sales of Services in 2016 was due primarily to growth from the App Store, licensing and AppleCare sales,  The increase in net sales of Services during 2015 compared to 2014 was primarily due to growth from the App Store and licensing.

2017 Q1
The year-over-year increase in Services net sales in the first quarter of 2017 compared to the same quarter in 2016 was due primarily to growth from the App Store and AppleCare sales,

2017 Q2
The year-over-year increase in Services net sales in the second quarter and first six months of 2017 compared to the same periods in 2016 was due primarily to growth from the App Store and licensing sales. 

2017 Q3
The increase in Services net sales in the third quarter and first nine months of 2017 compared to the same periods in 2016 was due primarily to growth from the App Store and licensing sales.

FY2017
The year-over-year growth in Services net sales in 2017 was due primarily to increases in App Store and licensing sales. Services net sales in the fourth quarter of 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information. 

The year-over-year increase in Services net sales in 2016 was due primarily to growth from the App Store, licensing and AppleCare sales, 

2018 Q1
The year-over-year growth in Services net sales in the first quarter of 2018 was due primarily to increases in licensing and App Store sales

2018 Q2
Services net sales increased during the second quarter of 2018 compared to the same period in 2017 due primarily to licensing, App Store and AppleCare. Year-over-year growth in Services net sales during the first six months of 2018 was due primarily to licensing, App Store and iCloud.

2018 Q3
Services net sales increased during the third quarter and first nine months of 2018 compared to the same periods in 2017 due primarily to licensing, App Store and AppleCare. During the third quarter of 2018, the Company recognized a favorable one-time item of $236 million in connection with the final resolution of various lawsuits.

Monday, August 6, 2012

Estimating 2Q 2012 US Smartphone Sales

Last week, Strategy Analytics published its estimates for 2Q12 US smartphone shipments; however, they can't been seen as reliable due to a number of problems. Whenever I read research or an article, or hear somebody quote market share figures from the large industry research houses, such as IDC, Gartner, Strategy Analytics, or Canalys, I cringe. Too often, I find wide disparities between these industry estimates and the numbers I know to be true- figures reported by manufacturers, carriers, resellers, etc. in press releases, SEC filings, and on conference calls. Another problem is that these research firms give little public explanation behind their methodology. A better framework is to first calculate sell-through, or sales to end-users which the top 4 carriers provide smartphone unit figures. These aren't 3rd-party estimates; they are actual sales figures from the horse's mouth. Since these numbers can be attained with a high degree of confidence, we can then hash out shipment estimates based on analyzing market and seasonal trends, as well as incorporating any guidance available from vendors and carriers/resellers. 

Strategy Analytics 2Q12 US Smartphone Shipment Estimates:


source: Strategy Analytics

The first problem with SA's Q2 US shipment estimates is that its figures for Apple aren't shipments, they are sell-through. The 7.9M unit shipment estimate for Apple is the sum of activations reported by AT&T, Verizon, and Sprint. To be consistent with measuring shipments, as we assume SA is doing for the other OS platforms, sales to iPhone carriers and resellers (i.e. Best Buy, WalMart, Radio Shack, etc) need to be measured. 

Second, the activation figures used only include 3 carriers, however iPhone is available through 16 carriers in the US. Even though these carriers are very small and many weren't online during the entire quarter resulting in relatively low activations, there would be considerable iPhone shipments into these channels due to the need to build a stock of initial inventory.    

SA is assuming that iPhone shipments equals sell-through. Apple reported that channel inventory declined by 300K globally, hence 26.3M units sold-through versus the 26M units shipped. Apple specifically stated that China shipments were impacted from a reduction in channel inventory which was high at the start of the June quarter due to the iPhone 4S launch at China Unicom and the addition of China Telecom in the March quarter. Therefore, sell-through in China was significantly higher than sell-in (shipments) which resulted in the reduction of channel inventory. Apple stated the China channel inventory impact was more than $1B of iPhone revenue, which would equate to more than 1.5M units. Therefore, channel inventory had to increase by 1.2M units outside of China to equal the net 300K decrease in global channel inventory. Given that Apple added 12 carriers in the US, coupled with only a 12% sequential decline in activations at the top 3 carriers, we can attribute much of the 1.2M channel inventory build to the US.    

Third, we know the 7.9M figure for 2Q12 and the 5.9M figure from 2Q11 aren't the correct numbers to use. Tim Cook stated on the conference call that iPhone sales were up 47% year over year in the US. Using the activations figures as SA did, the Y/Y increase is only 34%. Therefore, we know that shipments don't equal the activation, or sell-through numbers that SA incorporates. 

So for SA's estimates to be reliable, or even taken seriously, they must be consistent in what they are measuring. If they are measuring shipments, then SA should use shipment figures for Apple, not sell-through. Obviously, shipment numbers are a lot harder to ascertain than sell-through figures since US carriers report smartphone sales or provide metrics to calculate it. 

Using the erroneous activation number, SA calculates that Apple captured 33% of shipments. SA also says Android shipments were 13.4M units and RIM shipped 1.6M units. Where or how did SA come up with these figures? We know the RIMM figure doesn't make sense. Taking the revenue numbers RIMM reported for the US for the May quarter, and adjusting for June month being much weaker than February, ASP's are highest in US, and significant portion of service revenue comes from high ARPU customers (such as enterprises) in the US, Blackberry shipments were most likely around 1M units, not 1.6M units SA estimates. So what about the Android number? That's a tough one to reliably estimate. However, we can make some meaningful assumptions for estimated shipments from sell-through estimates which are much easier to calculate given that carriers provide smartphone sales. Using the underlying trend of sales to end-users, we can then make assumptions of whether or not carriers & resellers would be increasing/decreasing or maintaining inventory levels.

Financial Alchemist 2Q12 US Smartphone Sell-Through Estimates:

AT&T & Verizon reported smartphone sales of 5.1M & 5.9M, respectively. Sprint stated that 81% of handset sales were smartphones, and given the upgrade rate and gross additions, Sprint sold around 3.3M smartphones. T-Mobile hasn't reported quarter results, but sold 2.5M in Q1, so estimating 2.4M units would likely be appropriate. Then comes the wild card: the other carriers.  They consist of very small regional post-paid players and national prepaid carriers which probably account for about for 30M subscribers. It's a hard number to quantify. It's also hard to quantify smartphone sales for those carriers as well. However, they only make up 10-15% of the market, and the percentage of smartphone sales is lower due to the high cost of hardware which isn't subsidized much for prepaid plans. A conservative estimate would be that the "other carriers" roughly resembles T-Mobile. 

In total, I estimate that 19.2M smartphone units were sold to end-users in 2Q12. SA estimates that 23.8M units were shipped, or sold into the channel. So is it reasonable that shipments exceeded sell-through by 4.6M? If sell-through were expected to increase by 4.6M units in Q3 it would, but it's very unlikely that it will by that much, if at all, for a couple of reasons. 1) Carriers are tightening their upgrade policies, charging higher fees and lengthening the time period until one is eligible for a fully discounted upgrade. 2) Smartphone penetration has reached over 50% at the top carriers  (62% at AT&T, 71% at Sprint), thus the pool of potential first-time smartphone buyers is shrinking. 3) Seasonality- typically demand softens in the summer, and gradually accelerates into the back-to-school period and holidays. Q3 generally sees the widest divergence between sell-in and sell-through as carriers build inventories. In sum, unit shipments likely exceeded sell-through slightly (20M units), or at best, only modestly (21M). The vast majority of any excess sell-in would consist of Android units, however. 

At the top 3 carriers, Apple captured 55% of smartphone sales to end-users. For the entire US Market, I estimate Apple's market share was 42%. In terms of share of sell-in, iPhone would likely only be lower by 2-3%. It's highly unlikely that it would be as low as 33% Strategy Analytics estimates. Estimating the sell-through for the other platforms is more difficult, since only Verizon provided Android figures. But taking data reported by RIMM and Nokia, as well as other company sources, unit sales and market share can be estimated with a modest degree of confidence.  

source: FA estimates, company reports



My method for estimating US smartphone sales mirrors the method used by Ben Evans from Ender's Analysis. In being conservative, I model a higher volume of unit sales to the other carriers (non-Big Four). 

In short, industry research firms such as the ones mentioned in the opening paragraph often don't produce reasonably accurate estimates. This instance is just one example of many where I have encountered considerable factual evidence to the contrary.  The best approach is to always take the figures reported by the industry players as we know that those are accurate. From there, we can make more reliable estimates with regards to the unknowns.

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. 


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