When you're a company like Apple (NASDAQ:AAPL), which generated $171 billion in sales in its most recent fiscal year, gross margin percentage movements can have a pretty meaningful effect on your bottom line. To illustrate the point, each percentage point of gross margin to Apple is worth a whopping $1.71 billion in operating income (assuming flat operating expenses).
A question worth investigating on this line of thought is whether Apple should buy Broadcom's mobile and wireless business and whether the gross margin savings would improve total profitability and whether the risks of bringing those projects internal would be worth such savings.
Acquiring Broadcom's mobile business doesn't seem like it could drive much margin upside
Apple pays Broadcom (UNKNOWN:BRCM.DL) for connectivity combo chips as well as touch controllers found across the Apple product line. During 2013, Apple accounted for 13.3% of Broadcom's $8.3 billion in sales during 2013, working out to about $1.07 billion in chip content. Assuming that this business comes in below Broadcom's corporate gross margin range at about 45%, Apple could -- if it were to purchase Broadcom's mobile group -- save approximately $482 million.
Ignoring for now the incremental operating expenses that would, of course, come with the acquisition of this business, bringing the connectivity in-house would have improved gross margins by 0.75% to 38.35% during the fiscal year ending in 2013. Given that Broadcom claims that it spends over $1 billion per year in R&D for its mobile and wireless business (to be fair, this includes cellular -- connectivity is more along the lines of $400 million), the payoff here doesn't actually seem as though it would be worth it.
What if we bring cellular on board?
While buying Broadcom's mobile and wireless business solely for the connectivity doesn't actually make a ton of sense, it becomes a lot more interesting if we consider that Apple could potentially get a pipeline of world-class cellular modems as well. While Broadcom's part of the Apple-device bill of materials isn't enough to offset the R&D bump, do keep in mind that the cellular portion that Apple pays Qualcomm (NASDAQ:QCOM) for is significantly more expensive (some estimate the dollar content per iPhone is between $15 and $20).
Let's be conservative and assume that Apple pays Qualcomm about $15 per phone and that this is 45% gross margin business. Let's also assume that only 10% of the iPads sold are enabled with cellular capability, meaning that Apple buys about 157 million cellular platforms (baseband and transceiver) per year. If Apple had this in-house, it would be able to "keep" another $1 billion in gross margin that it would have otherwise paid to Qualcomm. Let's also assume that the $1 billion per year in R&D that Broadcom alleges that it spends on mobile and wireless is the right level to fund these technologies.
What's the total cost savings?
If we assume that Apple would spend $1 billion per year in R&D on wireless chip development to drive an incremental $1.5 billion in gross margin, the savings seems to net out to about $500 million annually. Assuming a 26.2% tax rate, this would add about $369 million to the net income line or about $0.42/share (pre-split). While this is not trivial, it may actually not be worth the risk if the Broadcom-turned-Apple team stumbles and needs to buy chips from Qualcomm anyway.
Further, given that the competitive environment is likely to heat up in baseband (Qualcomm is likely to have at least one viable competitor long-term), the opportunities to squeeze these players to improve Apple's margins may make bringing this technology in-house even less appealing. So, at this time, Apple is probably not likely to buy Broadcom's mobile & wireless team and instead is likely looking forward to second-sourcing opportunities.
Ashraf Eassa has no position in any stocks mentioned. The Motley Fool owns shares of Apple and Qualcomm. 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.