Apple's Extended Warranties:
Every once in a while, someone sues Apple over its sales of extended warranties. But they never quantify the amount of money involved. Turns out, it's huge, based on some assumptions we made using figures from the company's own annual reports.
With yet another aggrieved group filing a lawsuit against Apple Inc. in Europe over the perceived clash between statutory warranty rights and extended warranties purchased separately, we thought it time to ask a simple question.
How big is Apple's extended warranty program?
It sounds like a simple enough question, but it's one that never seems to get an answer. Look at all the Apple articles here, here and here, and the one thing they have in common is absolutely no information about how many Apple customers buy extended warranties, and how much revenue that brings to the company each year.
Apple's Extended Warranty Business
So let's give a simple answer, and then let's go through the exercises that got us there. In the fiscal year ended September 29, 2012, we estimate that Apple collected nearly $5.3 billion in extended warranty premiums worldwide, which represented 3.4% of its total sales.
We estimate that the amount of extended warranty premiums paid by consumers to Apple grew by 57% in fiscal 2012, significantly faster than the 44% growth rate for all its other products and services. But in fiscal 2011 and 2010, extended warranty sales grew more slowly than the rest of the company, and in fiscal 2008 and 2009, annual extended warranty revenue grew by only 16% and 14%, respectively.
We also estimate that the amount of extended warranty revenue collected and set aside in 2012 was approximately 2.4 times as much as the amount of funds that was set aside as accruals to pay for basic product warranty claims. This is at the midrange of the multiples seen in years past, from a high of 5.7 times as much in fiscal 2007 to a low of 1.9 times as much in fiscal 2008.
What we don't know, and probably will never know, is the profitability of the $5.3 billion in extended warranty premiums paid. That $5.3 billion is the gross revenue of the program. What we don't know is the cost of claims. And therefore we don't know if the extended warranties are making money, losing money, or breaking even.
The product warranties, lacking revenue, are hopefully being run on a break even basis. In fiscal 2012, Apple set aside $2.184 billion in accruals, and spent $1.786 billion on claims. But remember, it's making accruals in 2012 for warranties that expire in 2013. And it's paying claims in 2012 for products that were sold in 2011. So there's never going to be an exact balance in any given year between claims and accruals. It's a break even program only on a long term basis.
Apple's net income was over $41.7 billion in fiscal 2012, so even with the most optimistic assumptions, Apple's $5.3 billion extended warranty operation couldn't have been a huge part of that profit. But in terms of cash flow, it has to rank Apple Inc. as one of the world's largest extended warranty administrators.
AppleCare & AppleCare+
In the U.S., there are two primary brands of extended warranty. AppleCare Protection Plans cover Mac computers, Apple displays, Apple TV, and iPod digital music players. AppleCare+ covers both the iPhone and the iPad families.
AppleCare plans last three years for the Macintosh family and Apple displays, and two years for the iPod and Apple TV. AppleCare+ plans last two years for the iPad and iPhone. AppleCare+ plans also include accidental damage coverage, with each of up to two covered incidents subject to an additional $49 fee.
Both AppleCare and AppleCare+ are sold separately and are supplements to the free warranty. For all of these products sold in the U.S., there is an underlying one-year product warranty, plus 90 days of free telephone support for both hardware and software problems. The extended warranty, if purchased, lengthens the duration of both to two or three years.
In Europe, the trouble arises because of Directive 1999/44/EC of the European Parliament and of the Council of 25 May 1999, which makes the seller liable for the cost of repairing product defects for a term of two years. Specifically, the product must "show the quality and performance which are normal in goods of the same type and which the consumer can reasonably expect." If it does not, "the consumer shall be entitled to have the goods brought into conformity free of charge by repair or replacement, or to have an appropriate reduction made in the price."
Article 5 of the directive specifies that " the seller shall be held liable where the lack of conformity becomes apparent within two years from delivery of the goods." So when Apple sells a two-year extended warranty, promising to repair defects for two years from the date of sale, that contract's coverage allegedly duplicates the mandatory coverage of the free warranty provided by the retailer under European law.
We're not lawyers, and we're definitely not experts on the legal impact of European Union directives, so we won't probe the merits of those frivolous and opportunistic lawsuits. We're also not accountants, nor do we play them on television, but in this case, that complete lack of bookkeeping skill and utter disregard for generally-accepted accounting principles will help us come up with some rough numbers that the EU lawyers can then cite in their briefs.
Extended Warranty Accounting
When a company sells an extended warranty, accounting rules specify that it cannot recognize all the revenue right away. Most companies choose to recognize it proportionally, using the straight-line method, over the life of the contract. In other words, if it's a two-year plan, they recognize half the revenue the first year and half the revenue the second year. If it's a three-year plan, they recognize a third of it each year. Or they might recognize a portion of the revenue quarterly, monthly, or perhaps even weekly.
If the company uses sophisticated warranty analytics tools, they can probably calculate an exact picture of when claims will emerge. Then they can drop the straight-line method, and recognize revenue on the same schedule. In other words, if 80% of the claims arise by the 18th month, they can recognize 80% of the revenue by that time. The straight line becomes a bathtub-shaped curve.
All of Apple's products are covered by a one-year product warranty, and also include 90 days of complimentary telephone support. This may affect the accounting for the cost -- is a first-year repair counted as an expense of the product warranty or of the extended warranty? But it does not affect the recognition schedule for deferred revenue. Because Apple uses the straight-line method, half the revenue is still recognized during the first year, and half is recognized during the second year.
However, extended warranties aren't the only item for which revenue is deferred. In Apple's case, there are at least two additional reasons to defer revenue: 1) the sale of gift cards, and 2) the sale of subscription plans for iPhones.
The first iPhone went on sale in June 2007. So at most, there were three months of iPhone sales in the fiscal year that ended on September 27, 2007. Gift cards go back much further. The iTunes digital music store opened 12 years ago in January, so gift cards redeemed for song downloads are likely to have been a source of deferred revenue for at least that long. And they've only grown in popularity as apps and other items were added to the sales mix.
Over the years, Apple has combined the accounting for these items in different ways. As far as we can tell from the explanations included in the company's annual reports, the main components of deferred revenue from fiscal 2000 until fiscal 2007 were extended warranties and gift cards. But then in fiscal 2008 and 2009, the company also added in iPhone subscription revenue. And then in fiscal 2010, it dropped the iPhone component and went back to bundling just gift cards and extended warranty revenue in the deferred revenue bucket.
Extended Warranties & Gift Cards
We believe this is the current methodology. In its 2012 annual report, Apple lists two primary sources of deferred revenue: extended warranties and gift cards, with a sprinkling of prepaid software upgrades.
"The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. This includes amounts that have been deferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products.
"The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeemable on the iTunes Store for the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer.
"Revenue from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic tools offered under the Company's standard limited warranty."
In another section of the annual report, Apple lists the products that include "revenue deferred for non-software services and embedded software upgrade rights." They include Mac desktops, Mac portables, iPhones, iPods, and iPads. But we're going to pretend that the amounts involved are minimal, compared to the contributions of extended warranties and gift cards.
As we mentioned, until fiscal year 2009, Apple used to also include deferred revenue figures from iPhone handset sales. In its 2009 annual report, the company explained it as follows:
"iPhone revenue includes the portion of handset revenue recognized in the relevant period in accordance with subscription accounting over the product's currently estimated 24-month economic life, as well as revenue from sales of iPhone accessories and carrier agreements. The year-over-year iPhone revenue growth is also largely attributable to the year-over-year increase in iPhone handset unit sales in both 2009 and 2008, which generated significant amounts of deferred revenue that is being recognized over the iPhone's estimated economic life."
In fiscal 2010, however, Apple stopped bundling the iPhone subscription revenue with the gift card and extended warranty revenue. And it restated the year-ago 2009 deferred revenue numbers to exclude the iPhone component of deferred revenue.
With iPhone & Without iPhone
Therefore, for fiscal 2009 we have two sets of numbers: one set that includes iPhone, and one set that excludes iPhone.
|from Apple's Balance Sheet:||2009, from the 2009 annual report||2009, from the 2010 annual report|
|Deferred Revenue - current||$10,305||$2,053|
|Deferred Revenue - non-current||$4,485||$853|
|Deferred Revenue - total||$14,790||$2,906|
In other words, we're suggesting that in fiscal 2009, the iPhone subscription component of deferred revenue amounted to $11.884 billion, and the combined figure for gift cards and AppleCare revenue amounted to $2.906 billion.
Next we're going to take some liberties with generally-accepted accounting principles, to figure out how much of that deferred revenue is gift card and how much is AppleCare. Good thing we're not accountants. We'd lose our license for doing this.
We're going to make three big assumptions.
First, we're going to assume that the Mac family is a dwindling component of the product mix, and therefore most of the extended warranties are for two years rather than for three. In terms of total revenue, the Mac family slipped below 50% of the product mix in fiscal 2005; was only 20% in fiscal 2011; and fell below 15% in fiscal 2012. So it seems reasonable to assume that very little of all that deferred revenue is for the third year of coverage.
Second, we're going to assume that all the gift cards are redeemed within a year, meaning that no deferred gift card revenue ever gets old enough to be classified as non-current. In other words, all the non-current deferred revenue is from the second year of AppleCare service contracts, because it's not from gift cards.
Third, we're going to assume that when a two-year service contract is sold, half of the deferred revenue goes into the current bucket, and half of it goes into the non-current bucket. In other words, at the moment an extended warranty is sold, Apple knows half the deferred revenue will be recognized within a year, and is therefore classified as a current liability. The remaining half will be recognized in the second year, and is therefore a non-current liability.
Now perhaps the reality is that only 90%, or perhaps only 75% of the gift cards are redeemed within a year. That may affect our model. However, if Apple expects them all to be redeemed within a year at the time they are sold, they would all initially have to be classified as current. If, at the end of a fiscal year some are not redeemed, they'd still have to be classified as current, because they could very well be redeemed the next day, or next week. So perhaps all the gift card revenue is current, whether they're redeemed or not?
It would be nice if all of a given year's extended warranties were sold on October 1, and half the deferred revenue was recognized by the following September 30, so it all fell neatly into two consecutive fiscal years. That's not the way the calendar works, of course, but let's keep it simple.
Most times, when a two-year contract is sold, some of the revenue will be recognized this year. Half of it will be recognized next year. And the remainder will be recognized in the following year. But basically, if they're all two-year contracts, then at any given moment half the deferred revenue will be current and half will be non-current.
Extended Warranty & Gift Card Totals
In the above chart, for example, we're pegging the second year of premiums for AppleCare service contracts sold in fiscal 2009 to be worth $853 million (the total for non-current deferred revenue). And we're chopping up the current total of $2,053 million into $853 million for first-year service contracts (same as for second year), and $1,200 million for gift cards (the remainder).
Therefore, we're suggesting that Apple's extended warranty revenue in 2009 was worth $1.706 billion -- $853 million of which was classified as current and $853 million of which was classified as non-current. Its gift card sales were $1.200 billion. And its iPhone revenue from all those two-year subscription plans was an astronomical $11.884 billion.
In the chart below, we've omitted the iPhone component, and extrapolated some of the data points to come up with a smooth curve for AppleCare and gift card sales from fiscal years 2000 to 2012.
As can be seen, we estimate that the $1.2 billion in gift card sales and $1.7 billion in AppleCare revenue from fiscal 2009 has grown to $3.3 billion in gift card sales and nearly $5.3 billion in AppleCare sales in fiscal 2012.
Apple's Deferred Revenue,
AppleCare vs. Gift Cards,
Fiscal Years 2000 to 2012
Shoot us if we're wrong. Undoubtedly, we are. We're wrong because that some non-current deferred revenue is for the third year of three-year Mac extended warranties. We're wrong because some of the contracts are sold in the middle of the fiscal year, and some are sold at the end. Very few are sold right at the outset. And we're wrong about the gift cards. Some are never redeemed.
However, the company doesn't disclose the true figures, and has declined to help us with this week's article. Apple's media relations department has not yet responded to a message left with their apparatus. So we're left with these estimates.
These are surely not accurate figures. But they are credible estimates based on accurate figures, and where no accurate figures were available, they're based on some extrapolation and best guesses. We'd welcome corrections and advice on how to improve the model. In fact, we'd like nothing more than to retract all these guesses and replace them with exact and official numbers.
Deferred Revenue Totals
As was mentioned, the composition of the figures Apple has supplied for deferred revenue over the years has changed. But it's not just because some are with and some are without iPhone. Some include just a total, while others break out the current and non-current segments.
In fiscal years 2000 to 2003, Apple's annual reports included a total for all deferred revenue, but that total wasn't further broken down into current and non-current portions. In all the fiscal years since then, Apple's annual reports have included figures for both current and non-current deferred revenue, but not a total.
It's easy to calculate a total by adding the current and non-current figures together. But it's not so easy to split the total into AppleCare and gift cards when there are no figures supplied for current and non-current deferred revenue. So again, we have to guess.
We'll add a fourth assumption. Let's assume that from fiscal 2000 until fiscal 2004, gift card sales and extended warranty sales grew at approximately the same rate. Actually, according to our estimates, gift card sales grew slightly faster than extended warranty sales from fiscal 2004 until fiscal 2010, but extended warranties have grown faster in the past two fiscal years. So let's just split the difference and say they grew at the same rate from 2000 to 2004, when the iTunes Store was just starting out and when most of the hardware sales came from the Macintosh family.
By the way, Apple provided no figures for deferred revenue before fiscal 2000, so that's the reason why our financial modeling begins there.
Back-dating our product warranty figures is a little easier. Apple actually began providing exact figures for its product warranty claims and accruals in fiscal 2001, along with beginning and ending balances, even though Warranty Week didn't begin collecting that data until fiscal 2003. So the only guesses we had to make were for claims and accruals in fiscal 2000, when all we had for certain were the beginning balance ($105 million) and the ending balance ($108 million) for that year.
Yet Another Assumption
We're going to make a fifth assumption that will really get the accounting police upset. In the extended warranty world, the premiums paid by consumers are set aside as deferred revenue, then eventually become recognized revenue. In product warranty, the analogy is not exact, but we're going to assume that the equivalent of deferred revenue -- the amount set aside -- would be the warranty accrual.
This is not of course the complete picture. For instance, the extended warranty equivalent of claims wouldn't be recognized revenue. The equivalent of a product warranty claims expense would be an extended warranty claims expense. Recognized revenue would equal claims plus profit. Or more simply, profit equals revenue minus expenses.
But we're not going to tackle the profitability of Apple's extended warranties in this week's newsletter. Instead, we're going to compare the amount Apple sets aside for product warranty to the amount Apple sets aside for extended warranty.
In the chart below, product warranty accruals declined in fiscal 2007, then again in fiscal 2009. However, a more complete accounting of Apple's product warranty data is available in the September 6, 2012 newsletter, so we won't repeat it here.
Apple's Warranty Cash Flow
Warranty Accruals vs. Deferred Revenue
Fiscal Year 2000 to 2012
Way back in fiscal year 2000, Apple's product warranty accruals and extended warranty revenue were both under $100 million per year, and each represented less than one percent of sales. But by fiscal 2003, extended warranty premiums were four times as much as product warranty accruals. The ratio got back down close to 2-to-1 until 2007, when extended warranty sales soared and product warranty accruals plunged. Except for another anomaly in fiscal 2009, the ratio has remained close to 2-to-1 ever since.
In fiscal 2012, the ratio was about 2.4-to-1, based on estimated extended warranty premiums paid of $5.3 billion and reported product warranty accruals of $2.184 billion. Since 2000 the average has been 2.7-to-1, though since the iPhone appeared it's been closer to 3-to-1.
Percentage of Total Sales Revenue
Finally, with product warranty accrual data, we usually make a comparison to product revenue data, and calculate an accrual rate. Apple's accrual rate, as detailed in the September 6, 2012 newsletter, has always been between 0.7% and 2.8%, with the highs coming late in calendar 2005 and the lows coming in the middle of calendar 2009.
Now, with the rest of the data in hand for extended warranty revenue, we can calculate a new metric, based on premiums paid divided by total revenue. We'll call it the extended warranty run rate.
Apple's Extended Warranty Run Rate
Premiums Paid vs. Total Revenue
Fiscal Year 2000 to 2012
The percentages on the left represent our best estimates of how much of Apple's total revenue in any given fiscal year came from sales of extended warranties. These figures are calculated using the figures for extended warranty premiums paid in Figures 1 and 2, divided by the total revenue reported in Apple's annual reports.
Way back in fiscal 2000, extended warranties accounted for just under one percent of Apple's total revenue. By fiscal 2004, the ratio was approaching 4.9%. There was a spike to 5.4% in fiscal 2007 as the first iPhones appeared, then the ratio gradually fell back downwards. In fiscal 2012 it was 3.4% of total revenue.
The long-term average is 3.7%, but since the iPhone was launched in 2007, extended warranties have accounted for over four percent of total revenue. That makes sense, because in fiscal 2012 the iPhone accounted for more than half of Apple's total revenue for the first time ever. So if one accepts the theory that extended warranties are more popular for smartphones than for computers, it makes sense to see a rising ratio in recent years.