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Paulo Santos, Think Finance (391 clicks)
Long/short equity, arbitrage, event-driven, research analyst
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First of all, I need to make something clear – this article is not a negative article on Apple (AAPL). This article just debates Apple’s biggest vulnerability, using publicly available data.

First, we need Apple’s sales breakdown, from its latest 10-K:

click to enlarge

There are a couple of noteworthy facts in the table:

  • The iPhone represents 43.5% of revenues, and the iPad managed to grow up to 18.8% of revenues – almost as much as the entire Mac line, which is perhaps even more amazing given the time it has in the market and the way it is mostly sold (not on contract, like the iPhone, so retail price is usually the full price);
  • Something else Is also impressive. The value per iPhone unit is actually HIGHER than the value per iPad unit, even though the iPad is certainly more expensive to produce, given its much larger screen (teardowns confirm this: iPhone BOM estimated at $188, iPad BOM estimated at $323).

If the iPhone is cheaper than the iPad to make, yet sells for a bit more, then its margins are much higher. Since the iPhone is also a large part of sales, there might be something here … exactly how much gross margin would there be in an iPhone? The estimates range from 60% to 70%+ (implied in the BOM calculated by iSupply).

This brings us to our next table…

And this truly is amazing. What we are seeing here is that a single product line – the iPhone – answers for between 64.4% and 75.2% of Apple’s entire gross margin!

And there’s more. The iPhone is usually sold to end-customers at a very subsidized price that ranges from $0 (free, the 3GS) to $199 (iPhone 4S, on contract). The implied subsidization by the mobile carriers is massive, and that’s what makes it possible for Apple to keep on selling those units at an effective average of around $650 (and still sell so many). But, while a massive subsidization might have made sense when just some operators had the iPhone, it might start to make less sense when every operator has it – after all, the mobile carriers are not gaining much from each other by all massively subsidizing it now.

The level of concentration can become evident if we compare Apple to some other large company seen as concentrated, for instance, Microsoft (MSFT). Microsoft has the following breakdown in its revenues and operating profits (data from last 10-Q, September 2011):

As we can see, even a company that’s usually said to be dependent on a franchise (Windows) shows a much lower concentration of its earnings (and the weights shown above are still influenced by the online division showing losses).

Conclusion

For a long time, it has been surprising that Apple, growing as much as it did – both revenues and earnings – traded for such low multiples (PE 2011 is at 11.4, PE 2012 at 10.2). However, once we do the analysis above, we come to the conclusion that between 2/3rds and 3/4ths of Apple’s gross margin is coming from a single product line. That means there’s a lot of concentrated earnings risk, that’s almost “one trick pony”-level concentration.

Also, the way the iPhone is sold, mostly through carrier subsidization, does not expose the end-customer to its true cost. That mode of selling presents an additional risk in that if the level of subsidization was to decrease, the costs to the end-customer could increase substantially, leading to lower sales of a product that is, as we’ve seen, massively important to Apple’s earnings.

All in all, while not saying Apple is expensive because of this, when seen through this kind of analysis the stock comes off as much more risky than the diversification implied in the number of large product lines would otherwise imply.

Source: Why Apple Is So Cheap