The Oppenheimer Code, Fiscal Q4 2013, Part 4 – Snapping Apple’s Five-Quarter “Losing” Streak in Gross Margins (Probably)

NOTE:  As a friendly reminder/disclaimer, this isn’t treatise-level or expert-level stuff, not even close.  Just one person’s exceedingly humble attempt to gain a bit more insight into Apple’s fundamentals.  This isn’t “forest from the trees” – it’s even higher up in the iClouds.  More expert AAPL fundamentals types need not read on.

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(ADVANCE TL;DR warning – this post is on the lengthy side, though a little shorter than Part 2.)

If its recent SEC filing (clarifying that Q4 2013 results will be in the upper range of guidance) is to be “believed” (remember, Oppenheimer was once the reigning king of Wall Street sandbagging), Apple is finally set to announce something that it hasn’t been able to for over 18 long months.

You guessed it – an increase in gross margin.

The prior downtrend has been remarkable, and the explanations from Apple management as to why unfortunately few (which didn’t help AAPL’s share price ever since October 2012 or so).  But that’s not to say that the explanations for the decrease in gross margin are hard to guess.  I’m sure many of you already have, so feel free to skip over this or stop reading.  Here’s my humble take:

The GM peak was almost certainly due to the shocking margins of iPhone 4S, combined with surging revenue growth and resulting leverage, catapulting Apple to an astounding 47% gross margin for fiscal Q2 2012 (and Apple might’ve caught a few minor breaks here and there for things like component prices and currency, I haven’t checked the conference call transcripts lately).  But then came the immense growth of the margin-“dilutive” iPad, followed by the higher-cost-structure iPhone 5, followed by the introduction of the even lower-margin, now-most-popular iPad mini.  Mix in management’s probably-quite-intentional decision to improve consumer value for money (and compete in the smaller-form-factor, lower-priced tablet market) at the cost of Apple’s relative profitability (having the luxury of taking this medium/long-term product transition/margin strategy from a position of immense strength and leverage).  Add liberal sprinklings of relatively disappointing iPhone 5 sales and higher-than-anticipated mix of the lower-ASP, presumably-lower-margin iPhone 4, and that’s most of it.

But I digress.  That’s all “past history” now, Apple’s undoubtedly poor gross margin communication to Wall Street and market participants notwithstanding.  (I mean, did anyone see a 1000+ basis point drop in gross margin coming before it was already well underway?  Apple hitting a multi-year low in GM?)

Er…before I digress further :D, let’s see what gross margin might look like for fiscal Q4 2013, and very broadly overview what major factors might be in play.

(Sorry about the somewhat “imprecise” fiscal quarter scale.)


Well, at least the quarterly compares should be considerably less daunting this fiscal year.

So, leaving aside Oppenheimer’s very obvious hint, why is the gross margin turnaround finally underway?  Here’s my 2 cents:

– Starting with the obvious – all of Apple’s major hardware (save MacBook Air) are about as “old” as they’ll get this product cycle.  Mature manufacturing processes, cost curve, probably positives for gross margin on a per-product-line basis absent something like a drop-off in product line unit sales.

– Of course, iPhone 5S and 5C look to be off to a very good start.  The “incremental” S generations of iPhones have seen solid gross margins, to say the least (just look at what iPhone 4S did for Apple).  While both the 5S and 5C have yet to really ride down the cost curve, it’s probably not a stretch to say they carry gross margins similar to or better than their predecessors at the same point as last year.  Economies of scale should be enhanced thanks to least 50% higher unit sales volume compared to last year’s initial sales.

– There’s a very good chance that iPad unit sales will decrease year-over-year.  In some ways it’s hard to fathom.  (As I asked earlier this series, if tablets are still a hot item, why would Apple post yet another quarter of YOY iPad unit decline, even with the admittedly skewed prior compares?)  But knowing what little we know about iPhone growth trends and the big initial sales of iPhone 5S and 5C, it seems literally impossible based on Apple’s guidance to see a situation where iPad, at the bare minimum, grows anywhere close to iPhone YOY unit growth.  In short:  Lower iPad revenue mix, higher iPhone revenue mix, higher overall gross margin.

– Mac unit sales are very likely to follow iPad unit sales trends – which is to say iPhone will at absolute minimum greatly outpace Mac unit growth as well. (I’m thinking Macs will follow the overall trend and decline in units YOY, and the lack of refreshes to this point isn’t helping.)  It’s fairly safe to say that Mac gross margin is lower than iPhone, particularly with the freshest Macs being the “lower-end” MacBook Air family.  Even though Macs are probably reasonably close to the corporate average, lower Mac revenue mix means higher iPhone revenue mix with the result once again being positive impact on GM.

– There could well be two moderating effects on the gross margin increase, though (aside from unknowns like currency, component costs, etc., which Cook and Oppenheimer usually give guidance on).  But only one is potentially “bad”.

>>> First, the potentially “bad news”.  If iPad unit sales are lower year-over-year, there’s a chance of lower product line gross margin overall at some point, assuming variable costs are still lowered by higher production at this stage in the product cycle.  I admit, this is pure speculation on my part.

>>> Second, and likely more influential, is the lower margin mix associated with Apple’s iTunes/software revenue category.  That category has never seen a YOY decline I can recall – nor should it, in theory, considering that the installed base of iOS, Mac and iPod users grows each and every quarter.  (Let’s agree that this statement doesn’t require any real leap of faith just yet.)  Based on historical growth rates, iTunes/software should see a YOY revenue increase somewhere around 20% or maybe even higher.  So if this holds and my memory is correct, this will be the first time that Apple’s software/content-based revenues exceed 10% of Apple’s total quarterly revenue.  While margin data on this category is basically non-existent, the extremely aggressive pricing on Apple’s own software (don’t forget, iWork, iLife and GarageBand are free for new iPhone and iPad owners going forward) combined with its hosting of low-margin music and media content are margin-dilutive, but entirely expected, factors on a revenue mix dominated by iPhone.  Note my intentional leaving out of the App Store up to this point.  It’s tough to figure out partly because of its being but a piece – albeit a giant one – of Apple’s immense software delivery/e-commerce platform.  On the one hand, the billions of free app and update downloads Apple delivers “can’t be good” for margins, even with iAds.  On the other hand, while apps generally are extremely cheap on a per-app basis, shouldn’t Apple be realizing some tremendous economies of scale somewhere down the road?  All the same, I’ll go out on a limb and guess that the “app mix” and generally low app prices probably mean that aggregate App Store margin, whatever it is, is more like Amazon-level than MacBook-level (though likely much better than “break-even” by now).

Shrouded in mystery is Apple’s accessories margin.  Sure, Apple’s own cases and goods may sell for great margins.  But Apple is also a traditional tech retailer of third-party products.  I’m sure it does better in this regard than many brick-and-mortar outlets, particularly for the many relatively-higher-end offerings for sale online and in Apple Retail Stores.  But how much so?  Surely not like Tiffany and Co. (which last I checked has mind-boggling gross margin in the 50-60% range), right?  At the same time, if it’s somehow around 40%, that will net help Apple’s gross margins as of now.  Whatever the case, Apple isn’t saying, and I doubt it ever will.  For the time being, accessories still comprise a relatively small slice of revenue – if you can call a $1.5B or so revenue per quarter category “small”, that is.

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