Apple: The Astonishing Margin On Flash Memory

| About: Apple Inc. (AAPL)

Our earlier report on the consumer product and pricing strategy at Apple (NASDAQ:AAPL) noted the firm ships its mobile products, unlike its computer products, with memory that is not designed to be removed. Rather, the base models of the iPhone and iPad (whether retina-display or Mini) have a fixed 16GB of flash memory with greater storage capacity (either 32GB or 64GB) being the defining feature of the premium models.

In addition to the strategic motivations outlined in our earlier note, this memory-pricing strategy for AAPL's mobile products creates enormous margins. The reason is that AAPL is effectively offering additional storage capacity to the consumer in price-increments of $100 but, according to iSuppli, pays only ~$10 for each 16GB. This memory-pricing strategy holds across all three of AAPL's new mobile products (see below where iPhone prices are without carrier subsidies or discounts).

Storage Capacity iPhone 5 iPad 4 iPad Mini
16GB - "Base" $649 $499 $329
32GB $749 $599 $429
64GB $849 $699 $529

A Quarter of AAPL Margin from Memory in 32GB/64GB Models

In short, on the incremental memory alone, AAPL generates a margin of ~$90 on sales of 32GB models of its new mobile products and ~$170 on sales of 64GB models. This note estimates that the gross margin contribution of the sales of additional storage capacity in these premium models will total over $4 billion in the December quarter (to be reported on January 23).

For perspective, our best-estimate of $4.2 billion is more than one third of the $11.8 billion reported by Microsoft (NASDAQ:MSFT) for last quarter's firm-wide gross margin and ~40% more than the equivalent $2.9 billion figure for Dell (NASDAQ:DELL). Furthermore, it represents nearly one-quarter of AAPL's expected gross margin in the December quarter of $18.7 billion (based on company guidance for a gross margin of 36% on revenue of $52 billion).

Most First-Adopters Buy 32GB/64GB Models

The enormous unit margins on the additional storage capacity of the premium models translate into enormous gross-margin dollars in the December quarter because AAPL has three new mobile products (i.e., iPhone 5, iPad 4, and iPad Mini), and most first-adopters of a new mobile phone from AAPL buy the 32GB or 64GB models.

For example and as shown in the table below, ~60% of purchases of the iPhone 4S, when it launched in October 2011, and of the iPhone 5, when it launched in October 2012, were premium models (although the split between 32GB and 64GB models differed somewhat).

The data also show that the model-mix of purchases shifts over time towards the base 16GB model. For example, the 16GB model accounted for 40% of purchases of the iPhone 4S when it launched in October 2011, and this increased to 50% over the next 6 months and then to nearly 60% by August 2012. By the time the iPhone 5 was launched in October 2012, all purchases of the iPhone 4S were of the 16GB model.

Estimating Unit Sales of New Mobile Products

To calculate the dollar margin on the incremental storage capacity of premium (i.e., 32GB or 64GB) models for AAPL's new mobile products, we need an estimate of unit sales by model. The base data derive from Wall Street expectations that AAPL will sell ~50 million iPhones and 24 million iPads (including 10 million iPad Minis).

Separately, CEO Tim Cook said in a December interview that "80 percent of our revenues are from products that didn't exist 60 days ago." This is not inconsistent with the data in the above table suggesting 90% of iPhone sales in October 2011 were of the newly launched version, then the iPhone 4S. (We are not using the version data from October 2012 because iPhone 5 sales were likely suppressed by supply constraints).

We assume that history repeats so that 90% of unit sales of AAPL's mobile products in the December quarter are the new versions (i.e., the iPhone 5, the iPad 4, and the iPad Mini) rather than old versions (i.e., the iPhone 4 and the iPad 2 - since the iPad 3 is effectively discontinued). The assumption suggests AAPL will sell ~45 million iPhone 5s and ~22 million of the newly-launched iPads of which ~10 million will be iPad Minis.

Estimating Sales of Premium (i.e. 32GB and 64GB) Models

Finally, we need the sales mix by model for each of the three new products. We assume that 40% of the purchases for each product are of the base model, 50% are of the 32GB model, and 10% of the 64GB model. We have the data in the above table supporting this assumption for the iPhone, and assume the relevant consumer behavior is similar for the iPad products; a risk to the analysis is that it is not.

This assumption for the model-mix allows us to generate the figures below for unit sales by model in the December quarter for each of the iPhone 5, iPad 4 and iPad Mini. The result is an estimate that AAPL will sell 33 million units of 32GB models and 7 million units of 64GB models.

Unit Sales (NYSE:MM) iPhone 5 iPad 4 iPad Mini Total
16GB 18 5 4 27
32GB 22 6 5 33
64GB 5 1 1 7
Total 45 12 10 67


Combining these sales estimates with the unit margin on the additional storage capacity of premium models ($90 for the 32GB model and $170 for the 64GB model as discussed above) generates an estimate for the total gross margin on this additional memory of ~$4.2 billion. The break-down is $3 billion for 32GB models and $1.2 billion for 64GB models.

Aside from an insight into how AAPL makes money, the profitability of the additional memory of premium models suggests that AAPL's margins are meaningfully impacted by the model-mix of purchases (i.e., across 16GB, 32GB, and 64GB models) as well as by the product-mix (e.g., across the iPhone, iPad, and iPad Mini).

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.