Apple’s Cost of Giving Out Replacement Gadgets – Warranty Claims – Rising Faster Than Sales

Apple (AAPL) will report its third-quarter results next Tuesday and analysts and bloggers already are locked in debate about whether iPhone sales will rise or slide, and whether earnings will climb toward record results.

For the first day, at least, all the focus will be on product sales and margins. But once the oohs and ahhs over iPad sales subside, you may want to peek inside the company’s 10Q filing to see how all those new products moving out the door are faring once consumers start using them.

In the first six months of the fiscal year, ended March 31, warranty claims on Apple products and software were up 72%, to $865 million, compared with $502 million last year. That means they’re growing faster than sales, which were up 66% over the same period. While that could be an aberration, it could also signal trouble in Mac-land, especially if sales start to slow.

AAPL Revenue Growth data by YCharts

Apple says it recognizes potential warranty claims at the same time it records revenue from sales, basing the reserve on its historical experience and any known problems. Each quarter, it says, it reevaluates the numbers, noting that inaccurate estimates could materially affect its results.

On the face of it, the warranty claims may not seem like much, especially at a company with fat profit margins like Apple.

AAPL Net Income data by YCharts

But they are one of those hidden costs that can quietly erode margins. Apple’s products typically come with a one-year limited warranty on workmanship and defects. That means you’ll probably get a new one if the screen inexplicably goes blank, but won’t help if you drop your iPhone in a puddle or send your Shuffle through the wash.

It also means this year’s warranty claims are tied to last year’s sales, so they could be a drain if sales actually slide.

How well Apple has projected its losses over time is a bit hard to tell because through fiscal 2009, it managed to keep some warranty claims off its balance sheet and didn’t detail them. Starting with its 2010 10-K filing, it got a lot more specific.

Accruals for warranty claims are handled like other reserves for potential losses. Apple starts the year with a balance left over from the previous year. From that it deducts actual claims, and then it builds the reserve back up with new additions. Ideally, it would have enough set aside at the beginning of each year to cover that year’s claims, but in fiscal 2010 and 2011, it came up short, with actual claims far exceeding its starting-year balance.

As a result, new additions to its product warranty reserve nearly quadrupled in two years, growing to $1.63 billion in 2011 from $440 million in 2009. During the same period, sales grew about 2.5 times, to $108.25 billion from $42.91 billion.

So far this year, it has added $1.3 billion to its warranty-claims account, giving it a total of $1.68 billion available. That could be an effort to be more conservative—or it could signal some blank screens ahead. Either way, it’s a number worth keeping an eye on, alongside the stock chart.

Karen Blumenthal is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.

Filed under: Company Analysis