AAPL's Fiscal Q1 - FY18 (iPhone Channel Inventory & ASP)
Apple (AAPL) beat the Street’s Q1-FY18 expectations on revenue, profit and earnings, but fell short on iPhone unit shipments and soft guidance for its fiscal Q2.
While Apple reported iPhone unit shipments of 77.3 million (a 1.3% year-over-year decrease), if you read through the commentary provided by management on its earnings’ call, the actual “sell-through” was likely around 73.2 million (a 5.1% year-over-year decrease).
Understanding the iPhone Channel
The iPhone channel is defined as any non-AAPL, authorized retailer that sells the iPhone. The reason why the iPhone channel inventory level (and changes) matter at all is because of the way AAPL recognizes sales (revenue). Here is how that criteria is defined in the "critical Accounting Policies" of its SEC filings:
(Sales to Retailers - Channel Partners – SELL-IN):
Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. (Emphasis Added)
Now contrast that with how AAPL recognizes revenue on sales to individuals:
(Sales to Individuals):
For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit.
So the key takeaway is that an iPhone sitting in the channel (e.g., on the shelf of a Best Buy or a wireless carrier) shows up on AAPL’s income statement as a reported sale for that period as that unit (and revenue) has already been recognized as a sale upon shipment. It makes no difference when an end customer buys that phone.
AAPL’s ‘uncharacteristic’ description of its iPhone channel inventory change.
I have been tracking AAPL's channel inventory since the company began providing detail around its channel inventory units in 2012. AAPL has historically been quite straight-forward with the estimated change in its channel inventory, but it has always provided that change on a “sequential” basis.
For example, CFO Luca Maestri has provided the remarks with regards to its iPhone channel inventory and they have typically been very straight-forward and detail the change during the quarter. A couple of examples:
Q4-FY17: “…iPhone channel inventory increased by 1.3 million units sequentially to support the launch of iPhone 8 and 8 Plus.”
Q3-FY15: “…"We reduced iPhone channel inventory by about 600,000 units during the quarter."
However, for Q1-FY18, Maestri worded the iPhone channel inventory change differently by comparing it to the year-ago quarter, rather than the previous quarter (sequential):
“We exited the December quarter towards the lower end of our target range of five to seven weeks of iPhone channel inventory with less than 1 million more iPhones in the channel compared to the December quarter a year ago...”
As I have been tracking this data (shown in table below), AAPL exited the referenced ‘December quarter a year ago’ (December-2016) with approximately 20.95 million iPhone units in the channel. Based on the commentary, I assume AAPL added around 900,000 units compared to the December-2016 quarter, meaning that it had approximately 21.85 million units in the channel.
But here’s where it gets interesting. If you look at the channel inventory on a sequential basis (as AAPL Management historically has provided commentary around), there was a sequential increase of approximately 4.1 million units – the highest ever channel build in the product’s history – surpassing the 3.3 million unit builds in both Q4-FY13 and Q1-FY16.
What this does and does not mean?
iPhone Unit Sales were lower than reported on a sell-through basis by nearly 3.9 million units: As described above about how it accounts for its iPhone revenue and it you assume the ‘less than 1 million more iPhones in the channel’ as mentioned by Maestri was approximately 900,000, AAPL actually had unit sell-through of approximately 73.2 million for the Dec-2017 quarter – a year-over-year decline of 3.9 million units (or 5.1%).
The iPhone channel is a ‘relative’ point-in-time measurement and must be analyzed over time: The iPhone channel is a complex and dynamic measurement of a point-in-time, and most importantly, it is a ‘relative’ measurement. The iPhone channel continues to expand – AAPL did not provide the number of points-of-sale for iPhone across the world, but as those points-of-sale grow, the more units that are needed to support those channels. When AAPL launched the ill-fated iPhone 5C in Q4-FY13 and had the 3.3 million channel build, it exited with approximately 14.3 million iPhone units in the channel. While AAPL may have added approximately 4.1 million iPhone units (sequentially) in Q1-FY18, Maestri indicated that the level was “towards the lower end of our target range of five to seven weeks of iPhone channel inventory”. Point being, while it was a large build, AAPL drew-down a substantial amount of iPhone channel inventory during FY17 – with a combined draw-down of 4.5 million units in Q2-FY17 (1.2 million units) and Q3-FY17 (3.3 million units).
Unit Sales are not everything: AAPL has never reported a quarter where reported iPhone year-over-year unit sales contracted, but revenue grew…until this quarter. AAPL reported a 1.3% year-over-year contraction in reported iPhone unit sales, but reported a 13.2% year-over-year growth in iPhone revenue growth – undoubtedly due to the introduction of the iPhone X at a $999 USD price-point and a reported heavier-than-usual skew to the iPhone 8 Plus over the iPhone 8.
How will AAPL’s iPhone Channel Inventory dynamics affect its FY18 performance?
AAPL’s management of its iPhone channel inventory, especially during its launch and subsequent holiday quarters can create significant issues for its financial performance during a fiscal year. An example of this was the launch of the iPhone 6S and 6S Plus in Q4-FY15 when AAPL built its iPhone channel inventory by a massive 5.25 million units in the launch quarter Q4-FY15 (1.95 million unit build) and the subsequent holiday quarter Q1-FY16 (3.30 million unit build). The remaining 3 quarters of FY16 saw AAPL have to draw-down a net 2 million units, resulting in year-over-year reported iPhone unit contraction of 16.3%, 15.0% and 5.3% for Q2-FY16, Q3-FY16, and F4-FY16, respectively.
That being said, the one dynamic that is new territory for AAPL, and its investors, is its availability and ability to move units at nearly $800 – a year-over-year ASP increase of 15%. After all, in the eight quarters prior to the 15% year-over-year iPhone ASP increase in Q1-FY18, iPhone year-over-year ASP contracted by an average of 1.9% per quarter, with its largest growth during that period occurring in Q2-FY17, where ASP grew by a $13.16 (+2.1%). So, when AAPL wasn’t moving iPhone units at a higher price, unit sales and ultimately, the channel inventory dynamic became a huge issue for the company’s performance.
So the question that emerges from Q1-FY18 iPhone performance and its effect on the remainder of the fiscal year largely shifts to ASP. Can AAPL continue to convince consumers to move to the higher-tiered phones and if it can, then the unit shipments and ultimately, the channel inventory levels become much more of the static than the true music of what every investor looks for – revenue growth.
It should be noted that the following analysis does not normalize any metrics or amounts to account for the 13-week (Dec-17 / Q1-FY18) vs. 14-week (Dec-16 / Q1-FY17) quarter.