When Tim Cook joined Apple (NASDAQ:AAPL) in 1998, he made bold and ingenious decisions with Apple's supply chain. As a veteran from IBM (NYSE:IBM), Cook began cutting inventories and shifting manufacturing processes overseas. By the mid-to-late 2000s, Apple was known for its operational efficiency and inventory turns often in the high-80s or low-90s, signifying that it never had more than four or five days of inventory on-hand at any one point. Like most businesses, Apple's inventory levels change based on product cycles and consists of two distinct types:
- Balance Sheet Inventory: Comprises: 1) Finished Goods, and 2) Components (also known as Work-In-Process, or WIP).
- Off-Balance-Sheet Inventory: Comprises recognized revenue sitting with its channel partners for resale.
Balance Sheet Inventory:
Apple recently started breaking out its inventory levels between 'finished goods' and 'components' in its quarterly filings with the SEC. For the quarter-ending December 28, 2013 (fiscal Q1 - 2014), Apple reported inventory of $2.1 billion, which was broken out into:
- Finished Goods: $1.6B
- Components: $523M
For a company that did $170B of sales in fiscal 2013, $2.1B of inventory does not seem like an excessive level. However, when you look at the amount of finished goods inventory, it seems unusually high. Consider this, Apple ended its previous quarter (fiscal Q4 2013) with $1.08B of finished goods inventory. The sequential increase of approximately 50 percent is significant. The total inventory at the end of the December-2012 quarter (fiscal Q1 2013) was $1.455B. If one was to estimate that one-third of that amount was components, the finished goods balance of approximately $970M was 65% less than the balance reported in December-2013 (fiscal Q1 2014).
Does China Mobile factor in to the inventory level?
There may be a good reason for this historically high balance of finished goods inventory - preparation for the China Mobile (NYSE:CHL) launch. On the January 2014 earnings call, Cook made it clear that Apple did not sell into the China Mobile channel during the December-2013 quarter (fiscal Q1 2014). This unusually high inventory level could be representative of stock-piled iPhone 5S units that were destined for China Mobile's launch, which occurred on January 17, 2014.
iPhone 5C Over-Production?
But what if Apple was sitting on iPhone 5C units that were "over-produced"? Apple's supply chain is too complex to ever really know how many 5C units were cranked out, but there were numerous reports throughout the quarter that Apple had slashed production of 5C units, and at one point, shifted production exclusively to the 5S. The weak underlying demand for the 5C is not just anecdotal; it has several key data points behind it:
- Apple's Management commentary on the FQ1 2014 earnings call;
- Jabil Circuit's (NYSE:JBL) mid-December 2013 results sending shares down 20%. Jabil is rumored to be the manufacturer behind the 5C;
- Apple's ending channel inventory at September-2013 (fiscal Q4 2013), which saw a 3.3M unit sequential increase - an interesting amount of excess inventory given the severe supply constraints on the 5S variant;
- Weak iPhone sales for fiscal Q1 2014 (likely hindered by the huge sequential channel inventory increase exiting fiscal Q4 2013) - a topic I wrote about in a previous article; and,
- Near 100% availability of the 5C worldwide from launch until present-day.
The fear plays in if the high-level of Finished Goods inventory is due to larger-than-expected quantities of iPhone 5C units that Apple can't push into the channel. The question I ask is, beyond the strategic impact, could Apple be facing a "financial statement" impact for this stranded inventory? For inventory valuation, the Apple states the following in its 10-Q:
The Company performs a detailed review of inventory that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The Company also reviews its manufacturing-related capital assets and inventory prepayments for impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the amount by which the carrying value of such an asset exceeds its fair value.
The statement is accounting-speak for, "we carry inventory at the lower of cost or market." I'm not implying that Apple will or won't need to take a write down for the inventory, as I don't know what the inventory is comprised of. However, if Apple is unable to move that inventory through its retail stores or push it into the channel, it may be looking at some type of margin hit, whether it be through discounted channel sell-in prices or discounts through direct customer sales via its own retail channels (brick-and-mortar or online stores).
Analyzing Channel Inventory:
Channel inventory is Apple's off-balance sheet inventory sitting with third-party resellers that the company has already recognized revenue on. The company's channel inventory reached an all-time high of 15.3M units exiting the December-2013 quarter (fiscal Q1-2014). There could be a very good reason why channel inventory levels are high - the channel has expanded. In an interview with the Wall Street Journal at the beginning of February, Cook indicated that Apple will be launching the iPhone on 50 additional carriers this quarter. By my estimation, that would put the iPhone on well over 300 carriers by March-2014. The 15.3M units may be the appropriate channel level to support current and future carrier needs within the four-to-six week forward-looking supply target.
An important concept to understand is that while Apple does have $11.4B in deferred revenue, of which $8.4B will be recognized in the next four quarters, it also has $9.5B (15.3M iPhones x $620 ASP) of iPhone inventory sitting with resellers that it has already recognized revenue on. By comparison, the channel inventory is over $1B more than the current portion of its deferred revenue balance.
The question now becomes, what is the mix of the channel inventory? If the mix is heavily skewed toward the more popular iPhone 5S, then that is an optimal mix. However, that balance is skewed toward the 5C with weak sell-through, as I believe was the case underlying the 3.3M sequential increase from FQ3 '13 to FQ4 '13, then Apple might have a problem.
I am not privy to Apple's contracts with its channel partners (carriers and other resellers), but it does bring into question "clawback" provisions if these channel partners cannot move the inventory at certain price thresholds. Apple does offer the following in its 10-Q regarding "price protection":
The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company's policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company's other customer incentive programs, the estimated cost is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered...
Management's estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company's results of operations.
If Apple does indeed have a significant number of iPhone 5C units sitting in the channel, it could have to record a reduction to revenue in the period in which price protection incentives exceed historical estimates - a direct reduction to revenue and margin.
The Bottom Line
Apple's inventory levels have not been an area of scrutiny for the greater part of the last ten-to-twelve years. However, the company's discussion about unexpected downside demand of a certain product (the iPhone 5C) was ominous and leads one to wonder if-and-when Apple might see a hit related to clearing out this inventory. As Apple looks to launch its next generation of iPhone(s), longs can only hope that it clears its last generation out as fast as possible.
Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.