Ahead of Apple Earnings, Are There Margin Concerns?

On Wednesday, Apple (NASDAQ: AAPL  ) reports its fiscal first-quarter earnings for the busy holiday shopping season, and the company expects new products introduced at the end of last year to drive 80% of the quarter's revenue.

One of the concerns that investors and analysts have expressed recently is Apple's decline in gross margins. There's been much debate over whether this is actually cause for concern or just a blip on the company's long-term upward trajectory in profitability.

How big of a deal is Apple's gross margin contraction?

Oppenheimer's got some 'splainin to do
Apple's lowball guidance calls for gross margin of 36%, which would be a sequential drop of 4% from the 40% gross margin it posted last quarter. That's a big plunge that the company is expecting, but there are several reasons  it's entirely justified.

On the last conference call, CFO Peter Oppenheimer specifically addressed concerns over gross margins by pointing to the number of newly redesigned products that had just been launched.

As you pointed out, this is the most prolific product period in Apple's history. We have an unprecedented number of new product introductions over the last six weeks, and this has led to record levels of demand. New or repriced versions of our products announced during this time frame represent over 80% of the total expected December quarter revenue.

But there are costs associated with such dramatic change and demand. The iPhone 5, iPad Mini, iMac, MacBook Pro 13-inch, iPod Touch, and iPod Nano have completely new form factors with great new features, and we've never before introduced so many new form factors at once. All of these products have higher costs than their predecessors, and therefore lower gross margins as they are at the height of the cost curve.

This has been the case with new products in the past, so nothing new. The difference this time is the sheer number of new products we are introducing in a very short period of time.

Of these products, three stand out as Apple's most important: the iPhone, iPad, and MacBook Pro. iPods continue to decline in financial importance, although they serve a critical strategic purpose. The new iMacs were extremely constrained during the quarter, and desktop sales are also less important, so I wouldn't expect much impact there.

The iPhone 5 carries a redesigned body, the fourth-generation iPad received some incremental upgrades along with a new Lightning dock connector, the iPad Mini is a totally new product, and MacBook Pros are now available with Retina displays.

Product

% of FY 2012 Revenue

iPhone

51.4%

iPad

20.7%

Mac portables

11%

Total

83.1%

Source: 10-K.

Those three product families combined comprised 83% of sales last year, so changes in those cost structures carry a lot of weight when it comes to Apple's overall cost of goods sold. While the MacBook Air is now positioned as Apple's consumer notebook, marketing chief Phil Schiller said at the October event that the 13-inch MacBook Pro is Apple's most popular notebook.

That was a bit surprising, since many would think that the MacBook Airs would be better sellers, but it also suggests MacBook Pro sales comprise a large portion of notebook revenues.

Faster cycling without performance-enhancing drugs
If you line up the product design cycles with historical gross margins, you'll see not only a strong correlation with new products and margin contractions, but also, and more importantly, a long-term upward trend. This chart focuses primarily on when products received new designs, since that transition is what causes downward pressure on gross margin.

Source: SEC filings. Fiscal quarters shown. MBP = MacBook Pro. rMBP = MacBook Pro with Retina display.

iPhone designs remain in use for about two years. Incremental "3GS" and "4S" upgrades followed the "3G" and "4" industrial redesigns. The iPad has been different, changing in some form or fashion every year. The iPad 2 was redesigned, and while the iPad 3 looked identical, it received a pricey Retina display. The iPad 4 got minor updates, but it also came in alongside a brand-new iPad Mini.

MacBook chassis designs typically last quite a bit longer. Apple introduced its aluminum unibody construction in the MacBook Pro family in late 2008 (early fiscal 2009) and only introduced the Retina models with new designs in 2012.

This is a cyclical pattern that investors have seen play out before in the past, except its effects are more pronounced this time because the company introduced redesigned products every quarter in 2012.

The gross margin rises
Ultimately, Apple continues to enjoy structural cost advantages over its rivals, and its business is surprisingly scalable because of how efficiently it spends on research and development as well as selling, general, and administrative expenses.

Sources: SEC filings and earnings conference calls. Fiscal quarters shown.

Operating expenses as a percentage of revenue were as high as 17.2% in 2007 but fell to a low of 7.3% last year. Thank you, operating leverage.

Guidance calls for operating expenses of $4.05 billion, or 7.8% of revenue outlook. Apple's operating expenses are typically right in line with guidance, which means that any upside in revenue and gross profit will translate into meaningful gains in net income and net margin.

Gross margins may very well decline this quarter, but as Apple works down the cost curves of its new products, gross margins will rise again.

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  • Report this Comment On January 20, 2013, at 9:43 PM, techy46 wrote:

    Apple's gross margins are just beginning to felll the heat fro Nokia and Samsung. Gross margins have to come down when competition offfers better products for lower price like Nokia's Lumia 920, 820 amd 620.

  • Report this Comment On January 22, 2013, at 2:42 PM, hiddenflem wrote:

    Nokia is sooo early 2000's.

  • Report this Comment On January 22, 2013, at 2:54 PM, Mathman6577 wrote:

    I think most people are overanalyzing Apple. In the fall it was a supposedly smaller number of people waiting in line for the iPhone5 at the Apple store in NYC. Then it was the map flap, then it was earnings concerns (gee Apple missed earnings by 8 cents), then "only" 5 million iPhones were sold over the first weekend, last week a few unconfirmed reports of Apple cutting orders to suppliers, this week it's gross margin. Everyone is missing the forest by only looking at a few trees or looking at one tree and ignoring other trees.

  • Report this Comment On January 22, 2013, at 5:59 PM, Pscartelli wrote:

    No reason to get in now, hold off and wait until the report. Apple as we know can never be taken for granted. If Apple is going to be the bellweather again anyone can buy after the dust settles.

  • Report this Comment On January 22, 2013, at 6:44 PM, mountain8 wrote:

    That's what healthy competition does, it lowers margins. Good. This country needs healthy competition. That doesn't make Apple any better or worse than any other company out there.

  • Report this Comment On January 22, 2013, at 8:22 PM, hiller147 wrote:

    I've been in retail all my life and magins are based on retained markon. When they introduce new products it makes onhand inventory obsolete which means sell at a discounted price, hence lower margins overall. To say that the products being produced cost more as compared to what they sell for would be mismanagement of what you think the public will pay. They also have lost margins because of the wholesale markets they expanded into, ie: Staples. Apple can't be compared to Nokia, its a totally different retail customer thats buying more than a phone, its a lifestyle pkg. Thats what Jobs created, can it be maintained and expanded thats the question

  • Report this Comment On January 22, 2013, at 9:47 PM, forbesinvestor wrote:

    Hi all,

    Why does Motley Fool ask you to click into additional layers of the website just to finish an article? It's annoying!!! I just paid for this and I just don't understand why we have to hunt and click for what we've paid for.

    Suzanne

  • Report this Comment On January 23, 2013, at 12:42 AM, TreyAnas wrote:

    Not to pick statistical nits, but I don't see the obvious correlation betweem new product introductions and gross margin declines. I see an upward trend with natural variability that doesn't correlate consistently (at all) with the product cycles.

    Given Apple's tendancy to sandbag, I don't think we have a clue whether margins will be a bit higher or flat this quarter, And I agree with what others have said: the market has overreacted to news since AAPL stretched to its peak in the fall.

    I'm long AAPL (if an in-the-money LEAP counts) but think anybody who correctly guesses what the earnings release will reveal just got lucky. Short-term market predictions are like guessing a coin toss.

  • Report this Comment On January 23, 2013, at 8:09 AM, mikecart1 wrote:

    Yeah Apple is feeling the heat of Nokia... I think Nokia is now selling about 1/30th of the phones Apple is selling on a quarterly basis now. Apple better watch out or Nokia will sell more! :)

  • Report this Comment On January 23, 2013, at 9:47 AM, Teaweed wrote:

    Suzanne hit the nerve that raises my blood pressure every time I read one of these articles. Another click, another layer, another frustrating experience. The Fool is slowly running off this "One" subscriber.

    Teaweed

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