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Apple Inc. (AAPL) Its All About Gross Margins: Evercore

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Apple Inc. (AAPL) Its All About Gross Margins: Evercore

Apple Inc. (NASDAQ:AAPL)’s gross margins (GM) peaked at 47.4% back in the Mar-12 qtr but has now declined for three straight quarters into the Dec-qtr’s 38.6% (-600bps Y/Y), with Mar-13 guide calling for a 4th down quarter off 10-110bps Q/Q. Analysts from Evercore are out with a new research note on Apple’s gross margins. Although they do not forecast Apple’s FY13/14 GM recovering nearly as much as may imply, they nevertheless see this Mar-qtr proving the trough qtr for Apple’s Y/Y GM declines down -910bps Y/Y. Setting up an improving backdrop for Apple Inc. (NASDAQ:AAPL) stock, they have typically seen positive correlation to gross margin trends across Hardware stocks, with Apple no exception.

Analaysts at Evercore believe that they may be conservative in modeling Apple’s gross margin merely “stabilizing” around today’s lower levels, they believe just stability alone could be critical for AAPL shares for two reasons:

1) Symbolic – as investors likely need to see that Apple Inc. (NASDAQ:AAPL)’s premium GM can withstand competitive pressure. The analysts do not believe recent gross margin pressure has come from competition pushing pricing down but rather upward pressure on COGS as the bar keeps getting higher for what qualifies as the smartphone market’s highest-end model. An example of this is Apple Inc. (NASDAQ:AAPL)’s Dec-qtr when iPhone ASPs held essentially flat at -1%Y/Y, but iPhone gross margins declined -10%pts Y/Y, making the declines almost completely driven by COGS +10%pts Y/Y. Although part of that COGS jump is likely due to low early component/manufacturing yields that Apple expects to recover, analysts at Evercore believe the much larger percentage may prove more lasting.

Competitively the analysts see iPhone maintaining its position as the leading smartphone platform, but reality is that when the first iPhone was launched in July 2007, the gap between it and incumbent smartphones at that time was practically infinite, whereas that gap today has been either arguably closed or at least inarguably narrowed. But they expect this can prove manageable with Apple uniquely controlling its own product cycles, hardware+software engineering and services ecosystem, providing it much more latitude than commodity peers. Evercore’s math allows Apple’s vertically-integrated business model to sustain gross margins still meaningfully higher than its peers even post the introduction of a new low-cost <$400 tier.

2) Structural – Over the next 2 qtrs, Evercore believes that Apple should be able to recover at least +200bps of lost iPhone 5 GMs and improve iPad mini GM +400bps from their low initial start, both overcoming high initial manufacturing/component costs by climbing associated yield curves. Even when factoring in downward mix dilution, they estimate this enabling Apple to report overall GM of 38.3% in its Marqtr (just -30bps Q/Q even on much lower revs) and then +50bps Q/Q to 38.8% in the Jun-qtr.

The analysts see this recovery then setting Apple up to handle/absorb the future dilution of a lower-cost iPhone Evercore anticipates launching in 2HCY13. With an upcoming low-cost iPhone, their analysis suggests that Apple could launch in the ~$390 range, not “as” low as some have speculated (e.g., $300) but nevertheless 40% cheaper than its flagship $650.

They estimate such a product coming via a 25% lower COGS profile, resulting in an iPhone with 13% points lower GM than a flagship iPhone (e.g., 34%-35% vs. 47%-48%) but GM profile they nevertheless forecast fitting within Apple overall and enabling it to maintain corporate average GM >38% through FY15; all while simultaneously opening up a broader addressable smartphone target market to sustain 12%-15% annual growth in revs for both iPhone and Apple through CY13 and CY14.

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