Apple’s Profitability and the Influences of Gross Margins, Tax Rates and OpEx

  • Posted: 22 November 2010 12:28 AM

    My latest missive at Eventide.

    This is the first of a two-part series looking at the influences of gross margins, tax rates and open on Apple’s quarterly performance. I’ll be back next week with a post tying the elements together. While gross margins are important, there are other factors to take into consideration that may have an equal or greater impact on the bottom line.

    Snippet: Each fiscal quarter Wall Street analysts, tech industry journalists and AAPL investors hone in the company’s gross margins as a percentage of revenue as if this one ratio has the greatest influence on the company’s success. As an independent blogger/analyst I’m not one to dismiss the importance of gross margins in Apple’s financial performance. But there are other factors such as tax rates and operating expenses that weigh heavily on Apple’s bottom line results.

         
  • Posted: 22 November 2010 01:02 AM #1

    adamthompson3232 - 22 November 2010 04:49 AM

    I 2nd the motion of “thanks to Sandy”. As always, great work, DT.

    The only suggestion I have with the charts is to put the quarters on the x-axis and the other metrics on the y-axis. I believe this makes it easier to visualize the points you are making. This is a small suggestion and others may disagree with me. Regardless, GREAT work!!!

    at, thanks for the feedback. I’ll pass along the compliment to Sandy. I’ll be leaving the graph work in her capable hands.  grin

    I decided to go at this in two parts and lay out the primary points tonight. Gross margin is important, but other factors greatly influence Apple’s bottom line results. As Apple aggressively pursues market share and unit sales at the cost of a slight ding to margins, the strategy will lead to increasing profitability through higher revenue and a lowering of open ratios as revenue scales. An important point to be made at a future date is the more iOS devices in the hands of consumers the higher the revenue and profitability as these devices will continue to generate revenue over the economic life of the device.

    In other words, slightly lower margins now, higher revenue and profits later.

         
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    Posted: 22 November 2010 02:18 AM #2

    Great analysis DT, looking forward to part 2.
    In another thread, I said I only know 1 person who uses Numbers (Horace) but looks like Sandy does too smile

         
  • Posted: 22 November 2010 02:31 AM #3

    Roman - 22 November 2010 06:18 AM

    Great analysis DT, looking forward to part 2.
    In another thread, I said I only know 1 person who uses Numbers (Horace) but looks like Sandy does too smile

    Sandy’s pretty amazing. Her Numbers skills are just the start. Together we’re parenting four teens. I often classify home life as an “extreme sport.” My iMac is positioned on a table at the “crossroads of household action” so I don’t miss out on any of the fun.  LOL

         
  • Posted: 22 November 2010 02:38 AM #4

    adamthompson3232 - 22 November 2010 05:09 AM

    What I find extremely interesting is that GM % is down only slightly and are still EXTREMELY healthy while sales are exploding. It is very easy to look myopically at a slight decline in gross margin and conclude that Apple (and AAPL) are poised for a turn in fortune. However, this really provides a MASSIVE opportunity since the “pro” wall street analysts are not modeling revenue growth in the same ballpark as what will come to fruition due to Apple’s aggressive pricing on new products (e.g. iPad), growing consumer acceptance across all product lines, and continued, rapid international expansion (both company-owned stores and additional iPhone carriers). So, the Wall Street guys are now modeling lower margins but are not nearly taking into account the revenue growth that will far more than offset the “lost” net income due to the lower margins. This is perhaps the best opportunity in mega cap investing today and I expect the next year to be extremely profitable for the longs as a result.

    at, that’s a fair assessment. There’s a more than offsetting factor in Apple’s decision to moderate gross margins and that’s revenue growth and future earnings growth. Every iPad sold, for example, only builds future revenue recognition. I’ve spent more over the past four months on apps for my iPad and iPhone than I personally spent through iTunes in the previous four years. Unit sales growth will all spur future revenue growth and the revenue segment inclusive of iTunes revenue may surpass iPod revenue as early as the June quarter and maintain that revenue position for three out of every four subsequent quarters (the December quarter the only exception due to seasonality of iPod sales).

         
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    Posted: 22 November 2010 02:51 AM #5

    GM will remain stable or even increase slightly as iPhone and iPad continue skyward.  Many of the current AAPL investors (who don’t follow Apple like those at AFB or other AAPL-watching locales) don’t remember when Apple managed 30% GMs and was blowing everyone’s minds.  Almost 37%, that’s just silly for a tech company that isn’t all about software.

    The upside of sacrificing a little GM…well, it’ll be increasingly evident as Apple continues to demonstrate how effective its own style of “go for share” can be.  I won’t care one bit about Apple’s GM unless it starts dropping to 33% or so.  Then I might care…a bit.

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  • Posted: 22 November 2010 08:06 AM #6

    Careful with the GM information. I have already seen it argued that Apple’s GM is “crashing”...

    MSNBC (like they have no axe to grind!)
    Apple has openly admitted that its future gross margins will decline because of aggressive pricing on newer “innovative” products.

    So looks like the competition has started to talk this feature up. Thanks for offsetting the concept.

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  • Posted: 22 November 2010 12:12 PM #7

    The two most important items in determining the gross margin is the sales price and the cost of goods sold.  Every time Apple introduces a new product they have to start a new learning curve and margins decrease, even at the same selling price.  I am sure that the cost per unit for the iPad is lower now than it was three months ago, so its margin should increase this quarter.  The iPhone’s cost should not change much because the manufacturing history is relatively long.  Ditto the iPods.  The Macs should also stay more or less the same except for the Macbook Air.  This product is different enough so that it’s cost should be higher than the old MBA’s.

    There is a possible margin kicker this qurter that I mentioned before.  This is somewhat speculative but is not far out.  Apple keeps tight control over its inventory.  I assume that Foxcomm ships much of its product directly to points of sale (Apple stores), or directly to customers (people who order directly from Apple.  Presumably Apple takes ownership when the product is on the plane, so Apple normally takes ownership of the finished goods at that point, if at all.

    Last quarter ended with an increase of roughly one billion dollars in finished goods.  This quarter Apple has added 10,000 points of distribution for the iPad.  I believe that Apple built finished goods inventory to fill the pipe line for this iPad blitz.  The cost of manufacturing these goods occurred in the last quarter, and would show up in the cost of goods sold, except that this build-up was not sold.  Finished goods inventory is usually carried at cost.  If sold in the current quarter it could raise gross margin by two percentage point.

    If my speculation is correct, look for an unexpected jump in margin in the next quarterly report.

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  • Posted: 22 November 2010 12:34 PM #8

    westech - 22 November 2010 04:12 PM

    The two most important items in determining the gross margin is the sales price and the cost of goods sold.  Every time Apple introduces a new product they have to start a new learning curve and margins decrease, even at the same selling price.  I am sure that the cost per unit for the iPad is lower now than it was three months ago, so its margin should increase this quarter.  The iPhone’s cost should not change much because the manufacturing history is relatively long.  Ditto the iPods.  The Macs should also stay more or less the same except for the Macbook Air.  This product is different enough so that it’s cost should be higher than the old MBA’s.

    There is a possible margin kicker this qurter that I mentioned before.  This is somewhat speculative but is not far out.  Apple keeps tight control over its inventory.  I assume that Foxcomm ships much of its product directly to points of sale (Apple stores), or directly to customers (people who order directly from Apple.  Presumably Apple takes ownership when the product is on the plane, so Apple normally takes ownership of the finished goods at that point, if at all.

    Last quarter ended with an increase of roughly one billion dollars in finished goods.  This quarter Apple has added 10,000 points of distribution for the iPad.  I believe that Apple built finished goods inventory to fill the pipe line for this iPad blitz.  The cost of manufacturing these goods occurred in the last quarter, and would show up in the cost of goods sold, except that this build-up was not sold.  Finished goods inventory is usually carried at cost.  If sold in the current quarter it could raise gross margin by two percentage point.

    If my speculation is correct, look for an unexpected jump in margin in the next quarterly report.

    I’m not sure I understand your point.  Gross margins aren’t volatile from the amount of inventory on hand; they don’t get a bump by carrying X amount of finished goods.  The cost of that inventory is recognized in the period of sale.  If you are making the argument that costs to produce go down during the product cycle, then the prior quarter’s ending inventory to which you allude are released in the current period at a higher, not lower cost, thereby depressing GM.  I think Apple’s margins will be fine this quarter, in any event.

         
  • Posted: 22 November 2010 12:47 PM #9

    rattyuk - 22 November 2010 12:06 PM

    Careful with the GM information. I have already seen it argued that Apple’s GM is “crashing”...

    MSNBC (like they have no axe to grind!)
    Apple has openly admitted that its future gross margins will decline because of aggressive pricing on newer “innovative” products.

    So looks like the competition has started to talk this feature up. Thanks for offsetting the concept.

    Yep. Gross margins are in free fall to woefully low 35% levels.  LOL

    Prior to the release of the iPhone and the iPad Apple’s gross margins might have been a more telling metric. But because revenue has risen so rapidly in the the past three fiscal years (add in this fiscal year’s 60% revenue gain) and the drop in OpEx as well as the dramatic drop in tax rates mitigate any moderation in gross margins for the sake of market share and unit sales.

    Absent a dramatic drop in gross margins from current levels I’m looking far beyond that one metric in determining net income and eps.

         
  • Posted: 23 November 2010 12:25 AM #10

    Mercel - 22 November 2010 04:34 PM
    westech - 22 November 2010 04:12 PM

    The two most important items in determining the gross margin is the sales price and the cost of goods sold.  Every time Apple introduces a new product they have to start a new learning curve and margins decrease, even at the same selling price.  I am sure that the cost per unit for the iPad is lower now than it was three months ago, so its margin should increase this quarter.  The iPhone’s cost should not change much because the manufacturing history is relatively long.  Ditto the iPods.  The Macs should also stay more or less the same except for the Macbook Air.  This product is different enough so that it’s cost should be higher than the old MBA’s.

    There is a possible margin kicker this qurter that I mentioned before.  This is somewhat speculative but is not far out.  Apple keeps tight control over its inventory.  I assume that Foxcomm ships much of its product directly to points of sale (Apple stores), or directly to customers (people who order directly from Apple.  Presumably Apple takes ownership when the product is on the plane, so Apple normally takes ownership of the finished goods at that point, if at all.

    Last quarter ended with an increase of roughly one billion dollars in finished goods.  This quarter Apple has added 10,000 points of distribution for the iPad.  I believe that Apple built finished goods inventory to fill the pipe line for this iPad blitz.  The cost of manufacturing these goods occurred in the last quarter, and would show up in the cost of goods sold, except that this build-up was not sold.  Finished goods inventory is usually carried at cost.  If sold in the current quarter it could raise gross margin by two percentage point.

    If my speculation is correct, look for an unexpected jump in margin in the next quarterly report.

    I’m not sure I understand your point.  Gross margins aren’t volatile from the amount of inventory on hand; they don’t get a bump by carrying X amount of finished goods.  The cost of that inventory is recognized in the period of sale.  If you are making the argument that costs to produce go down during the product cycle, then the prior quarter’s ending inventory to which you allude are released in the current period at a higher, not lower cost, thereby depressing GM.  I think Apple’s margins will be fine this quarter, in any event.

    westech:

    I agree with Mercel’s view. Inventory would have no impact on gross margins unless the costs of inventory are significantly higher or lower than current build costs. The costs of manufacture would be realized at time of sale. What’s interesting (and important) for the current quarter is the relatively low channel inventory levels at the end of the September quarter. Apple may be able to significantly expand channel inventory of the iPhone 4 heading into FQ2. Most likely iPad sales will benefit nicely from the expanded distribution in the holiday quarter, setting up the best quarter in Apple’s history and setting the stage for a $100+ billion fiscal year.

         
  • Posted: 25 November 2010 04:12 PM #11

    rattyuk - 22 November 2010 12:06 PM

    Careful with the GM information. I have already seen it argued that Apple’s GM is “crashing”...

    MSNBC (like they have no axe to grind!)
    Apple has openly admitted that its future gross margins will decline because of aggressive pricing on newer “innovative” products.

    So looks like the competition has started to talk this feature up. Thanks for offsetting the concept.

    ratty, the focus of my work is demonstrating reduced gross margins are in practicality an illusion considering the other big factors impacting the company’s earnings performance and the dip in today’s margins is contributing to an enormous leap in revenue growth and support for high margins in future quarters.

         
  • Posted: 25 November 2010 04:27 PM #12

    DawnTreader - 25 November 2010 08:12 PM

    ratty, the focus of my work is demonstrating reduced gross margins are in practicality an illusion considering the other big factors impacting the company’s earnings performance and the dip in today’s margins is contributing to an enormous leap in revenue growth and support for high margins in future quarters.

    Indeed, all I was saying was that analysts tend to ignore the facts and use “data” to spin, fear uncertainty and doubt, irrespective of what the numbers actually mean.

    But you are preaching to the converted. All of us here know. But then we’re not trying to finagle the markets…

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  • Posted: 25 November 2010 10:24 PM #13

    rattyuk - 25 November 2010 08:27 PM
    DawnTreader - 25 November 2010 08:12 PM

    ratty, the focus of my work is demonstrating reduced gross margins are in practicality an illusion considering the other big factors impacting the company’s earnings performance and the dip in today’s margins is contributing to an enormous leap in revenue growth and support for high margins in future quarters.

    Indeed, all I was saying was that analysts tend to ignore the facts and use “data” to spin, fear uncertainty and doubt, irrespective of what the numbers actually mean.

    But you are preaching to the converted. All of us here know. But then we’re not trying to finagle the markets…

    The slight moderation in gross margins will fuel the rise to $500 per share much faster than if Apple chose to forsake unit sales growth for the sake of 40% average gross margins. Analysts might make mention of the dip in margins, but many are now moving their price targets in response to rising revenue and earnings.