Apple Watch Analysis Shows Gross Margins Will Exceed 50% Eventually

  • After the quarterly earnings conference call, there was a lot of confusion around Apple Watch gross margins.
  • After doing further due diligence, it seems that supply chain issues are increasing costs.
  • However, with enough volume, the gross margin figure will likely improve.
  • After reviewing accounting notes from both Apple and Microsoft, and reviewing figures from IHS, I anticipate gross margins for the device to be 51%.
  • Admittedly, this is the gross margin I anticipate after various supply chain kinks have been resolved, and enough volume is achieved to offset various fixed costs.
Apple watch Profit margin analysis

There is still confusion around Apple Watch gross margin figures, as Apple’s (NASDAQ:AAPL) CFO mentioned on the conference call that gross margins were going to be lower than the average gross margin for the company. My guess is that both Tim Cook and Luca Maestri are offering those comments to ensure that investors don’t get too far ahead of themselves.

Also see: Amigobulls' latest Apple stock analysis video.

Despite the comments made by Tim Cook, Apple watch analysis reveals that the Apple Watch will be among one of Apple’s highest margin products following the current quarter. This is because the Apple Watch is facing production issues.

Replacing dysfunctional inventory with working parts will take time and money. Here’s what the Wall Street Journal reported:

The part involved is the so-called taptic engine, designed by Apple to produce the sensation of being tapped on the wrist. After mass production began in February, reliability testing revealed that some taptic engines supplied by AAC Technologies Holdings Inc., of Shenzhen, China, started to break down over time, the people familiar with the matter said. One of those people said Apple scrapped some completed watches as a result.

I’m fairly certain that Apple Watch gross margins aren’t going to be that phenomenal this quarter. Sure the component costs are relatively cheap, but the initial cost of starting production for the new device category, paired with product defects, and various other costs are putting front-end pressure. That doesn’t mean that the margin profile of the product will remain at depressed levels. Once production starts to ramp-up, and various efficiencies are developed, costs are likely to drop.

Apple watch cost of manufacturing

Source: IHS

Currently, IHS estimates that the cost of manufacturing the Apple Watch Sport edition is $83.70. The gross margin figure by IHS indicates 76%, but to stay on the conservative side, I’m going to figure in other costs that may not be included in IHS estimates, but is recognized in Apple’s cost of revenue.

According to Apple’s 2014 annual report:

Cost of sales related to delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, and engineering and sales and marketing costs are recognized as operating expenses as incurred.

Okay, so there’s a lot that goes on there. For starters, the COGS for software pertaining to the Apple Watch are also included into the cost, along with warranty, and service cost. So Apple’s actual COGS for the Apple Watch is going to be higher than $83.70. I can’t break down the software cost, but I’m going to assume that the cost of revenue for just software alone is going to be similar to the logic presented by Microsoft in its 2014 accounting note.

How Microsoft recognizes its cost of revenue:

Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs.

As you can tell, Microsoft does a much better job of describing its cost of revenue. This also pertains to Apple, because customer service, warranty, the cost of servers for various Apple software products like iMessage, iCalendar, iCloud, are costs that Apple has to recognize each time it sells physical hardware.

If we were to base the analysis on IHS figures, the gross margins for the iPhone at a $200 BoM (Bill of Materials), and a $650 price point is 69.2%. However, court documents from a couple years ago, indicate that Apple's gross margins on just the iPhone alone is 49% to 58% (based on GAAP accounting). So we need to subtract 10% to 20% of gross margin from the implied figure from IHS to arrive at the GAAP gross margin figure.

So after subtracting an additional 15% from the implied 76% gross margin figure from IHS, the Apple Watch Sport edition should have  a 51% gross margin. Now this is inclusive of all the other costs that Apple mentions in its annual report, along with the aforementioned component costs from the IHS report. The gross margin of the Apple Watch should be within the range of the Apple iPhone. Therefore, the Apple Watch will have a positive impact to Apple’s Q1’FY 2016 gross margin results by a couple hundred basis points. In the short-term the product isn’t going to move the needle by much, but over the long-term, the profitability and incremental revenue opportunity will boost FY 2016 - FY 2021 results considerably.

Alex Cho Alex Cho   on Amigobulls :

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Comments on this article and AAPL stock

Apple has always maintained superb margins due to their premium positioning and pricing. The real test will be whether people will pay the top dollars for this so called wearable. Author should cover how is the user response to Apple Watch.
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