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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Wednesday, July 29, 2009

Apple Inc (AAPL): iPhone's Substantial Impact on Gross Margin

Margins held steady Q/Q at 36.3% (down 10 bps) versus expectation of ~200 bps of margin contraction due to mounting headwinds.

Management issued Q4 GM guidance of 34%, 100 bps higher than Q3 33% GM guidance (which AAPL exceeded by 330 bps).

Considering the number of challenging cost environment Apple's Q3 performance and Q4 GM guidance are huge positives.

(1) Apple was able to maintain gross margins for Q3 and (2) According to Apple's guidance, I expect GM to hold in Q4.

The past two quarters have seen a significant lift in gross margins compared to the 3 periods prior (3Q08-1Q09) in which GM held steady at 34.7%. The rise in GM has be a major factor in the near doubling of the stock price since the January low. In the 2nd half of FY08, management started a chorus that it expects 30% GM for FY09. Even when GM turned out to be healthy for Q1 & Q2, Apple maintained its 30% GM outlook. This had many analysts and investors worried.

Last October, I reported Apple's FY09 Gross Margin Expectations Too Low arguing that GM will for FY09 will come in way above the 30% guidance. In January, I wrote Apple's FY09 EPS Estimate Too Low stating that the forecasted decline in FY09 EPS by analysts wasn't not going to happen and that earnings should increase by at least 5-10% versus FY08. (For the 3 quarters already reported for FY09, EPS is up ~8% versus the same 3 quarters for FY08.) The main thesis was gross margins would come in significantly above expectations mostly due to high margin iPhone revenue becoming a larger share of total sales.

1) Mitigated numerous factors pressuring margins.
- Transitioned entire notebook line.
- Cut prices across entire notebook line and/or added increased performance.
- Back to School promotion (Mac discounts plus free 8GB iPod touch).
- Revenue mix shifted towards lower margin Macs from weak business spending affecting the Mac Pro line.
- Component prices increased, coupled with higher commodity and energy prices.

Apple repositioned its entire notebook line, cutting prices significantly on Macbook air, and on 15" and 17" inch Macbook Pros. Apple also introduced 13" Macbook pros in place of the older aluminum body Macbooks. Macbook prices were cut anywhere from $100-$300. In addition, Apple kicked off its "Back to School" program that offers discounts on Macs plus a free iPod touch valued at $229. As a result, coupled with weak business spending, revenue was skewed towards the lower-margin models.

2) Guidance of 34% translates into GM likely coming in the 36%-38% range.
- Past 4 quarters GM has exceeded guidance by an average of 370 basis points.
- GM guidance has increased sequentially 3 quarters in a row. (2Q-32.5%, 3Q-33%, 4Q-34%)

Apple has routinely sandbagged on GM guidance by and average of 350 bps over the past 11 periods, and 370 bps for the last 4 quarters. In addition, over the past 10 quarters, when Apple has raised guidance sequentially, GM either rose or remained flat sequentially except for one instance. The scatter plot of change in guidance on x-axis versus change in actual GM on y-axis demonstrates managements accuracy in forecasting GM at least with respect to direction. Therefore, we can expect GM will up or at least flat in Q4 even in light of the challenging headwinds.

iPhone Contribution:
The profitability of the iPhone has played, and will pay a major roll in Apple's overall gross margins. Since Apple refuses to comment about product level margins, the iPhone's significance is often missed. Apple neglects to mention the iPhone angle due to the fact it doesn't want to discuss product level gross margins. The reasons for doing so are vast: firms desire to "cry poor" for the more money they rake in, the more money others will want to get a piece of. This extends to customers, carriers, suppliers, and competitors. Apple repeatedly exclaims it doesn't want to create an "umbrella" that would attract competitors to enter and undercut it. Therefore, much of the GM upside has been due to iPhone revenue being and increased percentage of total revenue, and since iPhone revenue is deferred, this trend will continue to intensify. I have been writing about this effect for nearly a year.

According to my Apple model, (which is i consider accurate being that its EPS variance has been 4 cents, 2 cents, 1 cent, and ZERO for the past 4 quarters) iPhone contributes an equal amount to EPS as does the Mac segment, and will surpass Mac's EPS contribution in the quarters going forward.

In Apple's 10-Q filings, it breaks out deferred revenue and deferred costs for iPhone and AppleTV reported on the balance sheet. Since AppleTV is a minute sliver of deferred revenue it is assumed that its impact on total deferred revenue (AppleTV + iPhone) is immaterial.

Looking at 4Q07, GM of deferred revenue (1- (deferred costs/deferred revenue)) is 27.5%. It was low since Apple received monthly revenue payments in place of an upfront subsidy as is the case today. 4Q08 comprised of the first quarter of subsidized 3G handsets, thus the bump in GM on the DR/DC on the balance sheet. Notice the non-current GM of 51.9% is 6.5% higher than the 45.3% GM of the current. This results from the non-current bucket comprising of a larger mix of 3G iPhones since much of the legacy (2.5G) iPhones have migrated to the current bucket.

Examining the trend, we can see that GM in the current bucket improves dramatically, at a much faster pace than the non-current bucket. This is due to the mix of new iPhones becoming a larger overall mix in the current bucket, whereas the non-current bucket is already majority of newer iPhone sales. The overall result is than GM are approaching near 60%, which I estimate iPhone GM is currently. This is evidenced by the rising GM Q/Q, especially in the non-current bucket which is impacted more by current sales.

My bottom-up iPhone gross margin estimate is 58.4% for the assumed mix, with the iPhone 3GS 32GB garnering the highest GM and the iPhone 3GS 16GB carrying the lowest of the 3 models.

The Bottom Line:
Deferred revenue as stated on the balance sheet has been increasing substantially. The gross margin attached to this deferred revenue has also increased significantly. Thus, going forward Apple will recognize higher iPhone revenue carrying a higher gross margin. As iPhone revenue as a percentage or share of total revenue increases, the impact of the higher iPhone GM on overall GM will intensify. This will assuage margin pressures Apple faces in other areas.

I wrote last year that the iPhone would cause Apple's overall GM to skyrocket, but I also posited another possibility. Apple would use iPhone GM to subsidize price cuts on other products to stimulate demand and ultimately avoiding an adverse impact on overall GM associated with such price reductions. As we just witnessed, Apple cut prices on its Mac line-up, and there hasn't appeared to be any noticeable impact on overall GM. Going forward, Apple is guiding Q4 GM to 34%, suggesting GM in the 36%-38% range, thus there doesn't appear that these price reductions will have a dramatic impact on its overall GM.


Orestes said...

Great article, awesome analysis.

Anonymous said...

How does Apple prepaying vendors for flash memory affect gross margins?

Turley Muller said...

Prepaying for components, such as flash should benefit Apple allowing it to get a better deal. Since Apple is such a dominant player, ie buyer of flash, it has leverage over suppliers.

Thus, getting components at a more favorable price lifts gross margins.

The prepayments though don't have any effect yet as those contracts have yet to be filled, but will in coming quarters

vinyl said...

What about distribution costs, marketing costs, research costs did you forget them

Anonymous said...

Where did the $375 flat subsidy-- per model --number come from? I have never seen that number talked about, written about, or even publicly available before. Is this an arbitrary guess on your part or is there Apple or AT&T documents that quote this number. Frankly, I don't believe the iPhone is carrying anywhere near that margin based on what I know from sources inside Apple of the margins on the iPods. The number, 60%, is almost an order of magnitude higher than iPod margins and the components for the iPhone (even in the volumes we're talking) are still more expensive when put together in the device.

Turley Muller said...

The subsidy number I have derived from a number of sources.

1- I know what Best Buy pays Apple per unit, and I know what AT&T reimburses Best Buy for- it's $400. The $375 Subsidy is a blend of wholesale price and Apple's direct sales where it captures the entire subsidy.

2- Using AT&T and Roger's wireless SEC filings and comments regarding impact from subsidy, it's possible to back into the number.

3- Taking cash value of phones sold as given by Apple and then dividing it by units gives ASP. Take that price (Apple receives per unit) minus the price customer pays, and the difference is the subsidy, or what AT&T kicks in.

I don't just pick arbitrary numbers, I use estimations that are supported by multiple sources and calculations. I take my analysis very serious, and wouldn't publish something that can't be backed up with math.

There are numerous figures in Apple's SEC filings that, by themselves, don't provide much insight. But applying mathematic principles, many unknowns can be backed into.

Turley Muller said...

I included shipping costs as it's a component of "cost of goods sold"

Marketing and R&D expenses are not part of COGS therefore not included in gross margin.

Daniel M. Ryan said...

It is quite a good, nuts-and-bolts analysis. I could follow it even though it's not in my line.

One point, though. Apple's at about $160 per share, and its P/E is 27.97. A very basic GARP rule of thumb says that the P/E should be less than or equal to EPS growth rate [for mathies: EPS GR multiplied by 100.] I performed a brute-force calculation of Apple's 10-year EPS growth rate: I got 19.3%.

Apple may very well be in for more margin growth, but there's a certain point when the share price has already discounted it. That rule I invoked is very basic, of course, but it does suggest that Apple's valuation isn't compelling at this price level.

The HardHead said...

Congrats my friend you have been mentioned in ZDNet Tech news!

Keep up the outstanding work.


Michael Lawrence said...

Additional congrats, mentioned on's homepage:

Anonymous said...

Prepaying for components (on Apple's scale at least) is a double edged sword - Apple gets best price (and price and supply stability) PLUS the shortage runs up the cost for competitors.

For as long as the iPhone train is gaining momentum the deferred revenue accounting treatment provides an 18-24 month cushion even when ceiling is reached. However, their market share is still so small overall and the potential for complimentary products (iPhone nano) so great that AAPL is going to remain an exciting investment for some time to come.

Even the P/E is not overly aggressive (c. 22.5x) when you net out the cash.


Lee Penick said...


I enjoy your work very much. You've got quite a gift for it.

Now that you've got your analysis down to the penny (and of course we all expect it to stay there!) how do you use that to influence your investing behavior?

At what price per share would you consider AAPL to be fairly valued now, such that you would be neither hot or cold to it?

Do you have any speculation on how PA Semiconductor will be used to differentiate products?

Hope to read more of your work soon.


APPLMike said...

Mr. Miller,

There is talk now that Apple may abandon subscription accounting and that this could cause a huge pop in stock price. Do you think this could happen? Thank you! Enjoy your work!


Anonymous said...

Turley, I see Apple doubling from here now that the street is realizing iPhone's earnings potential, please give us an update as how u feel going forward. Thank U !

Ludog said...

Mr. Muller,

Does AT&T keep any revenue from the iPhone? According to your analysis above, the answer is no. However, AT&T's 2008 annual report states, "Total equipment costs continue to be higher than equipment revenues due to the sale of handsets below cost.." This implies they do take some revenue from handsets, does it not?

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