Apple's Retail Headache

| About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) is widely referenced as one of the greatest American companies. Yet, the company's retail stores appear to be wrestling with margin crimping challenges resulting from inconsistent leadership.

Rumblings of trouble at Apple's iconic stores came to light last June when the New York Times ran a story questioning whether Apple store hourly workers were being paid fairly.

The pressure to address employee pay mounted as reports surfaced showing Mr. Cook's stock grants, received earlier in the year, climbed past $500 million last summer.

While pay disparity has long been a contentious argument between retail workers and c-level managers, the issue and fall-out appeared to catch Apple unprepared.

The situation was a complex one for the company.

Apple's stores generated $16 billion in merchandise sales in 2011, yet some of its biggest champions - front line employees - were earning just a little north of $11 per hour.

As a result, many of the company's 40,000 retail workers were reportedly earning around $25,000 a year - significantly less than the U.S. household median income of $50,000 in 2011.

The company notched $473k in sales per retail employee in 2011, much better than the $206k level across the industry. And an April 2012 study showed Apple stores generate 17x more sales than a typical retail outlet, notching the highest sales per square foot in retail in the process.

Faced with a growing retail footprint generating lower margins than other channels, the company was challenged to boost margins while still keeping workers happy ahead of the iPhone 5 and iPad mini launches.

Either in anticipation of the article or in response, Apple employees got pay raises around the same time the New York Times article printed.

On June 20th, Apple Insider noted some retail workers would be seeing income bumps of up to 25%. Those pay raises kicked in during July, which means they first showed up in September quarterly earnings.

Pay increases impact on Apple's bottom line.

While retail store sales were up 5.3% year-over-year and accounted for nearly 12% of the company's revenue last quarter, segment margins fell to 24.2% from 30.2% a year ago. This resulted in operating income of $1.6 billion, down from $1.9 billion last year.

This weighed on Apple's overall operating margin, which fell 31.6%, down from 37.3% a year ago.

As a result, Apple's earnings growth slowed to 23%, a rate below its sales growth of 27%. This marked the second consecutive quarter earnings growth trailed revenue growth.

Apple's retail headwinds will continue to weigh down results given the company's plans to spend $850 million this year on its retail stores. The spending will include adding 30 new stores, which will bring its store count up 20% from where it stood in FYQ2 2012.

The larger store count and employee base will be one of a series of factors weighing on Apple's bottom line this year.

Retail leadership remains a question mark.

The impact of retail's falling operating margins on earnings could have made for some tough conversations inside Cupertino's walls.

With Ron Johnson leaving for J.C. Penney (NYSE:JCP) in June 2011, Apple brought in U.K. retail executive John Browett in early 2012. Mr. Browett appeared an atypical choice given his prior tenure as CEO of low margin grocer Tesco and turnaround story Dixon's.

The decision to bring a cost cut oriented leader in to head up Apple's retail operation may indicate Apple was already concerned with retail margins heading into 2012

This theory is supported by reports Mr. Browett tried to offset last summer's wage hikes by cutting shifts and laying-off workers.

In the end, it appears the cost conscious Browett conflicted too much with Apple's culture. Mr. Browett's departed last fall - only six months after taking over.

The story got even muddier last month, when VP of retail Jerry McDougal exited the company under the veil of "spending-time-with-family."

While Mr. McDougal stressed his decision wasn't Apple driven, it should be noted he was once considered an heir to Mr. Johnson. Instead, the company went a different way with Mr. Browett.

Given the search for Mr. Browett's replacement is ongoing, Mr. McDougal's departure may signal Apple is close to appointing a new successor.

Whether the successor is internal or not, Apple remains clearly fixated on segment expenses. When Mr. Browett left, Apple sent finance veteran Jim Bean over to retail to "help" out.

The dysfunction at the top hasn't appeared to seriously dent retail stores sales, yet. Although an argument could be made Mac sales were disappointing during the holidays given they slumped 16% from last holiday season.

Despite fewer Mac sales, quarterly retail sales set a new high thanks to a record number of shoppers, driving profit dollars to their highest ever.

However, the question isn't whether more locations can keep the absolute dollar sales and profits growing.

Instead, it's whether Apple can find the right compromise between customer service and earnings to support margins.

Until a new leader is appointed and consistency in retail leadership is established, it's likely questions will remain regarding the segment. For investors, the struggles suggest adjusting expectations for lower margins - something the market appears to have done.

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.

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