The Mystery of Apple, Inc.'s One-Time Services Boost

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Apple (NASDAQ: AAPL) reported fiscal fourth quarter earnings last week, and it was a blockbuster release both in terms of the September quarter as well as guidance for the December quarter. However, there was one big question mark buried within the release: a one-time positive adjustment of $640 million that was booked in the services segment.

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Total services revenue jumped 34% to hit a new quarterly record of $8.5 billion, and $640 million is nothing to sneeze at, representing 7.5% of services revenue in the quarter. Apple's explanation was incredibly vague, merely stating: "Services revenue in the fourth quarter of 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information."

There was hope that Apple would provide additional detail in its 10-K, but the iPhone maker merely repeated the same language in its annual report. Beyond a passing mention or two, the adjustment was also not discussed in detail on the conference call. What's going on with this one-time boost?

Is it Google?

The most feasible explanation is that this adjustment is related to Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) subsidiary Google, which reported a meaningful increase in traffic acquisition costs (TAC) last quarter.

TAC

Q3'16

Q3'17

Change (YOY)

To Google Network Members

$2.6 billion

$3.1 billion

18%

To distribution partners

$1.6 billion

$2.4 billion

54%

Total

$4.2 billion

$5.5 billion

32%

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The TAC to distribution partners is the line item to focus on, which jumped 54% last quarter, as this relates to what Google pays to "browser providers, mobile carriers, original equipment manufacturers, and software developers."

Conference call clues

On Alphabet's earnings call, CFO Ruth Porat highlighted mobile as a driver of rising TAC expenses (emphasis added):

The increase in sites TAC as a percentage of sites revenues as well as network TAC as a percentage of network revenues continues to reflect the fact that our strongest growth areas, namely mobile search and programmatic, carry higher TAC. Total TAC as a percentage of total advertising revenues was up year-over-year, reflecting an increase in the sites' TAC rate, which was modestly offset by a favorable revenue mix shift from network to sites. The increase in the sites' TAC rate year-over-year was driven by changes in partner agreements and the ongoing shift to mobile, which carries higher TAC because more mobile searches are channeled through paid access points. 

On top of that, Porat added that TAC is expected to increase as a percentage of revenue going forward. Barclays analyst Ross Sandler asked if the TAC agreements might change as mobile search matures, and Google CEO Sundar Pichai emphasized the value in these deals:

Sandler: It's just a philosophical question on TAC. So as the mobile search market matures, particularly the Western markets, the question is, why does Google feel like it needs to pay any TAC to partners at all? Is the lesson that you learned from the Firefox desktop partner loss a couple of years ago was that you didn't lose any revenue and you stopped paying TAC on that agreement? Why wouldn't the same logic apply to mobile search if not now, at some point in the future?

Pichai: Look, I mean, first of all, we have a lot of experience in this area. We've been doing distribution deals for our search for well over a decade, and I've personally been involved all the way from the toolbar and the Chrome days. So by now, first of all, we want to construct a win-win construct. So we always want a construct in which we do better and our partners do better. And so doing TAC well aligns us in that way. And historically, it's driven a lot of growth. And so it's a model we understand. We understand the key economics behind it. And so we are very thoughtful about how we drive it forward. So we are driving it forward in a way in which we know it's going to give strong both revenue and earnings growth. And so I think we are pretty comfortable with how we are approaching it, and so we'll continue to do that.

It's probably Google

There's a big difference in mobile relative to desktop, particularly as it relates to Apple. Unlike macOS, which allows users to change default browsers, iOS forces Safari to be the default mobile browser and does not allow users to change this preference. (Users can change the default search engine on both desktop and mobile.) This tight control effectively puts a much more valuable premium on mobile Safari's default search engine -- and Apple knows it.

In contrast, the rising popularity of Google's Chrome browser over the past decade as it overtook Firefox directly undermined the need to occupy Firefox's default search spot (which was long Mozilla's primary revenue source); Yahoo! scored the default search spot in Firefox back in 2014. In other words, Chrome cannot displace Safari on iOS in the same way that it displaced Firefox on desktop. It's also worth pointing out that Apple just switched Siri search from Microsoft Bing to Google too, which sounds an awful lot like a change in "partner agreements."

This all comes just months after Bernstein analyst Toni Sacconaghi estimated that Google could end up paying Apple approximately $3 billion this year in TAC, which gets booked into Apple's services business. This revenue is "nearly all profit," since Apple incurs virtually no cost in sending traffic to the search giant, which helps boost Apple's overall gross margin. It could offset some other margin headwinds that Apple is currently facing, like the current memory pricing environment. Apple's gross margin last quarter came in at 37.9%, near the high end of guidance.

Investors don't have confirmation, but all signs point to that $640 million adjustment coming from Google.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.