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.