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.
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.
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.
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.
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.