How to predict Apple's gross margins
Apple's (AAPL) fiscal third quarter earnings are due out Tuesday, July 21, and once again the Street is focused on the big numbers — revenues, earnings and units sold for the Mac, iPhone and iPod.
But savvy analysts will be paying closer attention to the number that is the best measure of a firm's profitibilty: gross margin, expressed as the ratio of profits to revenues. Or
(Revenue – Cost of sales) / Revenue
Apple's gross margins, which have averaged 34.8% over the past eight quarters, are the envy of the industry. Dell's (DELL) first quarter GM, by contrast, was 17.6% and the company warned Wall Street last week that it is expecting a "modest decline" next quarter.
In its April earnings call, Apple low-balled its guidance numbers as usual, forecasting a sharp drop in gross margins over the next 6 months. Specifically, it warned analysts to expect no better than 33% in Q3 and "about 30%" in Q4.
But Turley Muller, for one, doesn't buy those numbers, and he should know.
Muller, who publishes a blog called Financial Alchemist, is one of a small group of amateur analysts who track Apple closely and publish quarterly estimates that are as good as — and often better than — the professionals'. In fact Muller's earnings estimates for Q2 were the best of the lot, missing the actual results by just one penny (see here.)
For Q3, he's expecting Apple to report earnings of $1.35 per share on revenue of $8.3 billion — far higher than the Street's consensus ($1.16 on $8.16 billion).
Why the discrepancy?
"Again the story appears to be gross margin," he writes. "Just like last quarter, when Apple blew out the GM number with 36.4% (just as I had predicted) this quarter's GM (3Q) should be roughly the same as last quarter.
The secret, he says, is in the profitability of the iPhone, "which is through the roof."
"Apple tries to deflect that," he says, but the evidence is right there, buried in a chart he found in Apple's SEC filings (see below). It shows Apple's schedule for deferred costs and revenue for the iPhone and Apple TV, which for legal reasons are spread out over 24 months rather than being recorded at the time of sale. Because Apple TV revenue is so small relative to the iPhone, this chart is a pretty good proxy for the iPhone alone.
This is complicated stuff, but the bottom line, as Muller points out, is that iPhone profitability has been rising to the point where gross margins on the device are over 50%.
Muller expects the revenue mix for Q3 to be roughly the same as Q2, except "with less low margin iPod revenue and more high margin iPhone revenue."
He acknowledges that Mac and iPod margins will be lower due to the recent MacBook price cuts and the impact of Apple's aggressive back to school promotions. "But on balance," he concludes, "I expect overall gross margin to remain robust around 36.5%."
For Muller's detailed guide to calculating gross margins on the iPhone, see here.
See also:
Somewhat less scientific, more Warren Buffet like approach. Follow the people…
http://www.youtube.com/watch?v=kItMudpgM8Y
ex ped: FYI, this was posted on July 18, 2009. The information provided YouTube reads:
"Here's the quick video I shot at the Apple Store opening today in Ottawa. I was in with the press for M2 Magazine. Woot!"
"Muller, who publishes a blog called Financial Alchemist, is one of a small group of amateur analysts who track Apple closely and publish quarterly estimates that are as good as — and often better than — the professionals’."
Well, DUH!
Professional Anal ists? The only being slimier than an Anal ist is a lawyer & the difference is VERY slight.
Ayuh
"This is complicated stuff, but the bottom line, as Muller points out, is that iPhone profitability has been rising to the point where gross margins on the device are over 50%."
This is key, absolutely brilliant, and frequently overlooked. I can understand the whining about AT&T, even though I was – and remain – an AT$T (sic) customer, but AT&T is paying significant dividends to Apple's share price (yeah, yeah, no dividend, but still, increasing share price).
Now we have to remember that iPhone 1.0 is going quietly to the grave in terms of money for Apple, but iPhone 3G (love it) and 3G S are going to start to replace *that* money stream.
How do you like them Apples? 
Fascinating article.
We should not forget, however, that Apple consistently beats estimates and then, in the conference call, gives guidance below street expectations. Some analysts say that low ball projection won't happen this time. But as the stock skyrockets, I suspect Apple's desire to dampen expectations will lead to a repeat. The stock often drops the day after the conference call. Then, especially if there are rumors of a new product in the wings, the stock price recovers. May happen again, given rumors of a mac tablet.
For those looking for a buy point, Wednesday might be good. For long term investors, my conjecture is irrelevant; Apple will grow over the long term regardless of any earnings announcement blip, and any advantage on Wednesday (or disadvantage if I am wrong) won't be significant.
Greg Bates
If you recall the conference call where Steve appeared and tried to get the analysts to reconcile non-GAAP to GAAP figures, one could look at the reconciliation table and figure out a close approximation for GM on iPhones.
Philip:
Nice work (as usual).
There are a few other factors impacting gross margins that aren't often discussed. These factors include sales of services such as AppleCare, MobileMe and sales of Apple software products such as Aperture and Final Cut.
MobileMe is a recurring annual source of revenue with virtually no additional cost per recurring or new subscriber. Additionally, AppleCare, with a retail cost that is often 10% or more of the cost of the hardware system it covers, adds appreciably to margins though the revenue is realized over the life of the extended warranty period. These "beyond the box" revenue opportunities raise gross margins and make Apple's revenue per customer the envy of the industry. Software sales, though dwarfed by hardware revenue, will add disproportionately to gross margins due a negligible cost per each additional unit sold.
In evaluating Apple's fiscal performance with deferred revenue accounting in place for the iPhone, one should also watch the non-GAAP financials as closely as the reported eps and gross margins.
The deferred revenue numbers provide a guide to what is in effect pre-paid future earnings.
The deferred revenue method of accounting shrouds the gross margin on each iPhone sold and in effect defers gross margin recognition to future periods as long as iPhone unit sales continue to rise over corresponding prior periods.
One other issue relating to operating margins on reported revenue: Because Apple recognizes general, selling and administrative costs for the iPhone unit as those costs are incurred, the deferred revenue accounting on handset sales tends to exaggerate those costs relative to GAAP recognized revenue. In short, Apple is making more per unit (all direct costs and indirect included) than the GAAP financial reports will indicate for as long as iPhone handset sales continue to rise when compared to corresponding prior periods.