Apple Inc. (NASDAQ:AAPL) reported a decline in gross margins in its most recent quarter which has caused investors to raise questions over the company’s ability to maintain a healthy growth rate in the future. Apple’s field of business is being attacked left, right, center, by its rivals using aggressive pricing strategies. Some of them are placing a near zero margin on production cost for their devices. This is forcing Apple to come up with cheaper products targeting the market being addressed by its rivals.
Competition Getting Tougher
Gates Capital Management's Excess Cash Flow (ECF) Value Funds have returned 14.5% net over the past 25 years, and in 2021, the fund manager continued to outperform. Due to an "absence of large mistakes" during the year, coupled with an "attractive environment for corporate events," the group's flagship ECF Value Fund, L.P returned 32.7% last Read More
For instance, Apple is facing an uphill task in challenging Google Inc. (NASDAQ:GOOG)’s Android platform in the Apps market. Android Apps remain cheaper, with some available for free from Google Play Store, while Apple App store based apps remain ever expensive. Apple’s iPads are also facing a strong challenge from Amazon.com, Inc.’s (NASDAQ:AMZN) Kindle Fire and Kindle Fire HD, not forgetting Google Nexus Tablet. The iPhone maker has already introduced iPad mini to try and address the question of price competition in the market.
The iPhone is not be left untouched, as Samsung Electronics Co., Ltd. (LON:BC94) (KRX:005930) Smartphones, especially the Galaxy phones, have put up a strong show against Apple’s iPhones. Additionally, several other competing companies are throwing in their challenges with a keen eye on price. Apple Inc. (NASDAQ:AAPL) is rumored to be plotting a plastic cover iPhone to be priced cheaply in order to address the low end market.
Apple Inc. (NASDAQ:AAPL)’s Gross Margins Assessment
In a report published Monday, Morgan Stanley (NYSE:MS) analysts, reviewed Apple’s SEC form 10Q, with a key focus on margins. The analysts pointed out that Apple’s gross margin quandary had nothing to do with its structure, but rather was a cyclical phenomena based on two cost drivers. The capital equipment to support iPhone 5 product cycle, and NAND pricing.
Capital investment in equipment to support iPhone 5 production cycle impacted on the company’s c4Q12 gross margins, while NAND pricing’s impact was well felt in the second half of C12. Nonetheless, the analysts believe that NAND impact could neutralize going forward.
“[Apple’s] quarterly stock performance (+29%) and GM (47.4%) both peaked in March 2012. Since then, investments in capital equipment for iPhone 5 and higher NAND prices lowered GM 900bps. While Apple states in its 10-Q that FY13 GM (we model 38.7%) will fall short of the FY12 peak (43.9%), lower capital equipment purchases and potentially more favorable NAND prices could improve margins later this year,” the analysts wrote in their report.
Apple Inc. (NASDAQ:AAPL) price seems to be responding to the change in gross margins since March 2012.
However, the company seems to have cut its budget for purchasing equipment for iPhone 5S production. This could be a good catalyst for Apple Inc. (NASDAQ:AAPL) as it looks to rejuvenate its gross margins. The 10-Q disclosed $904M of commitments for equipment purchases compared to $4.5B just two quarters ago, when Apple Inc. (NASDAQ:AAPL) invested in new in-cell touch displays for the iPhone 5. This is likely because the iPhone 5S may not require significant hardware changes, which means that iPhone GM awaits a potential upside in the second half of 2013.
There is a landslide decline in off-balance sheet commitments since June 2012. However, a decrease in off-balance sheet commitments might also cannibalize Apple’s revenues. The analysts expect conservative results on revenue from the iPhone maker in the March quarter. Apple Inc. (NASDAQ:AAPL)’s revenue is correlated 95 percent to off-balance sheet commitments.
The analysts wrote, “purchase commitments of $19.8B fell 10% Q/Q vs. five-year average of -12%, and suggest C1Q13 revenue could trend closer to seasonal average of -17% vs. our model of -21%”.
Apple Inc. (NASDAQ:AAPL)’s margin quandary seems to be seasonal/cyclical. However, the revenues tend to improve when the company deploys a lot of capital investment in equipment for product development. It will depend on how investors take the move. Last month, reports suggested that Apple Inc. (NASDAQ:AAPL) had reduced its product capacity by half, which symbolically identifies with the cut-down in capital investment for equipment production. This also signified an expectation that Apple’s will likely report Conservative revenues for its F1Q13. However, the biggest fear is that investors will translate the cut-down as a foresight for decline in demand for Apple Inc. (NASDAQ:AAPL) products.