Here's Why Apple's Margins Will Be Flat This Quarter

One metric that Apple (NASDAQ: AAPL) investors should pay attention to is the company’s gross margin. Gross margin, as The Motley Fool’s Knowledge Center explains, “reflects how much of its sales a company hangs on to after paying the up-front costs of producing the goods or services it sells.”

The greater that number, then, the fatter Apple’s profits are — all else being equal.

An Apple iPad.

Image source: Apple.

Some of the up-front costs involved in producing, say, an iPhone include component sourcing (e.g., chips, screens, cover glass, and casings), device assembly, product packaging and accessories, and royalty payments to companies from whom Apple has licensed intellectual property.

In the quarter containing June, Apple reported gross margin of 38.3%, which CFO Luca Maestri said was “flat sequentially, as cost improvements and foreign exchange offset the seasonal loss of leverage.”

For the quarter containing September, Apple’s gross margin guidance is between 38% and 38.5%, which, at the midpoint of the range, would be right in line with the gross margin that Apple enjoyed in the quarter containing June. During Apple’s earnings call in July, Maestri explained the key drivers behind Apple’s gross margin guidance. Let’s dive into them.

The headwinds

Maestri highlighted two key gross margin headwinds that the company faces during the quarter containing September relative to the quarter containing June.

“As you know, we typically have what we call product transition costs during the September quarter,” Maestri said. Apple generally introduces new iPhones near the end of that quarter, so this shouldn’t come as too much of a surprise to investors. 

In addition, Maestri explained that Apple is facing “about 30 [basis points] of headwind from foreign exchange again because the dollar has appreciated recently.”

The tailwinds

Since Apple is guiding gross margin flat quarter over quarter even in the face of these headwinds, the company must be expecting some good news to counteract the bad.

According to Maestri, the first mitigating factor will come in the form of “positive leverage.” Keep in mind that during the quarter containing June, Apple raked in $53.3 billion in sales. For the quarter containing September, Apple guided to revenue of between $60 billion and $62 billion. At the midpoint of that guidance range, Apple is set to see a roughly 14.4% quarter-over-quarter boost in sales. That boost in revenue should create that so-called positive leverage that Maestri refers to.

That’s not all, though. Apple has also seen the percentage of its revenue that comes from its fast-growing services business rise in recent years, reaching approximately 17.9% last quarter.

Fiscal yearFY 2017FY 2016FY 2015FY 2014
Services as a percentage of Apple net revenue13.1%11.3%8.5%9.9%

Source: Apple earnings releases. Figures rounded.

As you might recall, back on Apple’s earnings conference call in May, Maestri said that the company’s services business “is accretive to company margins.” What this means is that Apple’s gross margins benefit as services become a larger portion of its overall revenue.

Maestri called out “the mix to services” as one of the tailwinds that will help offset the aforementioned foreign exchange and product transition headwinds during the quarter containing September.

The big picture

Maestri declined to give any firm guidance about where the company’s gross margin would go beyond the quarter containing September. Nevertheless, he did say that he thinks Apple “has a pretty good record over the last several years to make good business decisions, balancing units, revenue and margins.”

Remember that Apple’s ultimate goal is to deliver as much operating profit to stockholders as it can. Higher gross margin helps with that, but as Maestri’s commentary suggests, it’s a balancing act. Apple could, for example, price its next-generation iPhones substantially higher across the board, a move that would almost certainly lead to a dramatic increase in Apple’s gross margin (assuming, of course, Apple doesn’t make any changes to the cost structure).

However, a big increase in pricing could lead to a reduction in the number of units that Apple sells. In that case, while Apple could report much higher gross margin, it might wind up seeing total revenue and operating profit decline.

So while Apple’s gross margin is a metric that investors should pay close attention to, it should be viewed in a broader context.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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