December 10, 2015

Apple's Warranty & AppleCare Programs:

Not only has the company grown into one of the world's largest product warranty providers, but it's also running one of the world's largest extended warranty programs. And smartphones are one of the hottest product categories for protection plans.

In the spirit of the holiday season, this week we're going to tell a simple story with the help of nine pictures. Once upon a time, there was a computer company that had an idea for a mobile phone with a touchscreen. That company was Apple Inc. and it grew up to become one of the world's biggest warranty providers and service contract program administrators.

Back in 2003, 72% of the company's revenue came from the Macintosh personal computer product line, and a small amount came from the iPod digital music players. The iPhone didn't begin to show up in the numbers until fiscal year 2007, and the iPad tablets showed up in 2010.

By 2012, the iPhone was half the company, and the iPad contributed another 21% of total revenue. In the fiscal year ended on September 26, 2015, the iPhone comprised nearly two-thirds of the company's revenue, and the Macintosh was down to 11%. Digital music had largely transformed into a service in which downloaded songs were sold to end users.

Figure 1
Apple's Product Mix
Percentage of Revenue, 2003 to 2015

Figure 1

The other major service in the Apple product line was revenue derived from the sales of AppleCare and AppleCare+ extended warranties. But of course, services like iTunes and AppleCare and consumables like gift cards don't get warranties, so they shouldn't be counted when looking at product warranty expense rates.

Product Warranty Claims

In Figure 2, we're counting up the amount of product warranty claims paid per quarter by Apple, as reported in their quarterly financial statements and annual reports. In the most recent annual report, Apple reported $4.4 billion in claims paid, up from $3.76 billion in claims paid during fiscal 2014. That's more than either General Motors or Ford paid out over the same period of time, though Volkswagen AG is likely to beat that mark by the time calendar 2015 is over.

Figure 2
Apple's Product Warranties
Claims Paid per Quarter, 2003 to 2015
(in Millions of U.S. Dollars)

Figure 2

The other major product warranty metric is the amount of accruals made by Apple -- the amount they set aside each quarter to fund future warranty expenses. This metric is entirely based on expectations and is closely linked to sales, in the sense that a company estimates the future cost of warranty for every product it sells, then it sets aside a sufficient amount to cover that expense.

In Figure 3, we're looking at two spikes, in the final calendar quarters of 2013 and 2014, which would translate into the first fiscal quarters of Apple's fiscal 2014 and 2015. A quick look back at Figure 2 suggests that whatever product quality crises the company saw coming didn't come to pass, but external parties were never informed one way or another.

$5 Billion in Warranty Accruals

In fiscal 2015, were up slightly from fiscal 2014 levels, but were actually down a bit from fiscal 2013 levels. But in all three years, the annual total was very close to $5 billion, a figure that again only GM and VW have ever surpassed.

Figure 3
Apple's Product Warranties
Accruals Made per Quarter, 2003 to 2015
(in Millions of U.S. Dollars)

Figure 3

The reason for these mammoth warranty expense totals is simple: mammoth sales figures. The iPhone sales total surpassed $155 billion last year, and even the Macintosh had its best year ever (even though it was only 11% of the total, that's still $25.5 billion). With all this hardware revenue, it's inevitable that warranty expenses would also climb.

Warranty Expense Rates

When warranty expenses are compared to product revenue, a somewhat different trend emerges, however. In Figure 4 we're taking the warranty data from Figures 2 and 3 and comparing it to the hardware sales data illustrated in Figure 1, to calculate what percentage of Apple's product revenue is going towards warranty expenses.

As the chart reveals, the expense rates were somewhat high from 2004 to 2006, somewhat low from 2007 to 2012, and have been somewhat higher ever since. Please note that Figures 2 through 4 follow the calendar year rather than Apple's fiscal year, so there are only three pairs of measurements so far in 2015.

Figure 4
Apple's Product Warranties
Claims Paid & Accruals Made as a
Percentage of Product Revenue, 2003 to 2015
(in Percent)

Figure 4

So that gives some measure of the cost of product warranties at Apple. It's ranged from one percent to four percent over the past dozen years. But at the end of fiscal 2015 the claims rate was 2.1% and the accrual rate was 2.3% -- somewhere in the middle. This is great news, because as we've stated numerous times before, smartphones and other handheld computers seem to have much higher warranty expense rates than either laptops or desktops. So Apple seems to have successfully navigated the migration of its product line from Macintosh to iPhone without encountering the problems encountered by Palm Inc., or more recently, by BlackBerry Ltd.

Extended Warranty Estimates

Now, let's switch to extended warranties, which of course are service contracts sold separately by the manufacturer as an option for the hardware buyer to enhance the amount of protection bought for their product. Apple sells service contracts called AppleCare and AppleCare+ in certain countries for iPhones, Macintoshes, and other hardware products. But it doesn't disclose a sales total for them anywhere in its financial statements.

AppleCare Protection Plans cover Macintosh computers, Apple displays, Apple TV, iPhones, iPads, and iPod digital music players with basic break/fix coverage. AppleCare+ covers the iPhone, iPad, iPod, and the Apple Watch product families with break/fix coverage plus accidental damage protection. AppleCare plans last up to 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.

Apple doesn't break out AppleCare or AppleCare+ revenue figures separately. Fortunately, though, it does reveal the amount of revenue it is deferring through its sales of gift cards and AppleCare contracts. Unfortunately, when it announces its totals for deferred revenue, the company doesn't differentiate between the two sources of it.

This requires us to perform an accounting trick that would make an actuary choke on their oatmeal. Some deferred revenue is current, in the sense that the amount of time remaining before its recognition is one year or less. Other deferred revenue is labeled as non-current, meaning it won't be recognized for a year or longer.

Because most AppleCare contracts run for two years, we're going to assume that at any given point in time, half the AppleCare revenue is current and half the AppleCare revenue is non-current. Therefore, the remainder of the current deferred revenue must be from gift cards, because gift cards can be used at any time, and therefore must always be classified as current.

This assumption would get us thrown out of accounting school, but it makes the calculations in Figure 5 possible. Basically, it helped us estimate that AppleCare is now a $7.3 billion worldwide program, which, even if we're off by a billion dollars or so, is one of the world's largest extended warranty programs -- much larger than any operated by the car manufacturers themselves. And it's still growing at a 20% annual rate, while we suspect gift card sales actually declined a bit last year.

Figure 5
Apple's Extended Warranties:
AppleCare Service Contracts vs. Gift Cards Sales
in Fiscal Years 2003 to 2015
(in Millions of U.S. Dollars)

Figure 5

So now we have hard numbers for Apple's product warranty expenses and somewhat dubious estimates for Apple's extended warranty revenue. Of course, they're not directly comparable, because even someone who flunked out of accounting school knows that revenues aren't the same as expenses. First of all, the AppleCare and AppleCare+ programs also have claims costs. And we'll assume that claims are less than revenues, meaning that the programs are probably profitable (though there's also overhead expenses, and the insurance company has to be paid, etc.). But we can't know those metrics as external observers, and anything we say would be just a wild guess.

So let's assume both the product warranty and the extended warranty programs have claims. Let's say the amount of deferred revenue from the extended warranty sales is somewhat analogous to the amount of accruals made for product warranties. They're not the same, and as we just mentioned, some of that deferred revenue is going to turn out to be profits once it's recognized and once all the bills are paid.

Warranty vs. Extended Warranty

Ignoring that advice, let's compare accruals made to AppleCare sales. The accruals totals come straight from Figure 3. The AppleCare totals come from Figure 5. Note that for the sake of simplicity we're comparing calendar years to fiscal years without accounting for the three-month time difference. That's another reason to kick us out of accounting school.

Figure 6
Apple's Warranties vs. Service Contracts:
Accruals Made vs. AppleCare Sales
in Fiscal Years 2003 to 2015
(as a Percentage of the Sum of the Two)

Figure 6

The ratio between product warranty accruals and extended warranty revenue has ranged from a low of 80/20 in 2003 to an approximately even split in 2013. A quick look back at Figure 5 will reveal that 2013 was the only year in which AppleCare revenue actually declined. And a look back at Figure 3 reveals that product warranty accruals really began to climb in earnest in 2012, 2013, and 2014. So the approximate parity at that time is not such a surprise.

The most recent ratio is 41% product warranty to 59% extended warranty. The long-term average is about 33% to 67%, so roughly 1-to-2. In other words, extended warranties are bringing in approximately twice as much money as is going back out in the form of product warranty accruals.

AppleCare vs. Warranty Expense Rates

In Figure 7, we've taken the claims, accruals and AppleCare totals from Figures 2, 3 and 5 and compared them each to product revenue. It's essentially the same chart as in Figure 4, with the addition of a new line for AppleCare. And it suggests that except for those two quarterly spikes in calendar 2013, AppleCare is and has always been a bigger program than Apple's product warranty operation, at least in terms of cash flow. But again, that's partly due to a lull in AppleCare sales that year.

Figure 7
Apple's Protection Plans:
Claims Paid, Accruals Made & AppleCare Sales
as a Percentage of Product Revenue, 2003 to 2015
(in percent)

Figure 7

So that explains the place of AppleCare within the company. What about its place in the world? We said it could be the world's largest extended warranty program. AppleCare is sold in numerous countries, by numerous local Apple subsidiaries. And it's not sold in lots of other countries, but can be administered internationally out of regional hubs such as Singapore or Florida. So is it really one program, and is it really worldwide?

Meanwhile, so far in these newsletters we've only gotten around to estimating the size of the extended warranty market in the United States, and only for consumer protection programs. So there may be some program out there for jet engines or for Chinese computers that's even larger than AppleCare. We just haven't heard of it yet.

AppleCare for iPhone in the U.S.

Fortunately, we did perform a market sizing for mobile phone protection programs in the U.S. back in the November 14, 2013 newsletter. And at that time we made some estimates that sliced and diced the AppleCare worldwide total into U.S. and non-U.S. portions, and iPhone and non-iPhone sources.

In Figure 8 we're adding 2014 and 2015 data to those calculations, and we're also going somewhat further than the last time we did an Apple picture book, in the October 30, 2014 newsletter. Here' we're estimating that the U.S. iPhone protection program is a $2.2 billion business for Apple.

Figure 8
U.S. Mobile Phone Protection Plans
AppleCare vs. Other Retail vs. Phone Cos.
Sales Revenue, 2009 to 2015
(estimates in U.S. dollars)

Figure 8

However, we're also estimating that, if they were all lumped together, other consumer electronics retailers such as Best Buy Co. Inc. are still selling a tiny bit more phone protection than Apple alone, at least within the U.S. But we expect Apple to finally get ahead of them in 2016, in part because Best Buy is selling AppleCare plans along with iPhones.

Mobile Phone Protection Market

In Figure 9, we're taking the mobile phone protection plan data from Figure 8. Then we're adding in estimates for U.S. sales of other types of consumer protection plans including vehicle service contracts and service contracts for everything else: appliances, laptops, televisions, home warranties, and other brown and white goods.

Basically, everything else is losing market share simply by standing still. The category's total revenue is fluctuating around $10 or $11 billion. Some segments such as home warranties are growing, but others such as laptop protection plans are not. Meanwhile, protection plans for passenger cars and mobile phones are growing much more quickly.

At the end of this year, we expect mobile phone protection plans to comprise 34% of a $40.6 billion industry. VSCs will account for about 41%. That leaves only 25% of the pie for everything else, their lowest share ever.

Figure 9
U.S. Consumer Product Protection Plans
Cars vs. Phones vs. Everything Else
Sales Revenue, 2009 to 2015
(estimates in U.S. dollars)

Figure 9

Back in 2009, cars were 38% and mobile phones were only 20%, while everything else accounted for a commanding 42% share. The problem is, many of the products in the everything else category don't seem as vulnerable as they used to. Either because of rising reliability or falling prices, or a little of both, consumers don't feel the need to protect their products as often as they used to. And they don't expect to require the services of a repair organization. If the product breaks, they'll simply buy a new one. And it will probably be a $120 Dell Latitude notebook or a $500 Kenmore refrigerator.

So it's a good thing that Apple's product mix shifted from personal computers to smartphones all those years ago. Even if everybody in the world seemingly now has a smartphone, there's always going to be a healthy replacement market that will always run on a faster lifecycle than either passenger cars or major appliances. And even if the pace of replacements taper off, there will always be a healthy protection market, at least until smartphones are given away in Happy Meals. And even after that happens, there will still be multiple billions of people in the world that haven't yet experienced the pleasure of paying to protect their own products from their own clumsiness.

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