Is Apple's Epic Run Over? The Key to the Company's Pricing Advantage

Apple (NASDAQ: AAPL  ) has gone from Wall Street darling that couldn't miss to a contrarian play trading at earnings multiples well below the broader market. 

With iPhones still flying off the shelves and the Mini an early hit, many investors are left wondering there are deeper problems with Apple that they're missing, or whether the current sell-off makes Apple a screaming buy. 

We've created a brand-new report titled "Is Apple's Epic Run Over?" that gives investors a comprehensive look at Apple. It answers whether the bears are right, or if Apple has huge advantages investors are overlooking. Following is a sample section of the report that focuses on Apple and its hidden cost advantages compared to competitors.We hope you enjoy this preview content from our premium Apple report.

An amazing supply chain in action: Apple and cost of sales

Cost of goods sold of selected companies

Company

Percent of Sales

Apple

56.1%

Samsung

64.3%

HTC

73.8%

Nokia

72.9%

Research in Motion

70.6%

Dell

78.6%

Lenovo

88.4%

Microsoft

24.8%

Google

40%

Source: S&P Capital IQ. All values for the past 12 months as of Dec. 1, 2012.

Cost of sales is the single largest expense for Apple, and is at the heart of the debate over whether or not the company can continue to grow in coming years.

Diving deeper into cost of sales
What's in cost of sales? Primarily, components costs, but any number of areas could make it into cost of sales, including certain costs from:

  • Component costs and manufacturing
  • Shipping and handling costs
  • Warranty costs
  • Licensing costs
  • Employee costs (As an example, Apple allocated $265 million in share-based compensation costs to cost of sales last year.)

This clarification is especially important, because a common mistake made by investors is seeing published reports of the cost of materials in phones and inferring that's the company's gross margin. For example, here's a breakdown from researcher IHS iSuppli on the cost of all the components inside an iPhone 5:

Cost Driver

Total Cost in 16GB
iPhone 5

Memory (DRAM and Flash)

$20.95

Display and Touchscreen

$44.00

Processor

$17.50

Camera(s)

$18.00

Wireless Section

$34.00

User Interface and Sensors / BT and WLAN / Battery / Power Management

$24.50

Mechanical & Electro-Mechanical

$33.00

Box Contents

$7.00

Total Component Costs

$199.00

Manufacturing

$8.00

Total Component and Manufacturing Cost

$207.00

Source: IHS iSuppli, September 2012.

The quick read on this situation would be to take the wholesale price of an iPhone 5 not on contract -- $649 -- and divide the costs above to arrive at its gross margins. Under that quick and dirty method, you'd arrive at Apple selling a device with $207 in costs for $649, an astounding 68% gross margin.

However, that analysis fails to take into account the myriad other costs that can go into gross margins. Take licensing costs, for example. They can be an absolute killer in the mobile world. Google (NASDAQ: GOOGL  ) purchased Motorola last year mainly for its patents. The company is now engaged in litigation asserting that companies using its patented technologies – many of which are essential to the operation of wireless technologies like LTE – have to pay 2.25% of the phone's price in royalties. That's over $10 on a $500 phone.

That adds up fast when you consider that Motorola is just one company attempting to enforce its patents. Qualcomm's (NASDAQ: QCOM  ) portfolio of patents on 3G and 4G has led to the company charging royalties upward of 5% on phone prices.

The troubling outlook on Apple's gross margins
Rising cost of sales are most troubling because they can quickly wipe out earnings growth even if a company's sales are exploding. The table below shows Apple's sales and earnings growth projected by analysts for next quarter, relative to its recent history.

Growth from prior year

 Metric

Quarter Ended September 2011

Quarter Ended December 2011

Quarter Ended March 2012

Quarter Ended June 2012

Quarter Ended September 2012

Quarter Ending December 2012 (Projected)

Sales Growth

39%

73.3%

58.6%

22.6%

27.2%

17.7%

Earnings Growth (EPS)

52.1%

115.7%

92.6%

19.6%

23.1%

(4.1%)

Gross Margin

40.3%

44.7%

47.4%

42.8%

40%

36%
(Apple guidance)

Source: S&P Capital IQ. Company estimates.

Your eyes aren't fooling you: In spite of almost certainly record-breaking demand for iPhones and iPads, the company is expected to post earnings that are in decline this holiday quarter.

The reason for this situation is simple. When Apple last released earnings, it offered guidance for investors next quarter that pointed to deteriorating margins. Apple is notorious for low-balling investors with guidance it easily crushes, but its forecast was low enough that it put outsized focus on a topic that's constantly wondered about in the tech world: How long can Apple keep up its huge margins as it faces a sea of competitors getting cheaper and cheaper?

Easy margins come, easy margins go
So why is Apple's guidance pointing to gross margin of 36% next quarter when it was all the way up to 47.4% in March of last year? Is the company in trouble? Wall Street has already made its own opinion known, with the company's stock dropping in the weeks following Apple's guidance. A central issue during this time was the decreased margins.

However, this reaction could very well be a mistake for several reasons. The first reason would be that gross margins are prone to fluctuations depending on the product mix Apple is selling and the length of time that products have been in production.

By that, I mean the longer Apple has been making a product, the cheaper it is to produce. We see this every day in electronics, but it's especially true in high-end ones. A very important reason for this is yield management. That is, when you create new components, there's a high level of failure on chips. It's not uncommon to see reports of high-end processors seeing a yield of less than 50%. That is, if you have a large wafer that's going to be cut up into a set of chips, fewer than 50% might work properly. That not only leads to costly supply constraints, but it also squeezes the gross margin as each (properly functioning) processor has more costs built into it.

Yields are especially important because they apply across Apple's components. For example, the iSuppli estimate of the component costs in an iPhone 5 lists the display and touchscreen together as the single most expensive component on the device at $44, or 22% of total component costs. However, reports following the iPhone's launch all pointed to low yields on its display as a culprit in the phone's limited availability. Apple had to do some serious engineering to shrink the iPhone, like integrating touchscreen controllers into the glass display. That decision helped drive the iPhone 5's design advancements, but it's also likely putting some serious hurt on margins in the coming quarter. Likewise, yield issues are being blamed on iPad Mini production that's struggling to keep up with demand.

The good news for the overall margin picture is that as companies learn more efficient means of production, components like displays and memory get cheaper from price competition and better processes. A good real-world example of this would be that the iPhone 4's components were originally estimated at just shy of $190, but researcher TechInsights puts the iPhone 4's component costs at an estimated $112 today. That's a decrease of over 40% in component costs.

Looking at Apple heading into this holiday season, you can see the impact of how newer products could be holding back the company's gross margin.

Product

Launch Date in 2011

Launch Date in 2012

iPhone

Oct. 14, 2011

Sept. 21, 2012

iPad Mini

N/A

Nov. 2, 2012

iPad

March 11, 2011

March 12, 2012 (iPad 3)
Nov. 2, 2012 (iPad 4)

The bottom line here is that the iPad Mini is launching this quarter at the high end of the cost curve, whereas last year all iPad sales came from a product which had been on the market for six months and was seeing improving margins. Likewise, the larger iPad itself was also upgraded. These upgrades didn't involve a body or display redesign, but could still see some minor added costs. Furthermore, not displayed above is the revamped MacBook Pro series, which was redesigned to be 25% thinner and 20% lighter. As with the products listed above, the MacBook redesign also puts the new MacBooks at the higher end of their cost curve relative to last holiday quarter (when Apple had been using the same body for an extended period of time).

Let's revisit the chart showing Apple margins over time to see how margins are affected by product life cycles.

Metric 

Quarter Ended September 2011

Quarter Ended December 2011

Quarter Ended March 2012

Quarter Ended June 2012

Quarter Ended September 2012

Quarter Ending December 2012 (Projected)

Sales Growth

39%

73.3%

58.6%

22.6%

27.2%

17.7%

Earnings Growth (EPS)

52.1%

115.7%

92.6%

19.6%

23.1%

(4.1%)

Gross Margin

40.3%

44.7%

47.4%

42.8%

40%

36%
(Apple guidance)

Product Impacts

New iPhone ramping

New iPhone still ramping

iPhone maturing; iPad ramping

iPad still ramping

iPhone ramping; iPad Mini ramping

iPhone and iPad Mini still ramping

Source: S&P Capital IQ.

Bottom line
Apple will almost undoubtedly top its 36% margin estimate in the coming quarter. However, all signs do point to a sizable margin drop from the 44.7% gross margin that the company enjoyed last year.

Selling Apple based on declining margins – or using these declining margins as evidence that the company will be unable to grow profits into the future – looks to be mistake. Apple's margin decline this quarter is less about a conventional long-term threat to its ability to price its products at high rates or suppliers getting an edge on the company. Instead, the margin decline comes from design challenges on new products (the iPhone 5 and iPad Mini) exacerbating a usual cycle of margin declines around product launches.

Apple's not afraid to sacrifice margins for the sake of design, and that's a decision investors should be happy with. That's the mentality that earned Apple a $500-billion-plus market cap, and it's the mentality they need to stick with. Making design decisions to improve the iPhone 5 at the cost of short-term margins that panic Wall Street is in Apple's best long-term interests.

There have been reports of suppliers pushing back against Apple recently, such as with Samsung having reportedly instituted a 20% hike on the amount it charges Apple to manufacture the company's processors. However, such pressures are more than negated by the fact that Apple can get favorable pricing on components and commodity prices through its scale, which allows it to buy up huge amounts of supplies at favorable forward pricing. Also, while a supplier like Samsung might attempt to squeeze the company based on the belief that Apple's leaving it, other suppliers may be more than happy to pick up that role. There have been recent reports of Intel (NASDAQ: INTC  ) considering opening up its fabrication facilities to Apple through a partnership. Such a deal would likely come with favorable terms to Apple.

In the end, switching suppliers -- especially on critical components like processors -- can be expensive and have unintended costs. However, with Apple now amounting to such a huge portion of total semiconductor sales, the risk-reward ratio of companies pushing back against Apple looks unfavorable. Instead, Apple will continue to command favorable pricing from its suppliers.

Apple's huge advantage in gross margin (shown in the table at the beginning of this section) is commonly attributed to its ability to price more aggressively than competitors. That is, a high-end iPhone will have better gross margin than a comparable phone because it sells for hundreds of dollars more. However, Apple's hidden advantage in this area is that its scale also allows it to buy the same components as competitors, but at a cheaper price.

Get the full report
We hope you enjoyed this sample of The Motley Fool's newest report that I wrote on Apple. It offers a comprehensive analysis diving into what's causing Apple's sell-off -- and whether the company is poised to bounce back. To get instant access to his latest thinking on Apple, simply click here now.


Read/Post Comments (3) | Recommend This Article (3)

Comments from our Foolish Readers

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  • Report this Comment On December 30, 2012, at 9:29 PM, JokerJoey wrote:

    First, @happypoordays....I guess you'e really SADpoordays probably because you sold your shares when you shouldn;t have. Too bad....

    Now, on to the important stuff:

    FINALLY! A Motley Fool article that accurately analyses Apple and draws logical and well-thought conclusions from that analysis!

    Kudos to Eric Bleeker! Now just 26 more days to see if everything pans out as it should.....

  • Report this Comment On December 31, 2012, at 8:59 AM, hembreeder wrote:

    Good job. Reasonable, logical and apparently quite accurate.

  • Report this Comment On December 31, 2012, at 3:45 PM, TheRealRacc wrote:

    Of course, it's easy to look at the positives and think how great it is.

    Will it be the switch to producing in-house processors, or the subtle decline in market share, that causes AAPL to stagnate for 2013?

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