Ahead of Apple Earnings, Are There Margin Concerns?

On Wednesday, Apple reports its fiscal first-quarter earnings for the busy holiday shopping season, and the company expects new products introduced at the end of last year to drive 80% of the quarter's revenue.

One of the concerns that investors and analysts have expressed recently is Apple's decline in gross margins. There's been much debate over whether this is actually cause for concern or just a blip on the company's long-term upward trajectory in profitability.

How big of a deal is Apple's gross margin contraction?


Oppenheimer's got some 'splainin to do
Apple's lowball guidance calls for gross margin of 36%, which would be a sequential drop of 4% from the 40% gross margin it posted last quarter. That's a big plunge that the company is expecting, but there are several reasons  it's entirely justified.

On the last conference call, CFO Peter Oppenheimer specifically addressed concerns over gross margins by pointing to the number of newly redesigned products that had just been launched.

As you pointed out, this is the most prolific product period in Apple's history. We have an unprecedented number of new product introductions over the last six weeks, and this has led to record levels of demand. New or repriced versions of our products announced during this time frame represent over 80% of the total expected December quarter revenue.

But there are costs associated with such dramatic change and demand. The iPhone 5, iPad Mini, iMac, MacBook Pro 13-inch, iPod Touch, and iPod Nano have completely new form factors with great new features, and we've never before introduced so many new form factors at once. All of these products have higher costs than their predecessors, and therefore lower gross margins as they are at the height of the cost curve.

This has been the case with new products in the past, so nothing new. The difference this time is the sheer number of new products we are introducing in a very short period of time.

Of these products, three stand out as Apple's most important: the iPhone, iPad, and MacBook Pro. iPods continue to decline in financial importance, although they serve a critical strategic purpose. The new iMacs were extremely constrained during the quarter, and desktop sales are also less important, so I wouldn't expect much impact there.

The iPhone 5 carries a redesigned body, the fourth-generation iPad received some incremental upgrades along with a new Lightning dock connector, the iPad Mini is a totally new product, and MacBook Pros are now available with Retina displays.

Product

% of FY 2012 Revenue

iPhone

51.4%

iPad

20.7%

Mac portables

11%

Total

83.1%

Source: 10-K.

Those three product families combined comprised 83% of sales last year, so changes in those cost structures carry a lot of weight when it comes to Apple's overall cost of goods sold. While the MacBook Air is now positioned as Apple's consumer notebook, marketing chief Phil Schiller said at the October event that the 13-inch MacBook Pro is Apple's most popular notebook.

That was a bit surprising, since many would think that the MacBook Airs would be better sellers, but it also suggests MacBook Pro sales comprise a large portion of notebook revenues.

Faster cycling without performance-enhancing drugs
If you line up the product design cycles with historical gross margins, you'll see not only a strong correlation with new products and margin contractions, but also, and more importantly, a long-term upward trend. This chart focuses primarily on when products received new designs, since that transition is what causes downward pressure on gross margin.

Source: SEC filings. Fiscal quarters shown. MBP = MacBook Pro. rMBP = MacBook Pro with Retina display.

iPhone designs remain in use for about two years. Incremental "3GS" and "4S" upgrades followed the "3G" and "4" industrial redesigns. The iPad has been different, changing in some form or fashion every year. The iPad 2 was redesigned, and while the iPad 3 looked identical, it received a pricey Retina display. The iPad 4 got minor updates, but it also came in alongside a brand-new iPad Mini.

MacBook chassis designs typically last quite a bit longer. Apple introduced its aluminum unibody construction in the MacBook Pro family in late 2008 (early fiscal 2009) and only introduced the Retina models with new designs in 2012.

This is a cyclical pattern that investors have seen play out before in the past, except its effects are more pronounced this time because the company introduced redesigned products every quarter in 2012.

The gross margin rises
Ultimately, Apple continues to enjoy structural cost advantages over its rivals, and its business is surprisingly scalable because of how efficiently it spends on research and development as well as selling, general, and administrative expenses.

Sources: SEC filings and earnings conference calls. Fiscal quarters shown.

Operating expenses as a percentage of revenue were as high as 17.2% in 2007 but fell to a low of 7.3% last year. Thank you, operating leverage.

Guidance calls for operating expenses of $4.05 billion, or 7.8% of revenue outlook. Apple's operating expenses are typically right in line with guidance, which means that any upside in revenue and gross profit will translate into meaningful gains in net income and net margin.

Gross margins may very well decline this quarter, but as Apple works down the cost curves of its new products, gross margins will rise again.

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The article Ahead of Apple Earnings, Are There Margin Concerns? originally appeared on Fool.com.

Fool contributor Evan Niu, CFA, owns shares of Apple. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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