Apple's Gross Margin Even Lower Than Reported

| About: Apple Inc. (AAPL)

Summary

When adjusted for warranty accruals, Apple's gross margin is at its lowest point since 2009.

However, $3.6 billion in channel inventory reductions and the stronger dollar impacted gross margins.

Expect warranty accruals to increase, which could keep a lid on gross margins.

One of the analysis I do on Apple's (NASDAQ:AAPL) finances every quarter is to adjust the company's reported gross margin for its warranty accruals. Apple's warranty charges have ranged from 0.9% to 3.7% of total revenue since fiscal 2007. I believe it is worthwhile to understand the changes and the adjusted results as it provides insight into what are the "true" costs and profits of Apple's products and how gross margins may change.

Warranty accruals have a negative impact on gross margins and can also "mask" the company's actual gross margins for its products. I have developed a Google Doc that has Apple's gross margins and warranty accruals from fiscal 2007 to 2009 on an annual basis and then quarterly to June 2016 available via this link.

In the June 2016 quarter, Apple's reported gross margin was 38.0%, which was the lowest result since the September 2014 quarter. It was at the high-end of the company's 37.5% to 38.0% guidance and only the second time in the past 12 quarters that it did not exceed the high-end.

Warranty accruals matched historic lows

Apple accrued $380 million for future warranty claims, which was 0.9% of revenue. It is the lowest percentage of revenue since the June 2012 quarter, which was also 0.9%, which was essentially three quarters after the iPhone 4S became available. It is not surprising that the warranty percentage amount in the June 2016 quarter is low since the most recent iPhones, the 6s, 6s Plus and the SE are largely derivatives of previous generations. Apple's suppliers should be far down the learning curve, making parts and assembling the iPhones leading to lower warranty claims.

But it does mean that the 38.9% gross margin (38.0% reported plus the 0.9% accrual) in the June quarter is the lowest since fiscal 2008 or 2009. There are some mitigating factors in the quarter including the 4.1 million iPhone channel inventory reduction of largely higher priced units. This negatively impacted margins along with the stronger dollar whacking almost 300 basis points off the total compared to a year ago.

I expect warranty accruals to increase in the September quarter

Gross margin guidance for the September quarter is 37.5% to 38.0%, which mirrors the June quarter's and is slightly disappointing since not having the impact from a channel inventory correction should mean it would move higher. However, it is typical that warranty accruals increase from the June to September quarters as new iPhones become available with the change ranging from 0.1% to 1.6% over five of the past six years. With the iPhone 7 not expected to have a large amount of new technology, I would peg the accrual percentage at the low-end of historical amounts, but it does mean the reported gross margin may not have as much upside as hoped.

Note that September quarter's gross margin guidance has a 50 basis point range, which is the third quarter in a row of being this narrow. For the previous 12 quarters, it had been a 100 basis point range. Either management is getting better at projecting what it will be, is pulling various levers during the quarter to hit it such as warrant accruals, or wants to give better visibility so that analyst estimates are more accurate.

Disclosure: I am/we are 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.

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