Are Declining Margins The Problem?
Bloggers and analysts have had a field day tossing out opinions on what's wrong with Apple (AAPL) stock. In their most recent note to investors, Barclays stated it believes declining margins are the biggest concern to investors. Specifically, Barclays states that Apple needs to demonstrate a "margin floor" exists at 35%. The report goes on to say that while Apple understands market concerns, the company is not willing to provide long-term margin guidance. (Emphasis is mine.)
Primarily margin concerns are tied directly to the iPhone (and a lesser extent to the iPad tablet). The current argument goes: Competition has reached parity. The high-end of the smartphone market is saturated. Smartphones have become commodities. As smartphone manufacturers turn their attention to emerging markets, margins will compress as manufacturers make a rabid grab for this more price-conscious market share. (The proverbial race-to-the-bottom.)
Relationship Between Apple Margins And Share Price
Over the period 2009 to early 2012, Apple's gross margins trended up driven by the +50% margins of the wildly popular iPhone. The chart above shows the recent downward trend in both gross margin and share price for the company.
Barclays estimates each point in gross margin equates to about $1.50 in EPS (based on FY13 estimates). Or, with a P/E ratio of ~10, Apple investors could expect share prices to decline approximately $11.50 for every percent decline in company gross margins.
What's Driving Apple Margin Declines?
The key question for Apple's margin decline is this: Are the declines short term or long term? (Short-term declines can be attributed to the early costs associated with new product introductions, while long-term declines are a clear indication of a decline in pricing power.)
Unfortunately, identifying all the factors driving down margins for Apple is more of an art than a science, so it's up to the investor to dig into available information and determine the level of comfort for Apple's margin risk.
To help identify short-term margin declines, I've plotted quarterly gross margins against recent product release dates. (Remember, new product results in higher initial cost of goods as a company works through the product release cycle.)
The margin declines experienced by Apple in 2010 are probably the best period to review when evaluating the company's current margin declines. During 2010, the company executed three major product launches (iPad, iPhone 4 and MacBook Air 11"/13"). Recall each of these three releases involved a new product form factor, which would result in higher product ramp costs for Apple. (As opposed to the lower costs associated with a simpler product upgrade. Example: The smaller margin impact from iPhone 4S release in October of 2011.)
The higher costs of these new products are clearly captured in the margin declines during the period. (Lower margins will result from both higher cost of goods sold and short-term depreciation).
Notice, during the period 2011 to early 2012, Apple was able to recapture margin declines as the company worked the manufacturing cycle and captured manufacturing scale efficiencies.
Now, let's take a look at the margin declines for 2012 - like the 2010 period, Apple executed 3 major product releases with new form factors (iPhone 5, iPad Mini, iMac). While clearly the declines for 2012 are significantly larger than what was seen in 2010, (perhaps a large margin hit from the iPad Mini?) investors should still expect a significant margin rebound based on Apple's product cycle history. Hence, a large percent of current margin declines are likely short term.
Another potential factor further impacting margin compression for 2012 is the near exponential increases in Apple's capital expenditures (excluding retail) for 2012. (see below).
What is unclear to the investor is 1) The extent to which capex rolled into new product depreciation for FY12 (short-term margin decline); and 2) The reason for the doubling of capex for FY2012 vs. FY2011. Were the initial investments in the iPhone 5, iPad Mini and iMac materially greater than for past products? Does the increase in capex indicate more aggressive investments in the supply chain? Or, is 2012 capex spending levels an indication of more upcoming product launches?
While we're left with more questions than answers, let's work with what we know and try to suss out possible margin impacts:
- Apple, historically, has been remarkably efficient in its R&D spending. (See: Microsoft and the Infinite Monkey Theorem of R&D Spending). So it seems unlikely that such an increase was due to a change in R&D policy, or poor resource management.
- The launch of the iPhone 5, iPad Mini and iMacs were unprecedented in their aggressive timing (3 products launching within a two-month window. The iPhone 5 rolled-out to 100 countries by the end of 2012).
So given the aggressiveness of the rollout, I'm willing to bet a higher proportion than normal of capex ended up in FY12 depreciation (short-term margin compression - recaptured during product cycle). However, given what we know about Apple's strategic product needs (and product rumors) it also seems likely that Apple's much higher capex investment is foreshadowing new products - which would mean further near-term pressure on margins moving forward. (i.e. The margin "dip" for 2012 may continue forward as another group of new product(s) cycle through launch).
Conclusion: A Long-Term Investor Has Reason For Hope
The current market narrative for Apple paints a gloomy scenario of a company with limited market power facing its final moments prior to an ignoble decline into obscurity: That Android and Samsung are eating Apple's lunch and it's only a matter of time until we see a $99 iPhone with a 2% margin.
The media points to the company's decline in margins as proof of this hypothesis. However, a review of historic data would indicate that the recent, steep declines in Apple gross margins should not be surprising given the aggressive nature of Apple's product launches in 2012.
While Android and Google have certainly shown an ability to capture smartphone market share (+70%), some investors are far more interested in Apple's ability to capture the majority share of smartphone profits (+70%).
Of course, Apple's ability to capture such a high share of industry profits is dependent on the maintenance of the company's historically high margin levels.
From what we've seen from past aggressive product launches from Apple (late 2010 - early 2012), Apple investors are likely to see more upside in gross margins as the new product cycle unwinds for the iPhone 5, iMacs and iPad Mini.
That said, it is somewhat disconcerting, especially given current stock performance, that Apple is not willing to provide more clarity on long-term margin expectations.
Some thoughts on possible scenarios for the reluctance of Apple in providing long-term margin forecasts:
- Apple is still unsure of product mix at equilibrium. Remember, Apple has indicated surprise over the demand for the both the iPhone 4 and iPad Mini in Q1. Given the constraints in supply of both product in Q1 and the likelihood of more significant near-term changes to the product mix (addition of iPad Mini w/Retina Display, discontinuation of iPad 2) and it's likely that Apple still doesn't have a clear handle on product mix at equilibrium. (Also, don't forget about the rumors of a lower-margin iPhone for emerging markets and an iPhone 5S later in 2013!)
- Apple is being Apple. Tim Cook is confident in Apple's ability to perform and sees margin forecasts as providing the competition with too much insight into the product launch cycles. (Margin forecasts might provide too much information on what's driving the high capex spend for the company.)
- Apple expects continued declines in margins based on increases in competition and feels it needs some time to develop strategic responses.
While running with scenario 3 makes for far more exciting copy, "Margin Eroding Maggots Eating Apple Alive!," I suspect that right now a mix of scenarios 1 and 2 are likely resulting in Cook's reticence.
Are there areas for concern with Apple margins? Certainly. If the iPad Mini ends up capturing the overwhelming majority of tablet sales, Apple margins will face downward pressure. And while I'm convinced a lower margin iPhone is inevitable (and strategically sound), more critical in my view is Apple's ability to drive value and differentiate via iOS.
Want more insight into Apple's ability to maintain margins? Wait to see if the company can leap ahead of the competition in mobile software with iOS 7. In the mean time, keep in mind that Apple's historic product cycle data shows much of the current margin decline is likely to be short term.
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