Iphone upgrade program business

H A R V A R D B U S I N E S S S C H O O L

9-117-020 REV: NOVEMBER 22, 2016

JONAS HEESE KRISHNA G. PALEPU H. PAVID SHERMAN MONICA BARALDI

A c c o u n t i n g f o r t h e i P h o n e U p g r a d e P r o g r a m ( A )

The iPhone has become one of the most important, world-changing and successful products in history. Last week [July 27, 2016] we passed another major milestone when we sold the billionth iPhone. We never set out to make the most, but we've always set out to make the best products that make a difference.

- Tim Cook, Apple CEO1

I n t r o d u c t i o n

On September 9, 2015, Apple Inc. (Apple) launched its new iPhone 6s and iPhone 6s Plus models and, at the same time, announced the "iPhone Upgrade Program," a new way to purchase those iPhone models in Apple's retail stores throughout the U.S.2 Under the program, eligible consumers could buy an iPhone 6s and 6s Plus and, as a form of payment, agree to a 24-month loan in partnership with Citizens Bank (Citizens).3 An iPhone purchased under the program was unlocked, meaning customers were able to switch their wireless carrier according to their contract terms. The offer included Apple's AppIeCare+ service, which provided extended warranty and software support compared to the regular one-year limited warranty. After one year the iPhone customer could turn in her old iPhone, get a new iPhone model, and enter into a new installment loan agreement, with a new two-year payment obligation.4 In the event the iPhone upgrade program was terminated by the customer, the customer was responsible for any outstanding balances due under the terms of the loan with Citizens.5

Following the announcement, several financial analysts reacted positively to the new upgrade program; some of them described it as a "smart move" forward.6 According to one UBS analyst, the "Upgrade Program increases stickiness and makes the iPhone look more like an annuity business."7

Another J.P. Morgan analyst estimated that Apple's margin for an iPhone sold under the new program could be four times higher than that for iPhones sold through the carrier channel, as Apple was charging $50 more per device under this program.8 A UBS analyst wrote that the iPhone Upgrade Program "could be a big deal," as it allowed Apple to take control of the customer relationship.9 One observer predicted that 75% of Apple's iPhone customers would eventually switch to an annual upgrade, increasing Apple's U.S. iPhone unit sales by 10% over three years.10

HBS Professors Jonas Heese and Krishna G. Palepu, Professor H. David Sherman (Northeastern University), and Case Researcher Monica Baraldi (Case Research & Writing Group) prepared this case. This case was developed from published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not Intended to serve as endorsements, sources of primary data, or illustrations of effective or Ineffective management.

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117-020 Accounting for the iPhone Upgrade Program (A)

Other business analysts were more skeptical about the program, as it came with risks related to competition from wireless carriers. Because carriers made money when phone users paid them for service, and because phone users tended to stick with a single carrier long-term, carriers had an incentive to try to lock in customers by selling them phones that came with a two-year contract They could do this by offering other brands of phones at lower prices than Apple.11 "Apple's move is perhaps a bit threatening, in mat it incrementally erodes the carrier's relationship with the customer," said one senior analyst.12

Next to the strategic implications of the Upgrade Program, analysts tried to understand the accounting implications, especially for recognition of revenue, which the Upgrade Program could have on Apple's financials. Some assumed "no dramatic change" in revenue recognition, while others were waiting for more guidance from Apple.

In an effort to increase iPhone sales, Apple was pushing the Upgrade Program hard for the 2015 holidays in its retail stores, on its website, and in unsolicited e-mails.13

C o m p a n y B a c k g r o u n d

The iPhone went on sale for the first time at the end of June 2007 and, at a starting price of $500, was immediately criticized by bloggers and news commentators for being too expensive compared to an average smartphone priced roughly around $200.M The doubts were soon dispelled. By the end of 2007, Apple sold two million iPhones, and almost seven million in the last quarter of fiscal year 2008.15 Front a strategic perspective, between 2007 and 2014 Apple had been "remarkably consistent"16 in maintaining a smartphone price somewhere near $700 and annually launching anticipated handsets which featured incremental or radical innovations.17 Apple typically releas_e3^ewTPhqne models in the fall, increasing Appkys~sma~rtphone.units-spld and boosting revenue during the first quarter of the

-fiscal year, which typically started on 6ctober-l .18 ^

In 2015, Apple faced a challenging and changing competitive environment. The major wireless service providers such as AT&T, Sprint, T-Mobile, and Verizon were competing for subscribers in a mature U.S. market.19 Most consumers already had a cell phone and switched carriers infrequently. The average phone upgrade frequency in the U.S. had risen from 18 months in 2010 to an estimated 26 months in 2015.20 The average contract between the consumer and the wireless carrier stretched across two years in which the customer had to sign an agreement with the carrier and pay early-termination fees "in exchange for a discounted price on a phone."21 However, new trends were emerging.

In the summer of 2015, two-year contracts were disappearing,22 unlocked phones were becoming more popular, and consumers were accepting the idea of paying the full cost of a phone upfront in exchange for the freedom to select their preferred carrier at any time.23 By 2013, T-Mobile was the first carrier that no longer sold two-year contracts. "Once T-Mobile did it, all the others followed,"24 said an industry insider. Furthermore, new players were entering the mobile market. Google was testing a wireless service, Google Fi, which would allow consumers to switch from T-Mobile to Sprint and back multiple times.25

Apple's management decided that it was time to innovate the iPhone business model. In September 2015, the company announced the new iPhone Upgrade Program. For the first time, Apple financed iPhone sales directly to customers without locking them to any particular carrier.26