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Apple Inc. (AAPL)’s High iPhone Margins Are Unsustainable: Bernstein

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The gross margin of Apple Inc. (NASDAQ:AAPL) on the iPhone declined by more than 1000 bp from the mid to high 50s generated by the tech giant from its iPhone 4 and iPhone 4S, which is now in the mid-40s, according to analysts at Bernstein Research.

Apple Inc. (AAPL)'s High iPhone Margins Are Unsustainable: Bernstein

Toni Sacconaghi, Jr. and fellow analysts at Bernstein Research observed that Apple Inc. (NASDAQ:AAPL)’s iPhone operating margin ignited convictions in Wall Street that the high-end smartphone market is becoming more competitive, and the tech giant’s very high iPhone margins and its overall margins are unsustainable.

The analysts identified five factors behind the declining gross margin, including higher warranty accruals, currency, higher D&A costs, iPhone 4 discounts and iPhone mix, and higher iPhone 5 BOM.

Apple warranty accruals a factor

Sacconaghi and his colleagues estimated that the iPhone 5 BOM contributed ~380 bp out of the ~1080 bp iPhone gross margin decline. According to them, the iPhone 5 BOM is approximately $26 more expensive that the iPhone 4 during the same period in the product cycle. They noted that the higher BOM is the largest individual contributor and represents a third of the decline of the operating margin.

The analysts estimated that Apple Inc. (NASDAQ:AAPL)’s higher-warranty accruals contributed ~80 bp in the gross margin decline from FQ311. According to them, during the previous quarter of the current fiscal year, warranty accruals account 2.1% of revenue or ~80 bp higher than the 1.3% level in the third quarter of 2011.

Sacconaghi and his fellow analysts assumed that Apple Inc. (NASDAQ:AAPL)’s warranty accrual is driven by all of the company’s product lines in proportion to its share in the revenue (51.4% for the iPhone) in FQ313. They emphasized that the increase in warranty expense maybe arguably predominantly driven by the iPhone.

Apple’s margin affected by new competitive market

In addition, the analysts estimated that currency drove ~60 bp, D&A costs contributed ~320 bp, and the iPhone 4 mix and discounting had ~240 bp impact on the gross margin decline, respectively.

Furthermore, the analysts wrote in a note to investors, “A counter argument to the iPhone 5 BOM only driving only one third of the iPhone gross margin decline is that the higher warranty accruals and D&A, like the higher iPhone BOM, are all symptoms of a more competitive smartphone market.” They emphasized that if three items were included (higher BOM, D&A, and warranty), structural factors will be more than 70% of the iPhone gross margin decline, and contribute over $50 higher all-in cost to make the iPhone 5 compared with the iPhone 4 two years ago.

The analysts believe that overall iPhone gross margin is unlikely to rebound to its previous levels, but they think the current gross margin could improve in the near-term because of several factors including the possibility of a reversal of foreign currency exchange headwinds, the decline of D&A costs as a percentage of sales, and  whether or not the iPhone 5S is not materially different than the iPhone 5.

Bernstein Research recommended an Outperform rating for  shares of Apple Inc. (NASDAQ:AAPL) with a price target of $600.

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