I Don’t Have ESP, But I Do Have Estimates and Charts: A Home Gamer’s Attempt at the Daunting Task of Tracking iPad, iPhone and Mac Deferred Revenue

Ah, deferred revenue.

Just one of many, many pieces of the puzzle that is Apple earnings. And yet, an important one.

As a little background/potentially annoying meandering aside, one of the “problems” with Apple has always been its culture of secrecy. It’s not that big an issue for products at the end of the day (I mean, it’s making over $150B in revenues per year “despite everything”) and Apple is actually quite transparent relative to the tech industry when it comes to reporting GAAP sell-in-basis unit sales of key products, such as iPhones, iPads and Macs.

– Samsung, giving quarterly information about smartphone units sold? Amazon, giving any information ever about Kindle Fire sales? Yeahhh.

– As for guidance? Apple makes you guess share count, but c’mon, it’s not that hard to hazard a reasonable guess. Google and guidance? Exactly.

None of that is relevant to how great Apple is or isn’t – it’s just fact. Here’s another basically-fact: Apple isn’t great about non-GAAP context. Sure, it provides a few important data points here and there, along with commentary. But Apple doesn’t tend to spell out things like iPhone and iPad sellthrough, which hinders Wall Street/analyst/investor understanding of the company, nor does it help explain the main topic of this post as well as it could:

ESP. No, not the psychic thing or whatever. This (page 7 of Q1 2014 10-Q SEC filing):

Revenue Recognition

In 2013, the Company’s combined best estimates of selling price (“ESPs”) for the unspecified software upgrade rights and the rights to receive the non-software services included with its qualifying hardware devices ranged from $5 to $25. Beginning in the first quarter of 2014, the Company adjusted the combined ESPs for Mac from $20 to $40 to reflect additions to unspecified software upgrade rights related to expansion of bundled essential software.

Wha?

Here’s some additional context, once again courtesy Apple (pages 37-38 of the same Q1 2014 10-Q SEC filing)

For sales of qualifying versions of iOS devices, Mac and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades and features free of charge to customers. The Company also provides various non-software services to owners of qualifying versions of iOS devices and Mac. Because the Company has neither VSOE nor TPE for the unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the unspecified software upgrade rights and non-software services based on the Company’s ESPs is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided for each of these devices, which ranges from two to four years.

 

The Company’s process for determining ESPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s ESPs and the future rate of related amortization for software upgrades and non-software services related to future sales of these devices could change. Factors subject to change include the unspecified software upgrade rights offered, the estimated value of unspecified software upgrade rights, the estimated or actual costs incurred to provide non-software services, and the estimated period software upgrades and non-software services are expected to be provided.

Still confused? That’s part of my point about the “y’know, Apple could stand to explain certain stuff better” thing. (To be fair, Oppenheimer does provide some extra detail on the conference calls, but it’s still not “everything”.)

Here’s the quite-possibly-too-simplistic version of ESP deferrals (warning: I’m not an accountant)

(1) As you know, iPhone, iPad and Mac are Apple’s core hardware products. They collectively ring in the vast majority of Apple’s revenues.

(2) As you also know, iPhone, iPad and Mac come with software upgrade rights and certain other services that Apple doesn’t charge for (at least for a standard level of service), such as iCloud.

(3) This collection of “stuff” is, whether it’s Sarbanes-Oxley or whatever, assigned a value on a per-unit basis by Apple. Which, unhelpfully, varies from time to time. Here are the “assumptions” I’ll be using later in this article (don’t mind the mess). Some of the ESP values were explicitly stated by Apple in the relevant time periods; others, such as iPad and iPhone deferrals per unit “as of today”, require an “educated” guess.

deferral-assumptions

(4) These deferrals count dollar-for-dollar against revenue (of course) and also gross margin. In other words, if my understanding is correct, Apple treats these deferred revenue dollars as “100% gross margin dollars” for deferral purposes. Meaning Apple “intentionally” reduces gross margin each quarter by the full amount of the ESP deferral. Kinda material impact on revenues and earnings, as you’ll see.

(5) iPhone and iPad deferred revenue (which I guess you can also call ESP, ESP deferral, etc.) are amortized (basically, added back) on a straight-line basis over 8 quarters. Mac, over 16 quarters. I know, you already know this, but since I’m covering this topic for the first time, that means in “Quarter 1”, the ESP revenue is deferred, and in Quarters 2 through 9 (or 17 for Mac), 1/8 or 1/16 of the deferred revenue/gross margin is added back.

(6) Now, I’m pretty sure amortization won’t occur in the same quarter as the deferral, otherwise I’ve committed one of those transcription errors you always worry about in bubble-sheet multiple choice tests. In any case, the general “validity” of this post will still hold up, at least until I make the necessary adjustments. 😀

(7) ESP is only a part of the deferred revenue picture, which isn’t ideal because exact ESP for iPhone/iPad/Mac is only known to Apple (thanks to the change-ups in deferrals and those periods of time, like now, where Apple doesn’t provide full clarity on per-unit deferrals except for Mac). There’s also the iTunes/Software/Services side of things, where iTunes gift cards, AppleCare, and maybe other revenue are deferred and amortized on their own schedules.

And there’s apparently deferred revenue for price protection.

And rebates.

And various other sales and incentive programs.

And anticipated future product returns.

And still-in-transit sales made online to individuals.

And other various categories.

I’m…not gonna try puzzling those out yet. Or ever? Sorry.

Anyway, that being said, I still think there’s value in puzzling out iPhone/iPad/Mac ESP “by itself”, since it’s a big part of the total deferred revenue picture – and unlike the other deferred revenue, it can be estimated and charted out to some degree thanks to the fixed amortization periods. Again, subject to the dreaded “transcription error” problem, let’s begin with the basics. This is my estimate (based on the above assumptions, which I hope I applied correctly) of total iPhone, iPad and Mac ESP over time:

aapl-deferral-step1

Wow. Pretty steep, isn’t it. Does put a little perspective on that whole “Apple is doomed” thing, though yes, deferrals did increase a couple of quarters ago. If my estimates are generally correct (“if“), Apple has probably deferred over $10B – and counting – of ESP revenue for iPhone, iPad and Mac combined in about the past five years. It ain’t pocket change, and that’s why I think getting some kind of handle on ESP deferral holds value, even though it’s only a not-fully-clear piece of the deferred revenue puzzle.

Macs have the highest deferral at $40/unit, but sell around 4-ish million units per quarter on average. iPhone, with a ESP deferral of somewhere around $20 (call it a semi-educated guess), sells in much greater volumes – lately, over 35M units per quarter on average. And with iPad estimated to have similar per-unit ESP deferral, well, it’s not much of a stretch to conclude that iPhone accounts for the lion’s share of iPhone/iPad/Mac ESP deferred revenue.

Of course, that’s just Step 1. Those ESP deferral dollars are reintroduced according to their (thankfully never-changed) amortization schedules. My best guess about amortization by quarter is as follows:

aapl-deferral-amortization

Again, that’s revenue and gross margin added back “slowly” to Apple’s present and future fiscal quarters. It’s easy to miss, because deferred revenue that’s recognized in a given quarter isn’t broken out in Apple’s financials – you basically have “Deferred Revenue” under Current Liabilities (to be recognized within a year), “Deferred Revenue – Non-Current” (everything else that isn’t current), a line item in the cash flow statement, and this (for iPad and Mac as well):

iPhone (b)

(b) Includes deferrals and amortization of related non-software services and software upgrade rights.

Footnote (b). Awesome. Anyway, we now have a green line, which says how many deferred revenue/gross margin dollars, subject to a bunch of guesswork, are added back in a given quarter. But there’s still the new deferrals, right?

Right. So to “complete” this unclear piece of the puzzle (frustrating, yes I know), which only relates to iPhone, iPad and Mac ESP deferral, you take new deferrals from GAAP sell-in-basis (what Apple reports) iPhone/iPad/Mac units sold, and subtract by the amortized revenue that’s being added back on a rolling basis (nowadays, that means eight quarters of different-rate amortizations of iPhone and iPad each, and, about 18 months or so from now, 16 such quarters from Mac).

Result, or something like it? Net ESP deferral for iPhone, iPad and Mac combined per fiscal quarter. In other words, this is kinda, sorta, maybe the amount of net impact deferrals had in the reported quarter – and if you dare to project into the future, the estimated amount of net impact deferrals from iPhone, iPad and Mac will (er, might?) have on that future quarter’s revenue and gross margin.

aapl-net-deferrals-by-quarter

So, subject to all those ifs, seems Apple net deferred around $900M in revenue/gross margin attributable to iPhone/iPad/Mac ESP in fiscal Q1 2014. That number, however accurate it may be for that subset of deferrals, “should” drop substantially for the March quarter. We’ll see. Now that Apple’s unit growth is slowing, for now at least, maybe the net deferral estimates will paint a slightly clearer picture over time. Or – considering the apparently relatively low net deferrals in fiscal Q3 and Q4 – maybe not. Oh well.

A bonus chart: The iPhone/iPad/Mac revenue/gross margin dollar deferrals we think we know (red), and the running total of ESP deferrals that Apple has yet to amortize, maybe (orange):

aapl-deferral-cumulative-and-net-esp

To wrap up, who knows exactly how helpful estimating a portion of Apple’s deferred revenue will be, but it does provide some general perspective about the billions of revenue/gross margin dollars being, for lack of better term, “squirreled away”. Is there some intent by Apple management to smooth earnings? Is it more than compliance with accounting rules? I don’t know, and as to the “rainy day” theory, we may never know, though net deferrals could provide a partial clue over time.

 

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