Cracking the Oppenheimer Code, Part 4 of 5: There is No Spoon Profit Umbrella

So many ways to approach gross margin, so many pages that could be spent on the topic. And that’s before delving into the realm of commentary/opinion, such as discussing Apple’s managing of gross margin expectations, long-term pricing strategy, or any number of other things.

Well, since I’m just a humble “home gamer” tracking Apple fundamentals, I like to keep it simple. So let’s start with Apple’s historical gross margin including an estimated gross margin for the recently ended fiscal Q3 2013:

apple gm

Some observations/opinions to start regarding Apple’s recent gross margins (abbreviated as “GM”):

1) They’re still excellent by any objective metric, especially when compared against hardware-“focused” tech companies.

2) They’re considerably lower than just last fiscal year, which makes for tough YOY compares. Compounding the “problem” is a potential megatrend towards lower iPhone/iPad ASP going forward (which is already pretty much confirmed on the iPad side of things), along with poor visibility on future revenue growth at this point in time.

3) Oppenheimer and/or Cook stated in the past that Apple will not leave a pricing umbrella for competitors. And it certainly looks like Apple isn’t leveraging its revenue to improve its profitability. Of course, it greatly helps that Apple has always been a “premium” hardware company, and has had such high profitability over the years (taken to unbelievable heights on account of iPhone) that it can literally afford to be more aggressive in the marketplace (with room to spare).

4) It’s highly unlikely to me that Apple will deviate from that “no umbrella for competitors” policy. If anything, Apple will be “even less hesitant” to “sacrifice” a few percentage points of gross margin here and there to give its various product offerings (mostly iPhones and iPads, of course) a better chance of success of consumer uptake.

5) Apple probably won’t be continuing along its current sharp downward trajectory of GM decline. Though it depends on how various “megatrends” for Apple play out.

Those megatrends (yes there’s a lot of oversimplifying going on here, but this blog isn’t intended for treatise- or expert-level content) are, in my uneducated opinion:

iPhone pricing, cost structure and sales mix.  Apple’s selling more iPhones, but said iPhones appear to have high cost structures than before.  For example, iPhone recognized revenue and iPad recognized revenue in fiscal Q2 2013 were about 52% and 20% of total revenue respectively, and Apple’s total GM was 37.5%.  The prior year, that revenue mix was about 57%/16%, and Apple’s GM was 47.37%, almost a full 1,000 basis points higher.  The sharp decline from Q2 2012 to Q2 2013 simply isn’t something that can be “blamed” on a slightly higher iPad revenue mix and slightly lower iPhone revenue mix, even if you were to make the radical assumption that combined iPad gross margin was a whopping 2,000 basis points lower YOY (that would only account for somewhere around 400 basis points of gross margin dilution).  That iPhone “ASP” declined roughly 3.5% YOY (from about $635 to about $613) doesn’t fully explain the difference either.

If Apple comes out with an iPhone 5S-type iPhone, that might or might not increase iPhone GM depending on sales mix and the amount/cost of improvement that goes into improving the 5S vs. the screen and enclosure which would presumably be mostly unchanged.  If Apple comes out with an iPhone 6 this year, combined GM is very likely to be lower.  The proverbial elephant in the room, though, is unit/revenue share of lower-priced iPhones, particularly if Apple creates a new form-factor lower-cost iPhone as has been rumored.  For reference, the unsubsized price of iPhone 4 in the US is apparently somewhere around $400-450.  Until Apple dramatically changes up iPhone pricing, “ASP” (avg. reported revenue per iPhone, to be precise) will be important to watch going forward.

iPad sales mix.  iPad mini is clearly the the unit share leader for iPad going forward.  Apple has made no secret that iPad mini’s GM is significantly below the corporate average.  ASP has already fallen considerably, from $530 about a year ago to about $450 last quarter.  ASP will probably decrease more gently from this point forward (since the base price of an iPad mini is currently $329, with models priced up to $659), but if iPad continues to significantly outgrow iPhone in percentage terms YOY, GM will be further “diluted”.

Apple’s investments in property, plant and equipment.  In my layperson’s understanding (and in the off chance one of you five viewers are accountants, feel free to correct me), cost of goods sold includes depreciation of Apple’s CapEx – property, plant and equipment.  Since Apple is making immense investments in things like equipment to ensure supply, those capital expenditures made which are related to the products being sold will be recognized over their useful life, reducing GM.  Curiously, Apple has never once mentioned depreciation and amortization of CapEx in GM discussions that I can recall, but it’s still very much worth thinking about as Apple’s CapEx isn’t showing any signs of leveling off.

Macs and software, to a somewhat lesser extent.  The more people gravitate to the increasingly powerful/useful MacBook Air series, the more GM will be affected (although impact would be relatively minimal if Mac growth remains single-digit YOY, or even goes negative).  Software/content sales, on the other hand, continue to grow at a steady clip.  Considering that Oppenheimer has called the iTunes Music Store and App Store “a little over break-even” enterprises in late 2010,*** and that Apple’s own software is extremely aggressively priced, it’s difficult to see combined software/content GM as being in the 35% range.  In any case, iTunes/software revenue remains – for now – lower than Mac revenue.

*** This is a bit of a tricky one, because Apple announced a cumulative total of $1B paid to developers mid-2010, which is now over $10B as of June 2013.  You’d figure some additional efficiencies have been realized from such a massive increase in app store sales.

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