Apple's Margin Worries Are Over (For Now)

Apple (NASDAQ: AAPL  ) stock has had a rough ride over the last year, after peaking above $700 last September. Two main concerns drove investors to sell the stock en masse. First, Apple's revenue growth quickly ground to a near-standstill. Second, it experienced severe margin compression, as production costs rose and customers traded down within Apple's product lineup.

After Apple shocked the world on Tuesday by announcing that its iPhone 5C would retail for $549 unlocked -- rather than the expected $300-$400 price point -- its investors no longer have to worry about continued margin compression.

The iPhone 5C. Source: Apple.

Revenue growth may remain anemic, but Apple is now very likely to return to year-over-year margin growth next quarter. This should produce a return to solid EPS growth.

Apple's margin problem
The following graph of Apple's gross margin over the past five years adequately explains investors' margin concerns.

AAPL Gross Profit Margin Quarterly Chart

AAPL Gross Profit Margin Quarterly, data by YCharts.

While Apple's gross margin rate has been unstable over time, it has generally oscillated around the 40% level since 2009. Gross margin spiked to 44.7% in Q1 of FY12 and peaked at 47.4% in the following quarter. However, over the following five quarters, gross margin plunged by more than 1000 basis points, hitting 36.9% last quarter. Apple's guidance suggests that gross margin will be similar in the current quarter.

Back in January, I argued that this margin compression was a temporary phenomenon, not the beginning of a long-term trend. The release of the iPhone 4S in October 2011 had driven gross margin to an unsustainably high level, primarily because the 4S maintained the form factor of the iPhone 4, lowering production costs.

With the move to a new form factor (taller but thinner and lighter) with the iPhone 5, production costs rose. This was one of the main factors that caused gross margin to return to lower (and more normal) levels in the past year.

Enter the iPhone 5C
Back in my January article, I argued that gross margin was likely to stabilize in a range of approximately 38%-41% by the end of this year. Had Apple introduced an iPhone priced at $299, or even $349, gross margin may have fallen out of that range. Instead, the 5C has an unsubsidized price of $549 in the U.S. It is even more expensive abroad, retailing for the equivalent of $733 in China.

The 5C is very similar to the iPhone 5, but it has a plastic exterior rather than the aluminum and glass casing Apple has been using recently. This will presumably cut down on manufacturing costs. This will be better for gross margin than the alternative of simply dropping the iPhone 5 price by $100.

Moreover, the iPhone 5S -- like the 4S -- maintains its predecessor's form factor. The main changes are upgraded processors and a new fingerprint sensor on the home button.

The iPhone 5S maintains the form factor of its predecessor, the iPhone 5. Source: Apple.

These commonalities could lead to a repeat of 2011, when the iPhone 4S drove a strong increase in Apple's gross margin for the fall quarter. Gross margin is unlikely to return to the all-time highs it reached two years ago, but I expect it to expand to the low 40% range.

Keep playing the long game
I was not very surprised to see Apple stock take a big hit following its iPhone announcement. Investors and analysts are overly focused on the revenue growth side of the value equation and were therefore hoping for a "cheap" iPhone.

However, margin expansion can be an equally potent driver of earnings growth. While I was surprised at just how high Apple was willing to price the iPhone 5C, the company is much better off erring on the high side rather than pricing aggressively for market share and thereby undermining profitability. If Apple's margins break back above 40% next quarter, this week's hand-wringing over market share will be virtually irrelevant.

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Read/Post Comments (14) | Recommend This Article (5)

Comments from our Foolish Readers

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  • Report this Comment On September 12, 2013, at 9:15 PM, adamwins76 wrote:

    You don't see Louis Vuitton or Mercedes Benz compromising quality or producing cheap crap to "reach emerging markets." I don't understand why analysts think Apple "has to." They don't and they'll still make a boatload of money. They don't want to compromise their brand with a cheap product. I think they made the right decision. History will judge this decision more wisely than the fly by night day traders on CNBC.

  • Report this Comment On September 12, 2013, at 9:53 PM, gr8twhtebuffalo wrote:

    Going to a plastic case is a bad idea. This new iPhone will feel cheap.

  • Report this Comment On September 12, 2013, at 9:53 PM, st0815 wrote:

    Ok, lets say profits on device sales can be grown by selling fewer products with higher margins. (Which obviously depends on how much larger the difference in sales numbers will be.) That's not all which is relevant for Apple: there is also an ecosystem to consider. iPhone users are more likely to purchase other Apple products like tablets and accessories, to buy apps, music and other content via iTunes. Developers give more attention to the ecosystem which makes them more money - once that attention wanes, the ecosystem itself becomes less attractive.

    In the past Apple had a clear lead in that area, that lead has shrunk if it's still there at all. What strategy did they present to stop or reverse that development? I didn't see anything, and that's a worrying sign.

  • Report this Comment On September 12, 2013, at 10:15 PM, thethreestooges wrote:

    Great analysis.

    I will keep a tab on those analysts who downgraded the APPLE just because they can't get a cheapo phones from APPLE.

    But my guess is that they will still buy a more expansive smart phones from APPLE even thought they downgraded the company.

  • Report this Comment On September 12, 2013, at 10:20 PM, thethreestooges wrote:

    greenbear28, you don't have to get the plastic. You can still get a 5S with gold or silver aluminum casing. I can make a custom 5M iPhone with diamonds studded case if you want. 5M=$5 Millions. Great deal if you can afford it.

  • Report this Comment On September 12, 2013, at 10:48 PM, JT1951 wrote:

    Sure......... Apple will keep their margins healthy. But the whole point of a cheaper phone was to get new users into the Apple iOS world. Also they need a cheaper phone to get into the Chinese and Indian markets. The 5C will not do this. So why even come out with the 5C?? The only thing it will do is take sales away from the 5S. In my opinion a stupid move on Apple's part. Sure they have 150Billion in cash..... but doing stupid stuff because you have loads of money is Microsoft's game not Apple's.

    If the 5C was priced at $299 or $349 their margin would have been much lower but they would have sold 300 million phones. If you know anything about marketing you know high volume at a lower margin is just as good as low volume at high margins.

    The high end customers will buy the 5S and the low end customers will continue to buy the Samsung Galaxy line. The 5C will no be one of Apple's best sellers that is for sure. Why would anyone buy a plastic iPhone for only $100 less than the state of the art 5S ??? Not me.

  • Report this Comment On September 13, 2013, at 12:29 AM, Jaybones21 wrote:

    Ok here it is!!!

    Apple is a high end company. They dont want a cheap iPhone. The 5c is just cheaper. You dont see high end car companies making cheap $20k cars just to achieve market share. Its no diff with Apple. They arnt operating out of a garage either. They have a team of people who read about what people have to say. Like these comments. But making a cheap iPhone in the 300-400 range is outside of their business guidelines. It basically too easy to just make a cheap phone. Not saying they dont care about market share but they want to achieve it with innovation. They want the reward of how they got there. And both the 5c and 5s are examples. Investors are being blind to everything else but market share.

  • Report this Comment On September 13, 2013, at 12:36 AM, vv234 wrote:

    Right on, JT1951!

    Comparing Apple with Louis Vuitton or Mercedes Benz is either a wishful thinking or simply naive.

    For one thing, LV bags or Benz can last forever (almost) but electronic gadgets, esp, cell phones

    become obsolete every couple of years, no matter how well they are built. In fact, all the carriers as well as Apple want the customers to upgrade theirs phones every couple of years. So why do most users want to spend fortune to buy expensive cell phones only to replace them in 2 years (save for the rich %1)? Furthermore, I do not think anyone with a right mind would think the plastic IPhone 5C or the IPad mini is a "luxury" product or has any functionality that cheaper brands like Samsung or Xiaomi or HTC do not have.

    It's possible that Apple believes that they could sell enough units of IPhone 5S/5C while keeping the high margin, in the near term.

    However, unless Apple will release a new line of revolutionary products soon enough, its profit will suffer due to the shrinking market share, esp., in the emerging markets.

  • Report this Comment On September 13, 2013, at 12:38 AM, Jaybones21 wrote:

    Also with 135+million in cash i dont think Apple is to concerned about there market share that they would have to sell that cheap of a phone. Which would change the i on of Apple. They arnt in the same boat as Nokia was before the buyout.

  • Report this Comment On September 13, 2013, at 12:42 AM, deasystems wrote:

    @st0815: "In the past Apple had a clear lead in that area, that lead has shrunk if it's still there at all. What strategy did they present to stop or reverse that development?"

    Your assertion is wrong and therefore your concern is unwarranted. Apple's ecosystem lead is growing, not shrinking.

  • Report this Comment On September 13, 2013, at 4:47 AM, lukascranac wrote:

    A Mercedes car usually lasts no more than 5 years at its first buyer. Clothing retailers will sell you new models every season (3 months) and some innovative retailers like Inditex change inventory and adjust models lines every 2 weeks.

    A cell phone is usually kept for the 2 year contract. iPhones sometimes are kept for 4 years because of their quality.

  • Report this Comment On September 13, 2013, at 11:22 AM, TMFGemHunter wrote:

    Thanks for the comments everybody. I think the iPhone 5S/5C combination will be enough for sales growth over the next year; it just won't produce the same level of sales growth as a $349 iPhone.

    I also think people are forgetting very quickly about the iPhone trade-in program that was recently announced. Apple's "mid-tier" strategy may be used iPhones. Creating a healthy secondary market in iPhones in developing countries could be good for Apple in a number of ways. First, it can make a little money by buying up used iPhones and shipping them abroad. Second, it expands the total iOS user ecosystem just as much as selling new phones. Third, by helping iPhones maintain their value over time, it makes purchasing a new one more attractive. (That's why car companies today are very focused on maintaining the value of their used cars.)

    Adam

  • Report this Comment On September 13, 2013, at 11:26 AM, TMFHousel wrote:

    <<You don't see Louis Vuitton or Mercedes Benz compromising quality or producing cheap crap to "reach emerging markets>>

    I think you see them doing precisely that, in fact. The Benz C-Class was made to tap into new low-end markets. Same with Tiffany's key chains and simple silver bracelets. To a different degree Bentley and Lamborghini have done the same, producing cars about half the price of traditional models. They're still expensive, but so is the iPhoneC.

  • Report this Comment On September 20, 2013, at 8:46 AM, Wjarvis98 wrote:

    The 5c is for teenagers. Once my daughter sees the pink one she will want it. I save $100.

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