Where Is Apple's Gross Margin Headed Next?

Some analysts are starting to worry again about Apple's gross margin. Are they overreacting?

Jan 11, 2014 at 12:15PM

On the first business day of 2014, technology analyst Maynard Um downgraded shares of Apple (NASDAQ:AAPL), warning of gross margin risks ahead. This argument hits a sore spot with investors, since much of Apple's late-2012 and early-2013 swoon was driven by gross margin worries. With that in mind, what is likely to happen to Apple's gross margin in the next year or so?

While Apple's gross margin will always vary seasonally based on the timing of new product introductions, worries about margin erosion appear overblown today. Unless Apple enters a new product category with a much lower-margin profile, the company's gross margin is likely to stay near recent levels for the foreseeable future (which admittedly is not very long). In the next few quarters specifically, Apple is more likely to experience gross margin expansion than decline.

Where we are today
Apple's gross margin peaked in the March 2012 quarter at a staggering 47.4% and remained above 40% throughout fiscal year 2012. Gross margin then dropped severely in the most recent fiscal year, reaching 38.6% in Q1, 37.5% in Q2, 37% in Q3, and 36.9% in Q4 : the most recently reported quarter.

In October, Apple projected a 36.5%-37.5% gross margin range for Q1 of FY14 (i.e. the December quarter) . At the midpoint, that would be roughly flat sequentially, but still down by 160 basis points year over year.

G

Strong iPhone 5s shipments will boost Apple's gross margin (Photo: Apple)

However, there may be upside to that estimate. Output of the iPhone 5s -- probably Apple's highest-margin product -- hit a staggering level during the quarter. Foxconn was reportedly building 500,000 units per day by late November! Additionally, according to some analysts, demand for Apple's new iPads has been skewed toward higher-memory configurations, which have better gross margins. As a result, I wouldn't be surprised to see Apple's gross margin reach 38% when it reports earnings later this month.

Looking forward
Last year, Apple's gross margin fell sequentially from the December quarter to the March quarter (38.6% to 37.5%). By contrast, in the prior year, Apple's gross margin rose sequentially in the March quarter, from 44.7% to 47.4%. Which pattern will hold this year?

Apple's results seem likely to follow the 2012 pattern rather than the 2013 pattern this quarter, although the gross margin increase will probably be more modest. Last year, Apple sold a lot of low-margin iPad Minis in the March quarter, after experiencing supply constraints throughout the December 2012 quarter. This unfavorable mix shift was the most important factor leading to the sequential gross margin decline.

Ipad

High sales of the iPad Mini in the March quarter of 2013 hurt gross margin (Photo: Apple)

By contrast, Apple appears to have sold a lot of low-margin iPad Minis in the just-ended holiday quarter; it was a popular Christmas present! Going into the March quarter, consumer interest will probably be focused on the new iPad Air and iPad Mini Retina, which have higher margins.

Even more importantly, Apple should get a nice boost from the upcoming launch of the iPhone (Apple's highest margin product) at China Mobile (the world's biggest wireless carrier ). These catalysts could plausibly drive Apple's gross margin to 39% or thereabouts this quarter.

For the remainder of FY14, Apple's gross margin could drop slightly from the Q2 level. Early adopters tend to buy the most cutting-edge, high-margin products, whereas people who buy during the second half of the product cycle are often more value-oriented, causing an unfavorable mix shift. Sales volumes also decline, which increases unit costs. However, both of these factors are mitigated by lower component costs and higher yields as new products mature.

The next round
Many analysts worry that gross margin will move another leg lower later in 2014, upon the launch of the iPhone 6. Whereas the iPhone 5s kept approximately the same form factor as the iPhone 5 (reducing costs), the iPhone 6 is expected to be significantly larger. This would almost certainly increase production costs.

However, there's a good chance Apple will offset these cost increases with higher pricing. While new iPhones have been priced starting at $199 with a 2-year contract for many years now, some of Samsung's larger-screened phones have started at $249 or $299 on-contract. Furthermore, while the original iPad Mini started at $329, Apple set the starting price of the new iPad Mini Retina at $399 because it's more expensive to build. This creates a precedent for putting a higher price tag on a larger iPhone 6.

G

The iPad Mini Retina got a higher price tag than its predecessor (Photo: Apple)

The other major driver of gross margin will be new product launches. CEO Tim Cook has hinted that Apple will enter at least one new product category in 2014, and Apple could also broaden its existing product lines (e.g. a phablet or the rumored iPad Pro laptop/tablet convertible).

The possibility that Apple will introduce entirely new products makes it hard to predict gross margin trends beyond 2014. An "iTV" would probably carry a low gross margin (at least in percentage terms) given the TV industry's razor-thin margin profile, while an "iWatch" could be good for margins.

Investors shouldn't worry too much about the impact of new product lines on Apple's gross margin. The profit from new products will be incremental to the profit generated by existing products, so there's much more upside than downside from an earnings perspective.

Foolish bottom line
If you've gotten this far, by now you should have a better sense of the major factors that could impact Apple's gross margin going forward. Strong demand for the iPhone 5s and iPads with higher memory configurations create gross margin upside for FY14, with the highest gross margin likely coming in the March quarter.

Looking further down the road, the iPhone 6 launch and other potential new product launches could create cost pressures later this year and into 2015. However, Apple may be able to keep gross margin near the high end of the recent 36%-39% range by raising prices for costlier products, as it recently did with the iPad Mini Retina. In any case, the risk of rapid margin contraction (as occurred in FY13) seems remote for the foreseeable future.

The key to profiting from the smartphone boom
The Motley Fool's analysts have identified one company that sits at the crossroads of smartphone technology as we know it. It's not your typical household name, either. In fact, you've probably never even heard of it! But it stands to reap massive profits NO MATTER WHO ultimately wins the smartphone war. To find out what it is, click here to access the "One Stock You Must Buy Before the iPhone-Android War Escalates Any Further..."

Fool contributor Adam Levine-Weinberg owns shares of Apple and is long January 2015 $390 calls on Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers