Apple’s $2B, “Two-Dime” Accounting Change: Home-Gamer “Quantifying” Apple’s September 2015 ESP Deferral Adjustment

ONLY if you dare to get some “background”: I’ve gone down the unknowable rabbit hole of ESP (estimated selling price, software upgrade rights) deferrals twice, before.

As you know, we here at The AAPL Tree I often like to cover those topics a bit lesser known about everyone’s favorite continually-pressured-in-some-way smartphone and a few other things company. And this looks to be another such topic.

Luca Maestri, about 20:45 into Apple’s FQ4 2015 earnings conference call (podcast link available here for another few days or so)

“Second, in September, based on an analysis of market offerings, we reduced the estimated selling price of future software upgrade rights and non-software services that we defer for each iOS device and Mac sold. The reduction is between 5 and 10 dollars per unit.”

(Luca also announced that Apple would be extending iPad deferral revenue recognition period from 2 years to 3 years, which is an interesting “statement of opinion” from Apple on iPad lifecycle.)

Note also Page 45 of the FY15 10-K (Apple 10-K, linked at Investor Relations site.):

“Beginning in September 2015, the Company reduced the combined ESPs for iOS devices and Mac between $5 and $10 to reflect the increase in competitive offers for similar products at little to no cost for users, which reduces the amount the Company could reasonably charge for these deliverables on a standalone basis.”

(Also note: iOS devices are specifically defined as iPhone, iPad and iPod touch – we’ll assume pretty much 100% of GAAP-reported unit sales are “qualifying sales” – to the ostensible exclusion of Apple TV and Apple Watch, although the latter two device classes do have ESP deferrals.)

What could this reduction in deferrals amount to across Apple’s balance sheet in the Fallow Harvest of Fiscal 2016? 😀

Your “Forecast” for FY 2016, Part 1: Units

Here’s a very, very, VERY imprecise forecasting of Apple’s FY 2016 (the closest thing you’ll see to me doing any kind of advance forecasts), simply to get a reasonable baseline for the deferral reduction analysis.

We’ll go through each item real quick, slightly out of order.

~230M iPhones

Actually, Apple sold 231.2M iPhones in FY15. 😉 I expect Apple to grow iPhones YOY, and my personal, random horseshoe toss is in the 10-15% unit growth range. Who knows, maybe Apple sells more like 250-260M iPhones in FY2016 (big number, huh), but we’ll keep things reasonably conservative and assume flat iPhone growth. It’s all the rage lately, anyway.

~50M iPads

Apple sold about 54.86M iPads for the fiscal year, down 19% YOY, so that’s projecting a unit drop of around 8.5% for the current fiscal year. Is that too conservative, now that iPad Pro is here? Or is that a little optimistic, considering only iPad mini got refreshed, while the former flagship line, iPad Air/2, marches in place at the same price point as last year? Will iPad Air eventually get an update, changing this incredibly facile analysis? Eh, the ensuing weeks and months will tell. In any case, since I’m not “projecting” a return to growth yet, I deem this napkin math somewhat reasonable.

~22M Macs

About 20.59M Macs sold for FY15. Is 6.8% unit growth a little bit too high? Well…9% unit growth from FY14, which in turn was 16% growth from FY13. iPad growth could certainly impact Mac, though I doubt Mac would ever see something like iPad’s -19% unit decline anytime soon. Eh, there’s only so many units vs. iPhone. Won’t make a big difference for purposes of this post.

~10M iPod touch

It’s a total unknown. Implies $2.5B or so in Other Products revenue, but we’ll never know what iPod unit sales are. But I don’t think it’s an outrageous estimate, considering (1) iPod seasonality and (2) the possibility of another iPod refresh before CQ3 2016.

230M + 50+ 22 + 10. About 310M qualifying devices.

Between $5-10 per device. Talk about nebulous.

Well, if Apple meant something like “$5 for iOS, $10 for Mac” (since Mac deferrals are highest at $40/unit, if memory serves), that’d be slightly disingenuous (if legitimate), since over 90% of these devices would have the lowest ESP deferral reduction. And the opposite would appear to be true as well.

So, why not pick a midpoint of slightly under $7 for all devices? And really, if you note the “increase in competitive offers for similar products at little to no cost for users” language in the 10-K, that one class of product which is the “greatest offender” in terms of “free software” would have to be ultramobile operating systems, a.k.a. mostly Android. In light of the flood of free-software smartphones and tablets (never mind ease of updating, supported OS versions over time, etc.), which classes of product would Apple like to bind just that bit less by the vagaries of Sarbanes-Oxley accounting? My guess: iPhone and iPad.

Hey, if you think I’m totally off base, then adjust my estimate of $2B in deferred revenue “recapture” to the bare minimum of $5/unit, and scale accordingly.

Your “Forecast” for FY 2016, Part 2 – What $2B Could Mean, Throughout the Balance Sheet

Don’t look into the numbers too much, though I think them to be pretty reasonable, maybe a bit low. Yes, this biased Apple fanboy sees growth in FY 2016. Avert your eyes, doubters.

First, pre-deferral-reduction estimates.

$249B revs (6.54% YOY growth) – we now have Watch, Apple TV and iPad Pro along with Mac to aid revenue growth)

$148B COGS

$101B Gross Margin (an increase from full-FY 40.06% GM to 40.56%)

$24.3B OpEx (8.5% YOY increase)

$1.4B OI&E, I know, whatever 😀

$78.1B pre-tax income

$20.85B provision for income tax (26.7% tax rate)

$57.25B net income (7.2% YOY increase)

$10.29 EPS (based on 5.561B share-weighted shares outstanding, $30B worth of net share repurchases, ~232M shares purchased at ~$130 on average per share)

Second, we add the mystery two billion dollars. As you’ll see, and as you may already know, deferral dollars aren’t your garden-variety revenue dollars.

>> Adding $2B to revenue ($251B) — growth boost to ~7.40%, about 85 basis point impact

>> Adding $2B to gross margin ($103B) — GM boost from 40.56% to ~41.04%

Two points. First, deferred revenue counts dollar for dollar against gross margin, meaning that one deferred revenue dollar is presumed to have 100% gross margin for GAAP/Sarb-Ox purposes. Second, my brain is always confused by this, but the nature of the appropriate maths means that the $2B boost to gross margin does not have anything close to an 85 basis point impact on GM itself – it’s closer to 50 basis points. But as we’ll see a little farther down the income statement, it still makes an important difference.

>> Assuming deferred revenue doesn’t have any OpEx baggage, it flows straight to pre-tax income – at which point, of course, it gets taxed. Since Apple maxes out the top tax brackets of every relevant country in which it does business, most likely 😀 we’ll simply apply the same 26.7% tax bracket to the $2B in extra pre-tax income – resulting in a net income boost of ~$1.47B. That’s 2.56% in extra profit dollar growth. Seems a bit modest, but only until you see where Wall Street’s thinking is at now.

>> Finally, EPS. Because Apple will surely have net-reduced diluted share count with $30B+ in buybacks, the net income boost provided by no-longer-deferred revenue recognition is slightly enhanced. Assuming a ~4% reduction in diluted share count, the improvement to EPS would be around 26 cents – just over a quarter dollar.

But Wait, There’s Still the Amortization Factor 

Ah, but that’s not all! See, while $2B or so in deferred revenue now flows to revenue immediately, a portion of that revenue would have flowed to the top line over time via amortization anyway – and that schedule is 8 quarters for iPhone (and iPod, I believe), 12 quarters for iPad (new), and 16 quarters for Mac.

Ugh. Fear not though, for I have done some quick math so you can simply apply an adjustment factor to all of the above numbers.

Take revenue share of each quarter (a reasonable projection) to the full $251B FY 2016 wild guess, say, ($81/63/52/55B for FQ1-4 2016), and apply 37.5% amortization recovery for FQ1, 25% for FQ2, and 12.5% for FQ3 (this assumes amortization does not begin the quarter of deferral, but the quarter that follows – if you’re confused, exercise your right to tweet at me or leave a comment!), just leave the numbers as they are because iPhone unit share is so dominant, carry the 5…

…and you end up with a approx. 20% reduction of all of the above numbers, which is probably a touch high due to longer amortization of iPad and Mac, but that’s fine for purposes of this post.

So, finally, what you end up with from $2B in newly-non-deferred revenue is

— close to 70 basis point revenue impact

— close to 40 basis point GM boost

— close to $1.2B in net income boost

— slightly over 2% net income improvement

— around 2.3% EPS boost, but in any case around 20-21 cent EPS improvement

Against a Wall Street consensus for revenue to grow 4.9%, and EPS to improve from $9.22 to $9.87, or “just” 7.05%.

Now it’s true the 70 basis point boost in revenue, billion and change though it may be, doesn’t seem “that meaningful” given Wall Street’s call for Apple to boost revenue 490 basis points year-on-year. Still, it’s not nothing in this “game of inches” and fierce ForEx headwinds, and it’s unlocked “for free”. Moreover, an EPS boost of 20-21 cents (adjusted for amortization) goes a surprisingly long way, all by itself, to meeting the current expected EPS delta of about 65 cents.

Don’t worry. Unlike what transpired this past hyper-growth year, I’m pretty sure Apple, indirectly or otherwise, won’t induce analysts to skyrocket their estimates as if it were an auction.


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