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3 Reasons to Believe Apple’s iPhone Business Is Getting Better

By Chad Henage – Feb 13, 2014 at 9:00PM

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Everyone knows that the iPhone business is significant to Apple, and despite a just 6% increase in revenue in the current quarter, there are signs of improvement that some might have missed.

Any company that generates more than half its revenue from the sale of one product has to be watched closely. Since the launch of the iPhone by Apple (AAPL -0.34%), this product has slowly transformed the company from a second-tier computer company to one of the biggest players in the mobile phone industry. However, with just 6% revenue growth from the iPhone lineup, some may assume the product's best days are behind it. Looking at some historical numbers, there are three reasons to believe this assumption is incorrect.

More than just a marginal worry
One of the biggest headaches for Apple has been its shrinking gross margin tied to the iPhone. In the last two quarters of 2012, Apple witnessed its gross margin decline from nearly 43% to 40% largely due to the introduction of the iPhone 5. With its bigger screen and high resolution display, Apple's margins took a hit.

This initial decline was actually just the beginning. Over the course of 2013, the company reported its gross margin declined further to 36.9% as of the third quarter, before recovering slightly to 37% by the fourth quarter. While it may not sound like much, the fact that Apple introduced the iPhone 5s and 5c and the company's gross margin expanded from 37% to 37.9% was a significant win.

Apple's longtime competitor Microsoft (MSFT -0.80%) is finding out just how difficult margins can be in the consumer devices segment. In the company's current quarter, Microsoft reported that its Consumer and Devices hardware gross margin was just 8.7%.

The competitive landscape is also putting margin pressure on traditional retailers that sell these devices as well. Best Buy (BBY -1.91%) generated more than 45% of its domestic revenue from the computing and mobile phones division. Though the company reported positive same-store sales growth of 3.2% last quarter in this business, Best Buy's overall gross margin dipped to just 23%.

The point is, with Apple predicting a gross margin in the next quarter of 37% to 38%, this is in the range of the company's gross margin over the last four quarters. In short, the first reason Apple's iPhone business seems to be getting better is margins seem to be stabilizing.

Better than average
A second major issue has been the average revenue per unit on the iPhone has been under pressure. Some have speculated that this is due to consumers choosing cheaper models with lower profit margins.

According to research, it costs Apple between $199 and $218 to make a 16GB and 64GB iPhone 5s. In addition, the 5c costs between $173 and $183 for the same storage. The company sells the 5s without a contract for $649 to $849, and the 5c for $549 to $649.

The worst case scenario for Apple would be if every consumer chose the cheapest 5c model. In theory, Apple would only make $376 per unit ($549-$173 = $376). However, in the current quarter the company actually generated $637 in revenue per unit. This was actually the second highest revenue per unit since the iPhone 5 was introduced.

The second reason the iPhone business is getting better is if price is a major issue the company's results don't seem to bear this out.

Discounts for everyone except Apple
A third reason to believe the iPhone business is doing better is the clear demand for the company's products during this last holiday selling season. Best Buy routinely offered significant discounts or gift cards to those who bought an Apple product, and in particular an iPhone or iPad. In fact, at one point Best Buy offered $100 off either of the new iPhones if the customer was willing to sign up for a new two year contract.

Microsoft was hit hard by discounting too, as the company cut prices on its original surface tablets and even offered a $100 keyboard attachment for free to spur sales. With many Windows Phone units sold for $99 or less with a contract, there obviously isn't the same pricing strength as Apple's $199 iPhone 5s.

The point is, while Microsoft cut prices significantly to gain sales, and traditional retailers offer promotions and gift cards, Apple still gets paid the same amount.

Time to take a bite?
While some may doubt Apple's ability to reward shareholders in the future, this worry seems overdone. With a yield of just under 2.5%, the stock pays almost as much as Microsoft or Best Buy at around 3% each. While analysts expect earnings growth of 19% from Apple in the next five years, they expect EPS growth of just 8% from Microsoft and under 5% from Best Buy.

If iPhone margins have stabilized and consumers are still snapping up higher-priced versions of the iPhone, this seems to argue well for Apple's future. Investors looking for a growth and income play should consider taking a bite of the shares.

Chad Henage owns shares of Apple and Microsoft. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and Microsoft. 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.

Stocks Mentioned

Apple Stock Quote
Apple
AAPL
$142.16 (-0.34%) $0.49
Microsoft Stock Quote
Microsoft
MSFT
$245.42 (-0.80%) $-1.98
Best Buy Stock Quote
Best Buy
BBY
$81.81 (-1.91%) $-1.59

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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