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Introduction

One of the main reasons why Apple's (NASDAQ:AAPL) share price declined from $600+ to $520 over the last 1½ year is due to Apple becoming less profitable. Its gross margin declined from 47% in Q2 2012 to 37% in the most recent quarter. While we all knew that Apple's margins eventually had to come down, I think the pace of it, surprised almost everyone.

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So why exactly has Apple become less profitable? In my opinion, it comes down to a combination of 3 factors;

  1. The iPhone selling price has declined
  2. iPhone production costs have gone up
  3. iPad profitability has declined

While some followers of Apple are aware of the above 3 explanations, I think it is generally much less understood what has caused for instance the iPhone production costs to increase. In this article I will look into that, and in the end of the article I will discuss what we should expect in the future.

1: The selling price per iPhone has declined

In the below graph, you can see that Apple today earns less revenue for each time it sells an iPhone. While its ARPU in fiscal Q4 2011 was $647, it had declined to $577 in the most recent quarter.

(click to enlarge)

So how come the ARPU of the iPhone has declined? Apple still offers its newest phone at $650, the midrange phone at $550, and its entry-level at $450. Therefore the decline may seem somewhat counterintuitive. But I believe it can be explained by a combination of 2 factors;

  1. The low-end and the mid-end phones are getting relatively more popular amongst consumers. The quality of the older phones are simply good enough that consumers no longer feel a need to always purchases the newest one. Especially in China, the low-end iPhone has been growing at a higher rate than the high-end.
  2. The iPhone is getting increasingly popular in the US relative to the rest of the world (below diagram). In the US, iPhones are being sold at a lower price than in most other countries, and therefore the ARPU is being pushed down each time a phone is sold in the US.

(click to enlarge)

Source: Apple's financial reports. The US data is reported by carriers.

2: iPhone production costs have gone up

In order to calculate gross profit, we subtract cost of goods sold (COGS) from revenue. The COGS related to the iPhone mainly consist of the below five parts;

  1. Royalties
  2. Bills of material
  3. Warranty cost
  4. Depreciation & Amortization (D&A)
  5. Manufacturing & Shipping

Of royalties, Apple pays around $10 per device it sells to Nokia. However, this deal was implemented relatively early in 2011 and thus doesn't explain the increase in production costs. Neither does the bills of material, which according to iSuppli has been relatively constant over the last couple of years.

But the warranty policies have changed, and that implies higher costs for Apple. In 2012 warranty expenses totaled roughly 1.4% of revenue. In 2013 the level had increased to 2.95%.

Further, D&A expenses have also increased as percentage of revenue. While it is easy to think of the iPhone as a hardware product, it is important to remember that the "iPhone package" consist of both hardware and software. When Apple spends money developing the software, the investment is being capitalized on the balance sheet. However, as time progresses it shows up as amortization costs on the income statement.

As D&A cost have increased at a much faster rate than Apple's revenue, it seems that Apple is "giving away" more valuable software than previously. This is actually quite an important part to understand as it implies that the hardware part of the iPhone is being sold at a lower price than previously. So while Apple hasn't directly increased the price of the hardware, it has indirectly reduced it by increasing the value of the software it gives away.

At last, it is likely that manufacturing costs have gone up as well. Due to negative press related to Foxconn's (Apple's iPhone and iPad supplier) bad working conditions, Foxconn found it necessary to improve them. It has since been revealed that Apple and Foxconn shared the expenses related to the better worker conditions.

Combining all of the 3 factors, I estimate that the gross margin of the high-end iPhone declined from 60.6% in 2011-2012 to 53.3% in 2012-2013 (below table).

(click to enlarge)

3: iPad has become a lot less profitable

While iPhone margins has declined by quite a bit over the last 2 years, the iPad decline has been much more severe. To be more specific, I see 4 factors which has had a negative impact on Apple's tablet margins;

  1. The extra costs related to warranty, D&A, manufacturing costs (improved worker conditions at Foxconn) are also having an effect on iPad production costs.
  2. The iPad BOM have increased as well. The 1st generation iPad had bills of material of a mere $253, which is much less than the 3rd generation iPad of $306.
  3. Older iPad models are accounting for an increasing amount of total iPad sales. The average selling price of the 10-inch iPad declined from $654 in Q3 2011 to $535 in Q4 2012
  4. The 1st generation of the iPad Mini had a lower gross margin than the 10-inch iPad. So after the Mini was introduced, the average iPad gross margin declined even further.

By combining all of these factors, I estimate that the iPad gross margin declined from 33% in 2011 to 22% in 2013.

What should we expect in the future?

Since Apple is reducing the price of its Mac-computers and giving away more software for free, it is tempting to extrapolate historical growth into the future.

But I think it will be a mistake to expect declining margins for Apple - at least over the next year - as Apple's new pricing/product strategy should benefit margins. For instance, just look at the following margin-improving strategies;

  • Apple is maintaining the iPad 2 in the lineup (instead of replacing it with the 3rd or 4th generation). From 2011 to 2012 the iPad 2 (16GB) bills of material fell from $300 to $237. Assuming the bills of material have continued to decline, this model should have a pretty high gross margin today.
  • The iPad Air also has lower BOM than the 3rd generation iPad.
  • The price of the newest version of the iPad Mini is increased from $325 to $400.
  • The iPhone 5c works as a substitute for the more expensive iPhone 5 as the mid-end phone. This is positive as the BOM of the iPhone 5c are roughly $40 less than the BOM of the iPhone 5.

So while Apple's gross margin has suffered from a lot of headwinds over the last 2 years, the new product lineup should offset the gross margin losses we would otherwise see in the next year.

Therefore I expect that Apple will post gross margin of around 36% for fiscal 2014.

Source: The Explanation Behind Apple's Gross Margin Decline, And Why The Future Looks Brighter