Apple-nomics And Gross Margins 101

| About: Apple Inc. (AAPL)

What has happened to Apple (NASDAQ:AAPL)? This is the question that has investors scratching their heads over the last 6 months. In summary - economics 101 happened to the company's gross margin, as it fell from a high of 49.26%, in March 2012, to 41.55%.

When Apple reported quarterly earnings it showed sales increasing over last year 17.65%, from $46,333 mm to $54,512 mm. Most CEO's would love 17%+ sales growth. However, the cost of goods sold rose from $25,630 mm to $33,352 mm, or 30.52%. More specifically, in the short run, marginal cost was greater than marginal revenue for the last quarter.

After taking out SG&A expenses, Apple was left with operating income falling from $17,340 mm to $17,210 mm. A decline of - $130mm or -.75%. Apple's marginal revenue product was negative and it ....

"follows the law of diminishing marginal returns. As the number of units of a variable input increase, the revenue generated by each addition unit decreases at a certain point."

A graph of this concept is shown below, as Apple was in position "C" with respect to its gross margin:

Source: Microeconomics (6th Edition) by M. Parkin, Pearson Education Inc, 2003, Page 239

The only reason Apple had net income growth is from "other income/(expense), net" increasing from $137 mm to $462 mm YoY; this allowed Apple to show a miniscule $14 mm increase in net income. With the increase in shares outstanding leading to a drop in EPS.

Source: Apple SEC filing

What happened to make the cost of sales increase so dramatically? First, let's recall the formula for cost of goods sold:

COGS = Beginning Inventory + Purchases - Ending Inventory

We can then reverse engineer how much, in dollars, Apple has purchased each quarter (depreciation was taken out).

We can see in the last quarter purchases grew 28.2 YoY while Sales grew only 17.7% YoY; hence, the increase in cost of sales and the reduction in gross margin.

How does this large increase in purchases compare to sales? Is it abnormally high?

Historically, the answer is no, it is not very high; there has just been a trend up since March of 2012. However, compared to the last several years it is just about in the middle of the range. Now, has Apple been able to manage its inventory despite this large purchase? It would appear so, since the average inventory to sales ratio is still at an all time low.

Let's remember the above formula for COGS, since ending inventory is still low compared to sales, the increase in cost of sales is related to purchases increasing, and not from inventory sitting on the balance sheet.

One reason for the increase in the cost of sales is that Samsung (OTC:SSNLF) has been able to put through a 20% price increase in component costs to Apple. Evidently, Samsung has a contract with Apple through 2014 and the growing demand for components has led to a shift in the bargaining power of suppliers. Again, economics 101, as capacity runs low the marginal price increases, ceteris paribus. Finally, the legal battle between Apple and Samsung didn't help matters here.

Another component Apple investors have to consider is the declining marginal utility of apps purchased in Apples store. As shown in this article most people only use a few apps and delete/ignore the rest.

Also, competitors such as Google's (NASDAQ:GOOG) Android operating system are entering the marketplace; as shown in this article titled:

"In Asia's trend-setting cities, iPhone fatigue sets in"

There was also news that Android overtook the iPhone in web traffic.

When, all is said and done Apple's "problems" for investors come down to a few simple economic concepts.

1. A declining utility curve of consumers

First adopters are great and pay the most when a consumer product is released. Apple has risen remarkably, with loyal owners rushing out to buy each new "iWhatever" the last few years. But even here, the law of diminishing returns holds, as shown by sales increases YoY:

2. Bargaining Power of Suppliers

When sales were lower there was a sufficient supply of components to give Apple bargaining power. Now, for at least the short term this has changed into the hands of the component vendors.

3. Entrance of New Competitors

High profits should attract more competitors to the marketplace and benefit consumers with lower prices, or more products, or both. The Android operating system, and to a much lesser extent, Microsoft's (NASDAQ:MSFT) Windows phone and Blackberry (NASDAQ:BBRY), is just capitalism in action.

What to expect with gross margins in the future?

In the table, below, are the averages of the components of Apple's cost of sales since December 2009:

Affect on Cost of Goods Sold Average Dec 2009-12
Purchases as % of Sales 56.92 %
Inventory Effect on COGS % of Sales -0.30 %
COGS as % of Sales 56.62 %
Depreciation as % of Sales 4.13 %

Apple should be applauded for great inventory control over the last three years. But, going forward I doubt its ability to carry average inventory at less than 2% of sales. Therefore, the inventory effect of -.30% on the COGS margin should disappear. This would raise the average to about 57%. Then add on the average depreciation of about 4%. 57% + 4% = 61%, which means a gross margin of about 39% on average. Very close to the average 38.73 % quarterly margin from 2007-2010.

Now, 39% might seem low compared to gross margin of just under 45% from March 2011 - June 2012. However, from March 2007 - September 2009 Apple's Gross margin was, on average, 37.72%. Apple's Stock advanced over 120% from March 2007 - September 2009. The introduction of products consumers wanted drove sales and the stock price up; even when the gross margin was lower than in the last 9 quarters.

In September, of 2012, Apple was a great company at a bad price, and now it is a great company at a more reasonable price, and perhaps even cheap. The "cheapness" will depend on how fast Apple can spur competition in its components suppliers, and also develop other consumer products which would be a hit, such as possibly an Apple TV or watch.

In the short term, Apple could still drop as "hot money" hedge funds leave. However, long term investors now have a stock with favorable metrics. A forward P/E of just over 8.5 compared to the SP-500's 13.85. This one metric suggests Apple is cheap compared to the overall market, even when risk adjusted, since Apple has a historical beta of .74.

Here, economic theory indicates that Apple should begin to trade up to the general market's levels in relation to earnings and risk (or the general market could trade down). Long-term investors should make plans to enter patiently, on the long side; while still keeping an eye on new product development, bargaining power of suppliers, and competitors.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours. 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.

Additional disclosure: I have no financial interest in any book link, or other link.