Is Apple Inc. (AAPL) Likely To Face Serious Margin Pressure?

  • A teardown of iPhone 7 has revealed that the smartphone costs substantially more to manufacture than iPhone 6S.
  • This can potentially place Apple's already squeezed margins under pressure.
  • How bad is Apple's situation?.

Over the past two years, Apple Inc. (NSDQ:AAPL) has been able to maintain a relatively high gross margin by leveraging large sales volumes, introducing higher priced iPhone models, and generally improving cost curves. But with the company posting two consecutive quarters of falling sales, gross margins and, consequently, net income, have been trending south. During the last quarter, iPhone unit sales declined 15% while iPhone ASP clocked in at $595, a 10% drop. Gross margin contracted 170 bps Y/Y to 37%, leading to a huge 27% decline in net income to $7.8 billion.

And now the situation is threatening to get worse. IHS Markit recently published the results of an iPhone 7 teardown. According to the report, the bill of materials (BOM) for the 32GB iPhone 7 clocks in at $219.80. After factoring in $5 in basic manufacturing costs, all-in manufacturing costs for the phone comes to $224.80, about $36.89 higher than the manufacturing cost for iPhone 6S. The higher costs are mainly due to a bigger battery and larger storage capacity.

Apple's iPhone 7 (Left) and iPhone 7 Plus (Right)

AAPL-8

Source: Forbes

How is this likely to impact Apple's gross margins in the coming quarters? Apple issued gross margin guidance of 37.5%-38% for the fourth quarter, a 115 bps Y/Y decline at the mid-point.

Apple stock has rallied after the launch of iPhone 7 and is now firmly in the green YTD.
AAPL stock chart

Source: Apple Stock Price Chart by amigobulls.com

IHS Markit data in question

If the IHS Markit data is accurate, then Apple could probably see an additional 300-400 bps decline in gross margin, or as much as 500 bps Y/Y. One thing that remains unclear is whether IHS Markit used list prices when doing the BOM for iPhone 7 or the discounted prices that Apple is most likely getting from suppliers. It's more likely that IHS used list prices in its breakdown since Apple is not likely to share that kind of information.

There's, however, evidence that Apple has been squeezing its parts suppliers in a bid to preserve its margins. RBC Capital Markets analyzed 11 key Apple suppliers and found that 10 had projected lower gross margins during the second half of the year leading to the analysts to conclude that Apple has been pushing for substantial price discounts from its suppliers.

AAPL-7

Source: Bloomberg

It's noteworthy to remember that CEO Tim Cook once said about teardowns:

 “never seen one that is anywhere close to being accurate.”

The IHS Markit figures could, therefore, be well off the ballpark. That said, there are other solid reasons that suggest that Apple's margins might be safe.

Also Read: Should You Book Profits Following The Recent Rally In Apple Inc. (AAPL) Stock Price?

Higher iPhone 7 Plus sales, lower iPhone SE volumes

Falling iPhone sales volumes might mean that Apple is not in a position to leverage scale and increase margins as well as it has done in the past. The iPhone 7 Plus though, might help it out. iPhone 7 Plus is currently outselling iPhone 7, marking the first time in Apple's history that a Plus smartphone is outselling the standard model.  The people's favorite jet black iPhone 7 Plus is only available in the more expensive 128GB and 256GB models and is said to be selling well.

This is great for Apple's margins since a favorable iPhone 7/7 Plus sales mix can help offset some of those extra iPhone 7 costs, and could even cancel them out altogether. This line of argument is supported by the fact that Apple's gross margin has usually improved substantially in years when it launched higher priced iPhone models.

The second and probably more important factor that might help Apple's margins is lower iPhone SE sales. The biggest reason why Apple's gross margin fell 10%, slipping below $600 for the first time in two years, can be chalked up to the launch of the lower-priced 4-inch iPhone SE in late March. It appears there's robust demand for 4-inch iPhones, as evidenced by Apple's comments during the second quarter earnings call when it said it had sold 30 million 4-inch iPhone handsets or about 13% of total iPhone volumes.

But demand for iPhone SE is not likely to remain that high. By the time Apple launched iPhone SE, the comparable iPhone 5s was already long in the tooth leading to pent-up demand for a smaller screen iPhone. iPhone SE has, however, been in the market for more than six months now and much of the pent-up demand must already have been spent. Moreover, iPhone SE production remains constrained since Apple is keen to avoid becoming a perennial low-end manufacturer.

Also read: Apple Inc. (AAPL) IPhone Sales Look Set To Beat Wall Street Estimates

Services business can keep Apple's margins ticking

Apple's rapidly growing Services business sports high margins reputed to be north of 60%. During the last quarter, the Services segment brought in revenue of $6 billion after growing 19% YoY. But this could even get better. Apple Music has been posting strong subscriber growth, with subs already having crossed the 17M mark. This implies Apple Music could finish the year on a $2 billion run-rate. The service has lately hit a growth spurt and could reach $10 billion in revenue in three years or perhaps less. This bodes well for Apple's long-term margins.

Investor takeaway

Although Apple's iPhone 7 margins could take a hit due to higher production costs, the fact that the higher priced iPhone 7 Plus is selling so well could help offset these costs. Throw in the fact that iPhone SE is not likely to sell as well as it did during the first few months after launch and Apple's gross margins do not seem to be under serious threat. I expect Apple's gross margin to come in slightly above its projected range during the fourth quarter, and to gradually increase as the quarters roll on.

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