Bad News For Apple's Juicy Margins

Investors aren't quite sure what to make of Apple's (NASDAQ: AAPL  ) December quarter.

On one hand, revenue is all but guaranteed to set all-time records. The company's own lowball guidance calls for $52 billion in sales, topping the current record of $46.3 billion. However, once you move past the top line, increased costs are expected to lead to gross margin contraction and -- gasp! -- maybe even negative earnings growth.

Next stop: gross margin
Of course, once you start working your way down from top-line revenue, the first stop on your journey to the bottom line is gross profit. Gross margin has been on the decline for the past couple quarters, after topping an incredible 47% in the first fiscal quarter.

Source: SEC filings and conference calls. Fiscal quarters shown.

The December quarter is guiding gross margin to just 36%, primarily due to the high cost curves that newly redesigned products face when they're first launched. You know, as in, practically all of Apple's product families.

Right now, more than ever, Apple needs as much help as it can get with maintaining gross margins until it can ride down the cost curves and gross margins can reexpand. Too bad it can't count on frenemy Samsung for any assistance in this department.

All your chips are belong to us
Recent reports suggest that the South Korean conglomerate is jacking up prices on Apple for its A-chips, which are manufactured in Samsung's facilities in Austin, Texas. Samsung has recently plunged billions of dollars into its chip plant, and Apple's newest chips are built on Sammy's 32-nanometer manufacturing process.

Samsung has reportedly boosted its fabrication rates by as much as 20%, which is plenty of reason why Apple may be considering moving its business to Taiwan Semiconductor Manufacturing (NYSE: TSM  ) next year for its 20-nanometer node for quad-core chip production. Rumors of Apple tapping Taiwan Semiconductor have persisted for years, but it seems investors might actually be getting close to realization.

Munster math
Everyone's favorite Apple analyst, Gene Munster, has come out with some thoughts on Sammy's price-jacking ways. Munster figures that the price increases make sense in light of the escalating competition between the two, and agrees that a move to Taiwan Semiconductor or another contract chip manufacturer also makes sense.

Since the processor comprises anywhere from 6% to 9% of the total component cost in a given iDevice, a 20% increase could translate into a whopping 1% to 2% hit on Apple's gross margin. That's an enormous impact on corporate-level margins related to a single component.

Let's dig into this a little deeper using recent bill-of-material (or BOM) estimates from iSuppli.

 

Third-Generation iPad (March 2012)

iPhone 5 (September 2012)

iPad Mini (November 2012)

Processor used

A5X

A6

A5

Processor cost

$23

$17.50

$13

BOM total before manufacturing

$306.05

$199

$188

Processor % of BOM total

7.5%

8.8%

6.9%

Gross margin after manufacturing

36.7%

68.1%

39.8%

Processor at 20% price increase

$27.60

$21

$15.60

Gross margin after price increase

35.7%

67.6%

39%

Gross margin reduction

1%

0.5%

0.8%

Source: iSuppli (March 2012, September 2012, and November 2012). 16 GB Wi-Fi iPad models shown. 16 GB iPhone 5 model shown.

The third-generation iPad has now been phased out in favor of the fourth-generation model, and the pricing estimates are from March. The new fourth-generation model uses a beefier A6X processor, but component estimates haven't been released yet on the new tablet. I'm showing the third-generation figures as a proxy, since most of the internals are the same.

Munster bash
While Munster has a solid track record with all things Apple, his estimates on the negative impact seem a little high to me. The entry-level models generally carry the lowest gross margins, while upselling storage configurations typically translates into higher gross margins for Apple. That means it can potentially sacrifice more to component costs if forced to.

The 50 basis point hit for the entry-level iPhone 5 stands out as significantly below Munster's 1% to 2% estimate. The iPhone carries disproportionate weight in overall results, and the latest model would see the smallest reduction in gross margin under a 20% processor price increase.

It's also unclear if this price hike applies uniformly among all A-chips that Samsung produces, or if it's primarily related to the newest 32-nanometer processors. Any price hike is certainly bad news for Apple's juicy gross margins, but I don't think we're talking about a 2% hit from Sammy alone.

There is absolutely no argument that Apple is at the center of technology's largest revolution ever, and that longtime shareholders have been handsomely rewarded with over 1,000% gains. However, there is a debate raging as to whether Apple remains a buy. The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and more importantly, your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 15, 2012, at 1:57 PM, chinaman8 wrote:

    Samsung has already indicated the processor price increase rumour is not true.

  • Report this Comment On November 15, 2012, at 3:04 PM, jdmeck wrote:

    How come your the only idiot that is still talking about something that everyone else has said was not true?

  • Report this Comment On November 15, 2012, at 8:48 PM, wangkon936 wrote:

    Evan,

    It's unlikely that Apple can decouple from Samsung as far as production of logic chips are concerned. TSMC doesn't want Apple to be a big customer and recently rejected a $1 billion advance from Apple to be a major supplier. The $1 billion was offered to TSMC to help build additional capacity. They are stuck w/Samsung for about 2 more years.

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