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Margin Call 2

I expected Apple’s margins to improve  last quarter. They didn’t and so the question I needed to answer is why. Here is a history of Apple’s gross margin and operating margin as reported since late 2005:

Screen Shot 2013-04-25 at 4-25-9.26.53 AM

For a company selling hardware these are extraordinarily high margins. They are higher than those of Google and have narrowed the gap with Microsoft,  neither of which has a high proportion of hardware sales:

Screen Shot 2013-04-25 at 4-25-10.06.04 AMBut they are not growing and the reason is to be found in the reason they grew in the first place: because of proportion of iPhones making up the total sales.

As a reminder, the iPhone is a uniquely profitable product. I estimate that it obtains about 50% gross margins. The history of these estimates is shown below:

Screen Shot 2013-04-25 at 4-25-9.32.34 AM

It remains in stark contrast to the margins Apple obtains for its other products. Much of that is due to the pricing power of the product as shown below:

Screen Shot 2013-04-25 at 4-25-9.33.13 AM

Notice that even after the launch of the iPhone 5 and the persistence of two previous generations of iPhones (and their lowered pricing) has barely put pressure on pricing.

Contrast that with the iPad. As its breadth of offerings increases, it causes a lower price per unit.  The iPhone is now at $613 per unit, even with two older generation products available. (The lowest price was in Q2 2012 when the average price was $608.) The iPad is at $449 per unit, down from $662 at launch three years earlier.

So overall, margin is a function of three things:

  1. Price changes: iPhone had a small reduction (from $635 to $613) but the iPad has had a moderate reduction in price (from $531 to $449).
  2. Cost of components: This is reflected in product-line gross margins which can only be estimated. Compared to last year I estimate that iPhone gross margin dropped from 58% to 48%. iPad margins also fell from about 38% to 27%. The reasons were given by management as “Last year, our business benefited from …a more favorable foreign currency environment, and historically low costs.”
  3. Mix of high and low margin products. The iPhone units grew at 7% but the iPad units grew by 65%. A year ago iPhones were 58% of revenues and this year they were 53%. The iPads were 17% and now they are 20%.

The result is seen in this one graph showing the allocation of revenues and margins by product:

Screen Shot 2013-04-25 at 4-25-8.46.04 AM

 

So what is surprising? My expectations were met in terms of iPhone units (and exceeded in terms of iPad units). The mix was also something that falls out of the unit expectations. The pricing is also not  surprising.

My guess is that the largest contribution to the “reduction of margin” is the increased cost of components. Note that the graph implies that even though iPhone revenues were nearly flat at 3% growth, the cost of those revenues went up by 29%! In addition, the iPad revenues grew 40% while costs went up 65%.

Unit pricing (and implicitly competitive pressure) is still not the primary cause of the reduction in Apple’s margins. Indeed, the curious thing is that margins are now at levels seen for most of 2009 and 2010, a time when the iPhone (and iPad) were seen as near monopolies in their respective categories.

  • http://twitter.com/designker Nigel Hietala

    Fascinating as always Horace! At the end of June it will be the sixth anniversary of the first iPhone shipping. It still has huge margins compared to all other phones in the industry. It still has the highest average sales price in the industry. You can look at Amazon.com and see after shipping other flagship devices like the Galaxy S3 lose value and their price drops. But the iPhone stays at the same price for the entire time it takes for the next new model to ship. And six years on although growth has slowed it has not stopped so we still cannot say it is over. Six years in a market no sane person can claim lacks competition.

    I recently was able to put an iPhone 3GS, 4S, and 5 next to each other. The leap from the 3GS and 4S is huge. The hardware and screen alone are just in a different league. However there is not the same difference between the 4S and 5. It just looks like an evolved/stretched 4S. It is no ‘fat iPod nano’, but it is a conservative redesign from the consumers perspective. No doubt the 5S will look identical to the 5. It will be interesting to see that if the iPhone 6 manages to appear fresh we would see another growth spurt.

    • James Katt

      And how exactly does a rectangular slab change in appearance so it looks fresh?

      The iPhone is a blank slate with minimal buttons. It is difficult to change its appearance. The appearance is already optimized.

      My guess is that there will be the addition of two more side buttons. These would allow quick switching between multitasking apps. Otherwise, the iPhone form is as good as it gets.

      Of course, you can make the screen bigger. But then, the functionality is the same and the overall shape is the same. Thus, you can argue it is more of the same.

      The biggest change possible is in improvements to the operating system to add more features or improve on features like Siri.

      • JohnDoey

        It changes by offering so much more CPU/GPU power that you can run whole new categories of apps.

        For example, iPhone 4S runs GarageBand in a way that is simply incredible. It is a whole other league from the kinds of apps I ran on my 3GS or original iPhone.

        The hardware represents 10% of the device at most. It is like a plant pot or picture frame. Essential but only a supporting player and not the main point.

        Not enough focus is given to how far ahead Apple’s developer program and API’s and tools are compared to anyone else. An “app” is not the same on all platforms. iPhone is doing things that other phones have not even begun to dream about. And each new iPhone opens up new possibilities for developers.

      • Sacto_Joe

        The really big change between the 4s and the 5 was the overall look and feel. The argument is clear that some people prefer the hefter, more jewel-like look and feel of the 4s in spite of the advanced features of the 5. There’s also the cabling changeover to be taken into account, with many accessories out there for the 4s that match years of older models.

        I think Apple has wisely bowed to the inevitable and bumped production on the 4s, but doing so has cost them more production-wise. It’s as if a car manufacturer had to keep last year’s models in production in direct competition with this years’s models, but at a markedly lower price for last year’s models.

        I hope that Apple is smart next year and discontinues the 4 but keeps the price up on the 4s to its present level.

      • obarthelemy

        It is a bit of a competitive situation too: Android OEMs don’t have any high-end product at less than 4.5″, leaving Apple to own the “small but top-end” segment. I get lots of inquiries about smaller phones with a good camera and nice screen… IPhone 4S or GS2 are the only game in town, and GS2 lags markedly.

    • http://twitter.com/snookasnoo Idon’t Know

      The 4S and 5 look and feel very different.

  • LTMP

    You’ve discussed the growing CapEx in the past. Apple’s R&D expenditures have also gone up 33% IIRC.

    Since Cook stated clearly that Apple is launching new product *categories* in the fall, isn’t it likely that the costs associated with doing so are substantial and cutting into GM?

    If a new product type is launching in the fall, it seems likely to me that Apple is already spending heavily on production and components for that product, as well as having to flesh out resources in legal and marketing to prepare for the launch.

    • Mark Jones

      I think products being developed in new categories have no “costs of goods sold” since none have been sold. Their costs would fall under R&D (hence, the increase), and SG&A (legal & marketing).

    • http://www.asymco.com Horace Dediu

      Gross margin does not include R&D which are operating expenses. Operating margin does include that and it’s shown in the margin graph as a separate line.

      • Sacto_Joe

        What are the likely costs associated with having to run two separate iPhone form factors at full production at the same time? I think that has taken Apple by surprise. Overtime? Production backlogs? Issues with JIT? Geographical differences of appeal? This is also true to a lesser degree for the iPad.

        Also, there is aa distinct positive along with the negative implied by surprising growth in revenue and a simultaneous surprising reduction in margin: The iOS ecosystem growth has not slacked much if at all. Long term, that is hugely important, especially with the increasing importance of brand loyalty as smartphone growth starts to top out. I would note that Apple has to win new customers to their brand for growth to occur, while Samsung et al are able to convert their existing featurephone customer bases. Their row is a LOT easier to hoe!

      • http://twitter.com/fivetonsflax fivetonsflax

        Do feature phone users have brand loyalty? Anecdotally, some of them barely know what brand phone they have.

      • Sacto_Joe

        Nevertheless, you can bet that they’re in the database of the phone manufacturer. If I were a manufacturer, I’d move heaven and earth to keep those users loyal!

  • http://www.facebook.com/opherdu Opher Dubrovsky

    Horace – why would component pricing go up so dramatically?
    Is Apple losing its negotiating power due to other large competitors buying lots of components (Samsung)?
    Or is it that the new products just use very high end components that are just more expensive?
    Currency could also have an effect, but since they are selling worldwide, I’d expect it to be dampened.
    Any thoughts?

    • LTMP

      I would think that the rapidly growing costs of manufacturing in, and shipping from China have something to do with it.

      • http://www.facebook.com/opherdu Opher Dubrovsky

        a 65% increase in iPad costs seems huge !! I don’t think rapidly growing costs in China are enough to explain such a great increase

      • LTMP

        Sorry. I should have been more clear. I don’t think that increasing costs in china are the only reason.

      • http://www.facebook.com/opherdu Opher Dubrovsky

        my mistake. So costs went up 65% while sales went up 40% which is about 18% per device on average.

      • Chaka10

        The biggest contributor to the 65% growth in cost is the 40% growth in iPad sales. It’s the delta that ,taters, not the full 65.

    • http://twitter.com/vervaak Sijung

      Currency makes components more expensive. The Japanese Yen has risen against the USD by 20 percent in just half a year. Japan makes the flash drives, displays, and cameras used in i devices.

      • Chaka10

        JPY has fallen, not risen. That’s been one of the biggest stories in the currency markets over the last year. In your chart above, more JPY per dollar means the value of the dollar has gone up vs the JPY. That means the cost has gone DOWN in dollar terms for components that have stayed at the same in JPY terms. I don’t know, but would guess this is related to Apple’s efforts to transition from Samsung — there was a reason Apple went to Samsung for components to begin with — likely because they were the cheapest, most reliable source. That means by definition it’s more expensive to source elsewhere. I admit this is worrisome because, unless it is only transitionary, it may imply a potential longer term component cost advantage for Samsung. I think TC and Co. will figure this out.

      • Sacto_Joe

        True, but they won’t be able to use Apple’s money to build, as they have in the past!

    • GuruFlower

      This article in Bloomberg today may provide some insight into rising memory prices:
      http://www.bloomberg.com/news/2013-04-24/chip-shortage-looms-as-samsung-courts-rival-to-fill-orders-tech.html

    • http://www.asymco.com Horace Dediu

      Currency in this context is relevant in the purchase of components, which mostly come from Japan.

  • obarthelemy

    Very nice iPhone performance.

    I find the disconnect between the iPhone and the iPad interesting. The competition is pretty much the same: mainly Android with a dash of MS, same OEMs… Actually, I’d hazard Apple has a stronger position in tablets, since Android got their tablet act together later (4.0), MS is messing up with RT and no 7″/8″, and Apple started off with 80+% of the market…

    The steady and big drop in tablet ASP (33% over 3 years) can mean several things:
    - when prices are transparent (no subsidies), Apple can’t command as much of a premium. Even while their ASP lost 30%, they also lost 30+% market share.
    - I’m wondering if this means there is demand for cheaper Apple devices (iPad Mini), but not for last year’s devices (iPhone 3/4 family). That would bear confirming: is the iPad 2 selling well, or is the ASP drop almost all attributable to the Mini ? Are the iPhones 3/4 still on offer selling, with their lower price made up for by pricier 5 variants ?

    • Kizedek

      I guess the first of your “several things” is one way to look at the iPad situation. I think your second one is closer to the mark…

      Apple has broadened the appeal of the iPad to a wider market. Something that critics are constantly harping on Apple to do.

      iPad sales grew from 11.8 million to 19.5 million YoY. A higher percentage were lower margin models. I would suppose that is because these models were not available one year ago ;) . That could well be attributable entirely to the introduction of the mini.

      No biggie. Because new products always command lower margins (plus it is a smaller, lower priced model). So broadening your second point out into several things, we could also observe that:

      1) margins of Apple products will go up the longer they are produced and the more units Apple produces
      2) the sale of a Mini doesn’t necessarily mean a large iPad sale was lost. The number of sales is still going up substantially. The mini will broaden appeal base — to kids and multiple iPad sales per family, for example.

      Thanks, Apple, for introducing a new product category and not being afraid to “cannibalize” sales of your existing products. I purchased a mini late last year for my high-school-age daughter because her Dutch school provides all books as ebooks and the school has an iOS app out for scheduling and homework assignments, etc. However, we can’t pry it away from my wife who keeps it in her handbag, so my daughter has to make do with a full-size 1st gen iPad.

      • Tatil_S

        If Apple wants to target lower price points, I have a feeling they will come up with a phone with reduced functionality, rather than similar functionality, but worse performance or lower quality. Something along the lines of iPod nano or shuffle vs. iPod touch… I am surprised they have not launched such a product already.

      • JohnDoey

        Put a 3G chip in an iPod touch and you have an “iPhone 5 3G” for half the price of an iPhone 5 4G.

      • RationalChrist

        iPod nano + LTE for a phone + wifi hotspot. Then pair it with iPad mini, or MBA. This is my dream personal computer setting.

      • Tatil_S

        I don’t follow. iPod touch is sold for $300. Remove 16GB of memory, add 3G + GPS and increase battery size to make up for cellular power consumption, you get roughly 4 or even 4S price.

      • Walt French

        Mostly true. But you’d also need to up the RAM (the IPT is rather light on it and you DO need to keep your apps going during calls), the battery (asking the mothership if it has anything for you and giving your location ain’t free) and probably also…

        You get the idea; it wouldn’t be a drop-in. But the point is basically correct, and what you have is that Apple has NOT elected to build that device, not even one that ran exclusively on some Chinese standard and so wouldn’t hit the gray markets. So I think they must have something else up their sleeves.

    • Space Gorilla

      I would think any disconnect between iPhone and iPad comes mostly from the difference in how each product is sold. Outside of carriers/smartphones Android devices don’t seem to sell very well.

      • obarthelemy

        I’m not sure how to parse your answer. A quick lookaround seems to tell the opposite story: Android devices sell well at retail (as opposed to through carriers), and Android non-smartphones (tablets, desktops) seem to be selling OK too ?

      • Space Gorilla

        Every *sales* number I’ve seen for various non-iPad devices (mostly Android) isn’t very good. Android sells well through carriers, and Android *smartphones* sell well anywhere. But outside of that, call it the tablet PC device, Android (or any other OS/hardware) isn’t selling well. I don’t look at shipped numbers or analysts guesses, since those are meaningless. And usage data re: tablets shows the iPad is dominating, especially in business. If you’ve got actual sales data, please let me know.

    • http://www.asymco.com Horace Dediu

      The iPad ASP change is due to the introduction of new products and an increase in mix for lower spec versions. Apple did not drop prices on the same SKUs. For a historic perspective you can look at the pricing patterns on Macs and iPods. The iPhone is the only anomaly.

      • obarthelemy

        Apple does drop prices on older SKUs, as newer models are introduced. The iPad 2, iPhone 3 (and variants), 4 (and variants) all have seen significant price drops. The iPhone 4 was launched at 630€ in my country, it is now sold for 400€ (with 8GB RAM less though), as an entry-level iPhone.

        That did not happen this quarter since Apple haven’t introduced new models, but I’m talking of longer-term trends anyway: it is strange that the iPad Mini (and maybe iPad 2) are driving iPad ASP down, while the iPhone 4, 4S (and the 3 variants that some carriers and retailers still sell, my Apple Store doesn’t show them) aren’t doing the same for the iPhone ASP. Hence my question about the iPad 2 and iPhones 3x and 4x.

      • Kizedek

        Again, it’s a new product thing. When an Apple product has been around awhile, the margins will creep back up. Apple needs to recoup its initial investment; later, the cost to build each additional unit falls.

        The iPhone 4S costs less to build now than the new iPhone 5 to build, because the equipment and assembly lines and other investment were offset by the first year or two of its sales. That mitigates the greater margin that a higher-priced might garner (iPhone 5), especially if it is a new product.

        But the iPad Mini is a new product. So, it is both new (requiring the investment to be offset for a while) AND it is lower priced. If the iPad 2 was continued in place of the Mini, then we would see the same effect as you note with the iPad — little effect on average margin.

        One of the reasons OEMs don’t get anywhere near the margins Apple gets is because they are selling one model/iteration for barely six months before they put out a new one to try and get the customer’s attention, while selling any leftovers at fire-sale prices. …and you think, “Apple can’t command as much of a premium” (from your earlier comment)? I’d say Apple is doing jolly well in that department.

    • JohnDoey

      The disconnect is that there is an iPad mini, but no iPhone mini yet. If you take out the iPad mini, iPad ASP goes back up to $600.

      When Apple ships a low-cost iPhone, including it under the blanket heading “iPhone” will also make iPhone ASP drop. If you add iPod touch to iPhone today, that makes ASP drop.

      Too much is made by analysts of Apple’s product names. Apple could just as easily have included iPhone (iPod phone) and iPad (iPod PC) under the iPod heading in their earnings and we would see a different conversation about how great the iPod is doing and how it is taking over the entire phone and PC markets.

      • obarthelemy

        Aren’t the iPhones 3 and 4 still being sold “low cost” ?

  • r.d

    Horace,

    What about a mea culpa on your insane notion that
    there would bi-annual launches. All because that
    would guarantee your growth projections.

    It is clear that Apple is ditching Samsung
    so Samsung has raise prices and Apple
    is delaying until fall because new chip suppliers are not
    ready.

    • obarthelemy

      I don’t think the notion was insane. I think it made a lot of sense, and still does. It didn’t happen this year indeed, maybe because of the fab situation, maybe because Apple want to make a big splash in september with a raft of announcements, maybe because they’re unsure of where to go with the iPhone, maybe because other components are an issue (T. Cook did mention being unable to source good larger screens as a reason for a bigger iPhone not being in the cards right now…). IMHO, this fall’s 5S or 6 will be more than a CPU speed bump, and add NFC, wireless charging, and hopefully background synching, at least while charging.

      • synch

        “background synching”

        ?

      • obarthelemy

        If I understood right, 3rd party apps on iOS can’t run background processes (except in a very limited handful of cases), hence can’t synch in the background. iOS users must manually launch an app (bring it to the foreground) for synch to occur. That’s a pain, even moreso when you’ve want to synch several apps before rushing off.

        See http://help.getpocket.com/customer/portal/questions/319551-why-doesn-t-the-ios-app-have-instant-sync- , http://stackoverflow.com/questions/9096202/is-background-sync-in-ios-without-your-app-being-launched-possible , http://stackoverflow.com/questions/12433824/how-does-dropbox-sync-photos-in-background-and-get-approved-from-apple

      • Walt French

        I won’t claim to be an iOS expert but note in developer guidelines that (a) Newsstand apps are allowed to download content in the background, and (b) any app can take a notification while in background and alert the user to bring it to the foreground, say, to download content.

        When you “quit” an app, it “suspends” and goes into background but if memory is tight—say, if a user flips between a bunch of web pages—the app may be removed from memory. I don’t know if the notifications can wake an app from the dead.

        Your hypothetical InstaPaper clone or whatever would seem to be able to alert the user, on charger or not. The charger, of course, doesn’t per se provide any additional resources that an app needs besides assurance of power, so wouldn’t be that trustworthy of a guide.

        Apple’s synch services have to be the most actively developed of any on iOS, since devs are having trouble with anything beyond DropBox-level functionality (e.g., database updates). Whether there are new services, vs just bug fixes, I am in no position to speculate. But they will have a mini-riot at WWDC if there’s not some good news. I’ll opine that it’s a worse screwup than the Maps situation.

      • obarthelemy

        Actually,the simple lack of background services means that iOS is lagging. An alert to wake up an App is nowhere near as convenient as all apps that need to synching automagically: RSS reader, cloud storage, to do list, podcasts… Allowing background synch when docked solves the problem of background processes eating up cycles and battery.

      • Walt French

        “Lagging” on a particular feature is probably way down the list of how Apple prioritizes its development efforts.

        Especially if it’s not a development that features immediate user feedback/pleasure, or significantly reduces complexity of tasks that your average phone user performs a lot.

        Triply, now, if trying to play catchup takes them away from inventing their own future.

        Apple long ago put the stake in the ground about multi-tasking on the iPhone. Taking out OSX’s long-standing, inherent ability from iOS was probably a LOT harder than leaving it in; you can’t say it wasn’t done purposefully. Google’s Astroturf Irregulars have been harping on the feature forever, and Apple hasn’t yet been moved.

        Technology changes; an iPad has more than enough power and screenspace and target users that a more flexible multi-task model seems much more possible than back when the iPhone had only tiny amounts of RAM, battery and screen. But you won’t see it until Apple is convinced they’ve thought out a metaphor—card edges? glowing status bars?—that lets users manage it without turning them into nagged-at SysAdmins. I’m not sure we’ve crossed the line from “yet more housekeeping” to “yet more power for the VERY casual user.”

      • obarthelemy

        I understand Apple wanting to keep things simple, and make the attending tradeoffs. Background sync when charging and on a LAN (wifi, BT, NFC, USB..) is not a trade off though, it’s a straight gain with no drawbacks: battery and data use are irrelevant, CPU cycles probably too, since a docked phone is rarely used, and can overclock with no battery loss in the rare case it is being used.

      • Walt French

        I travel regularly (getting on a flight tomorrow). The assumption that “in the dock” necessarily means “has free/cheap data” is precisely untrue when I’m in my Minneapolis apartment or the high-priced hotels where my professional societies like to meet.

        I’m all in favor of things being easier, but finding the right mix for situations is non-trivial. As Apple and others have found out the hard way.

      • JohnDoey

        Another way to say that is that Apple is ahead on battery life and ease of use.

        When Apple first permitted 3rd party apps to do background tasks, many of the iPhone users that I know were unhappy with it and saw it as apps being sneaky, doing things that they did not specifically ask them to do. It is not necessarily a feature to enable 3rd party apps to do more in the background. You cite a handful of edge cases where it might be better but leave out the drawbacks. A user who can’t make a 911 call because their RSS feeds are up-to-date would not necessarily thank you. Same with a user who hasn’t run their RSS reader for a week but gets a larger data bill because their reader was toiling away in the background.

      • obarthelemy

        The funny thing is that none of those arguments actually makes sense… people with big enough blinkers can rationalize anything

      • Sacto_Joe

        Listen to the pot calling the kettle black….

      • obarthelemy

        If Apple users don’t realize that once apps have a privilege, they can abuse it in the foreground as well as in the background, it’s an issue with Apple users ^^
        Have there been any instances, ever, of missed calls due to background activity ? I call FUD.
        The “data scare” is easily taken care of, like, say, by Android, with a global switch to allow background sync only over wifi, then per-app settings for the meticulous. Before you come up with the attending battery scare, ditto with “sync only when charging”.

      • http://twitter.com/snookasnoo Idon’t Know

        That is incorrect. Excuses by the 3rd party developers.

      • Chaka10

        Didn’t happen last year either, on the iPhone

    • Bruce_Mc

      I don’t think use of the word “insane” is called for. There is not that much of a premium on “being right” in this place.

      The switch in chip suppliers is one factor. I think another factor is that Apple wasn’t ready for the 2012 holiday season in a few product lines. The word Tim Cook used was “constrained.” That means they couldn’t make as many as they could sell. I think Apple wants to make sure that doesn’t happen this year.

      Plus there is the “the potential of exciting new product categories” (Tim Cook’s recent words) which could be taking up design resources at Apple.

    • http://twitter.com/snookasnoo Idon’t Know

      Insane? Grow up. Samsung did not raise prices and Apple is already buying from other suppliers.
      Run along now…

    • http://www.asymco.com Horace Dediu

      You must be referring to http://www.asymco.com/2012/12/06/does-s-stand-for-spring/
      Suggest re-reading it for what I said and did not say.

  • def4

    I think your guess is right but your conclusion is wrong.

    iPhone revenues and volumes grew in tandem by 3% and 7% respectively, which does indeed imply pricing has not changed.
    I think it should be obvious to anyone that has held both that iPhone 5 is a significantly more expensive product to manufacture than iPhone 4S.
    Competitive pressure has not forced Apple to drop iPhone prices but they have created a significantly more luxurious device to maintain pricing.

    The exact opposite applies to iPad. Here costs and volumes grew at the same rate of 65%, while revenue grew by 40%.
    iPad mini and its lower unit pricing is obviously responsible for this, which can easily be classified as a response to competitive pressure.

    • http://twitter.com/matthewwanderer matthew

      “a response to competitive pressure”

      I agree with everything up to that observation. The iPad mini’s price might be a response to competitive pressure, but not it’s introduction.

      • JohnDoey

        I have a MacBook Pro and iPad and my girlfriend has a MacBook Air and iPad mini. Neither of us considered price when we chose those products — only form factor and usage. iPad mini is just “iPad Air.” It makes all the sense in the world even without considering the price. Some people really do want the smallest possible device and are willing to give up pixels and power.

      • http://twitter.com/matthewwanderer matthew

        Read my post. I’m not questioning the size. The inspiration for my speculation – that’s what it was, after all – are the iPad mini’s margins. Cook made a point to address the fact that the mini’s margins are lower than the Apple traditionally prefers.

        I believe this and the mini’s component mix suggests that Apple wanted to _price_ the mini as competitively as possible.

        FWIW, as an Apple customer since 1986, I rarely if ever have a problem with Apple’s pricing, as I am convinced of the value proposition. For example, premium pricing is what made it possible for me to schedule an appointment at my Apple store, drop in with my problematic iPhone 5 and have it replaced in about ten minutes. You get what you pay for. New-to-Apple iPad mini customers will be similarly convinced if Apple’s customer satisfaction rankings are any indication.

    • http://www.asymco.com Horace Dediu

      Introducing a lower priced model that appeals to a different, larger audience and is hired for a potentially different job does not necessarily imply a price reduction for the product line. It’s like saying that the iPod mini and iPod nano and iPod shuffle and Mac mini were launched in response to competitive pressure. They lowered average iPod prices but the objective was to get the iPod into the hands of more people. I only wish the iPhone would follow the same principle.

      • JohnDoey

        I can’t imagine that iPhone won’t follow the iPod example and expand to a full lineup.

        Steve Jobs promoted the idea of a full lineup in 1985 before he left Apple, promoted it again in 1994 when asked what Scully-Apple was doing wrong, and then obviously executed that strategy with iPod. It makes all the sense in the world that iPod touch and iPod nano would “grow up” into phones soon. Apple is a phone maker more than music player maker now. I can’t see why iPod touch gets the larger screen and why iPod nano gets a phone-like form factor recently unless they are evolving into phones. Also they both have Lightning, which is only abailable on 1 of the 3 iPhones. We may look back on the last few generations of touch and nano in the future and see them very clearly taking a step toward being a phone each year. 4G/3G is a great high/low differentiator right now. iOS/iPodOS is a great touch/nano differentiator. And an iPod nano with Wi-Fi/3G matches today’s iTunes much better.

      • Sacto_Joe

        I strongly suspect that the move to the milled aluminum backs is going to permit Apple to create a range of different iPhones, perhaps clear down to watch size. Pairing a relatively inexpensive watch phone with an iPad Mini would seem to be a natural way for Apple to respond to Samsung’s “fatphone” gambit. Note that a fatphone is neither a good tablet nor a good smartphone. It’s mediocre at both jobs.

      • obarthelemy

        I beg to differ, of course. A phone with a piddly screen can’t really be called smart, when reading or watching videos on it induces unslightly squinting and headaches.
        Smartphones are no longer mainly phones, they’re pocket computers: I spend less than 1% of my smartphone time actually phoning. The remaining 99%, I need the biggest possible screen, as I do on my desktop and laptop.
        - On my desktop, that “biggest possible” means “fits in my eye range”: 26″, times 2 or 3 (for some reason, I find several screens better than a single huge one).
        - On my laptop, it means 13-15″ so it fits in my briefcase/backpack.
        - On my phone, it means whatever is pocketable and fits a single hand. 5″ leaves room to spare, 7″ is too big… I’m shooting for 5;5″ to 6.3″ next, actually trying to not lose my nerve and buy the Ascend Mate before the Galaxy Mega, Galaxy Note 3, and attending reviews, are out.
        As for tablets (I know you’re wondering), I have 7″ (too small, I use it when kids are over, or when I forgot to charge other tablets), 10″ (just a tad too big for carrying in my man purse, just a tad too small for long video viewing) and 13.3″ (perfect as an extra screen next to my PC, useless for anything else, even in my lap it’s bad). Fun fact: my 3 tablets all together cost me less than a single iPad retina ^^

    • Sacto_Joe

      The cost of producing the iPhone 5 is a bit steep now, but recall that this is a cost that can be defrayed into future milled iPhones for years to come. The switchover to aluminum from glass will ultimately reduce the manufacturing cost as the generation of new form factors can be easily programmed in. In addition, the phones are both more rugged and lighter. There may be some issue with being too light, but that’s kind of like being too handsome; it’s a problem most people would love to have.

      The continued popularity of the iPhone 4 series has actually given Apple some breathing room to “catch up” on milling machine purchases. Remember, they need to ramp up every year for their holiday sales. For several years in a row now, they’ve left money on the table during the holidays by not having sufficient production capacity. It behooves them to get well ahead on that while they have the chance.

  • MattC

    I think they priced the iPad Mini too low. Should be $100 higher per model. Would not affect demand.

    • http://twitter.com/snookasnoo Idon’t Know

      Samsung’s latest cheap plastic tablet is $399.

      • obarthelemy

        You mean the one with a Wacom stylus, 1280+800 screen, multitasking… It is actually a premium tablet, but you need to be able to understand features, not just looks, to get that

      • Kizedek

        Then again, the only good feature is the one that is being used. But you need to understand “jobs to be done”, not just spec sheets, in order to get that.

      • http://www.asymco.com Horace Dediu

        Premium is in the eye of the beholder.

      • obarthelemy

        Actually, that’s “beauty”, but your amalgamating premium with beauty does fit. To me, premium is features, not looks, because a phone is closer to a backpack than to a handbag..

      • http://www.facebook.com/tony.lombroso Tony L’Ombroso

        For many people, build quality and materials are important features in backpacks ;-)

      • obarthelemy

        Very true. That’s why backpacks are rarely made of metal ★

    • Carthusia

      I agree, mainly, and was expecting $379. I wonder if a retina version is in the pipeline and will have an ASP in the $400 range, keeping the original mini at $329.

    • JohnDoey

      iPad mini is brand new. Apple will likely keep these same price points going forward and margins will increase over time. In 3 years, they may also be selling a 16 or 32GB for $329 and making double the margin they are now. They have done this many times in the past. The static pricing makes the devices easy to buy. People will consider a $329 iPad mini for a year and then hear there is a new model, also at $329, and pull the trigger.

  • Joe_Winfield_IL

    I wider how much of a factor increased labor costs at Foxconn play. In general, Chinese labor rates are spiraling upward, and I imagine all the changes Apple has forced are driving Foxconn’s costs even faster than the average.

    • Walt French

      Cost of labor for assembly is a very small share of Apple’s products. Production equipment might be significant, and several key components are; design & software very much so.

      Don’t I remember 5% of costs for assembly? Labor could rise by 20%—which I thinks is way high—and still only take another 50bps off margins. (Note that’s 5%—>6% of costs, which are very roughly half of revenues.)

  • ptmmac

    As usual Asymco is the place to come to get an excellent picture of what is happening at Apple. There are several balls up in the air and the result is that Apple is not getting quite as strong a margin for its products. The transition from one product type to another is an undertaking which Apple has managed in such a way as to make it look effortless in the past. I think we are looking at the end of Apple’s alliance with Samsung as having a clear cost to the bottom line for the company. My guess is the distraction of battling with Google at the same time is equally a problem. Management is having to deal with the strategic equivalent of a two front war and this has a high opportunity cost for the company.

    If I am correct about this, then I would hope that Apple would get it’s ego out of the way and mend fences with Google. Google should have it’s own worries about how Samsung is going to treat them in the long run. I don’t expect this to happen, but if it did it would give Apple a chance to put it’s focus on creating the best products it can and not “War”. The real pay off for Apple would be access to Google’s expertise in the Cloud. Apple just doesn’t have the corporate culture to make a world class cloud environment. I am making this claim based upon the results of a decade of efforts that have been mostly mediocre.

    The most important business decision that Steve Jobs ever made at Apple is an example of this kind of cut your losses decision making. The foundation for all of Apple’s success over the last 15 years was the end of the running war with Microsoft over IP. Mutual access between Microsoft and Apple’s IP has opened doors to both companies. Apple’s has definitely benefited more from this than Microsoft because they were so far down when it happened. In this case, I believe both companies would benefit equally from a renewed alliance.

    • http://twitter.com/matthewwanderer matthew

      “Apple would get it’s ego out of the way and mend fences with Google. Google should have it’s own worries about how Samsung is going to treat them in the long run.”

      Advantage Apple, imho.

      BTW, I think the “split” between Apple and Google has been over-played.

      • James Katt

        Apple doesn’t need Google that much any longer. Google is more of a parasite than anything on iOS.

      • http://twitter.com/snookasnoo Idon’t Know

        Googles experience in the cloud is a joke. A bunch of half finished products with terrible user interfaces whose only real attribute is that they are free as long as you give all your personal information to Google for them to sell. Google doesn’t even have any solutions for syncing data between applications as does iCloud.

      • JohnDoey

        The split is between Apple and Android, which is not the same as Apple and Google. Maybe it is becoming more the same now that Andy Rubin is no longer running Android.

      • http://twitter.com/matthewwanderer matthew

        Maybe I’m misreading your reply, but this simply isn’t true. The idea example is Google Maps. It’s no longer Apple’s default iOS map app.

        The “split” between Apple and Google is real, but as I mentioned above, I think the split was/is over-played, as in the tech press has blown it out of proportion.

    • Walt French

      And if Apple were to “get it’s[sic] ego out of the way,” what would it be doing differently and still be working to make sure its customers got the best possible experience?

      Certainly not going back to utter dependence on a company that has already monopolized Search and pretty much so, online ads, and has leveraged those monopolies to attack profitability of its competitors. E.g., the obvious example of giving away Android to keep Microsoft from getting into mobile search or anything else mobile.

      Nor to go back to the Maps deal they signed with Google back when they were best of buddies, but couldn’t do turn-by-turn, and couldn’t get Streetview etc because Google implemented it with Flash.

      Some smart people regularly harp on how Google has blown $12 billion in buying Motorola, and they go on to note that so far, life has been worse for Google as a consequence. But if it is not the Dumbest Corporate Move of All Time,

      • obarthelemy

        Android 4.2 doesn’t have Flash, but does have streetview and turn by turn. The lack of those on iOS was certainly due to contractual reasons, not technical ones.
        I think you’re forgetting that ads can be *targeted*. Targeted ads are worth way more than bulk “diet”, “manhood”, “get rich” ones. I’m fairly sure that’s where Google is looking for growth: better ads, not more ads. Actually, better ads allows for fewer ads.
        It would be mostly unheard of for a services/content company to move downstream into hardware, though MS begs to differ. Docs, Plus, Gmail, Search and Maps are far from unique though, switching is a pain, but not impossible. As is forking Android, if Google start to lock it up. The PlayStore would be a bigger issue, especially if Google start behaving like Apple and requiring exclusivity.
        And finally, the worst acquisition of all times is without a doubt HP’s Autonomy, they had to work up to this one with Palm ^^

      • Walt French

        I have some stories around targeted ads, such as using Google to find the cast for our particular night of our SF Ballet subscription—the page is (was) annoyingly impossible to find from their menus—which triggered ads for the SF Ballet every visit to the NYT and many other websites. Yup, I’m interested in the company. No, the ads don’t cause me to buy one extra ticket.

        In any case, there has to be some saturation level where that becomes true for every person who goes online—where ads accomplish nothing at the margin, except to raise the cost to the advertiser. That necessarily means they don’t pay as much, or advertise as heavily, which in turn drives down the revenues for the web sites who use Google’s ads and of course, Google, too.

        Do the math with the value of YOUR time on say, TV shows.

    • JohnDoey

      You are assuming that Apple cares about what Google and Samsung are doing. Their main problem is how to make even more iPhones and iPads each generation.

      I also find it laughable to suggest that Apple cannot compete with a whole 2 competitors. Apple basically killed BlackBerry, Nokia, LG, Sony, and many others. They killed Palm twice. They can handle competing with 1 profitable hardware maker and one unprofitable software maker in the phone market. Apple successfully competed with Microsoft’s PC cartel for generations.

      • obarthelemy

        MMmmm… not “for generations”, at one time Apple survived on a MS handout and promise to keep Office for Mac going… because MS need some facade competition to fight the “monopoly” charges.

    • Johnny

      What is so great about Google’s cloud services?

      Apple had iTools, email and Dropbox -like sharing features back in 2000.

      IIRC, Apple had Contacts, Calendar, and Safari bookmark syncing in 2003 with OSX 10.3 and .Mac (formerly iTools)

      Apple had iWork.com (beta) document editing like Google Docs in 2009.

      What exactly is new that Google is doing?

      Google Drive and Dropbox are nothing ambitious like what Apple has been trying with iCloud.

      iCloud is many different things, and that’s where many people are confused when they read theVerge or Ars and developers are complaining.

      iCloud uses IMAP and Caldev for mail, contacts, calendars, todo’s etc… These usually work fine just like gmail and gcal.

      The complex thing that Apple is trying to do is Core Data. This allows each app to have its own database and only sync individual transactions rather than the whole database. This is the main complaint from developers, who are having a difficult time debugging errors.

      Google Drive and Dropbox CANNOT do what Core Data is trying to do.

      Google doesn’t have GameCenter yet either.

      Again, what’s Google doing so great in cloud services? Google+, YouTube?

      IIRC iTunes is quite a massive cloud service that seems to be doing well for the last 10 years.

  • Roy Rodenstein

    $449 iPad ASP implies the vast majority of customers are buying the 16gb WiFi model of both Mini and regular, no? A bit surprising as even Mini can go to $659 maxed out. Horace does this surprise you? It seems more people are buying higher-end iPhone 5 mix than iPad mix!

    • http://www.asymco.com Horace Dediu

      I don’t know what it means on a product level. Too many assumptions to multiply. It does not surprise me that the WiFi version would be more popular. I would think it could be as much as 80% of sales by units. That’s simply because of what it’s used for and how it’s sold.

  • Chaka10

    Horace, I don’t think Apple gross margins stabilizes or returns to growth until iPhone starts growing again (not necessarily at the same historically high rates, but growing beyond 3% (revenue growth is the right measure, I believe). I don’t know if you’ve noticed my recent comments on Ben Evan’s site, but as I mentioned, I think it would be interesting to model potential replacement demand from the existing iOS/iPhone installed base (e.g., 247,676 iPhones sold w/in last 24 months) with an assumed upgrade/replacement percentage (maybe range), and similarly to model the net churn iPhone – Android. I can do so, but perhaps others have data more handy (e.g., Android sales in trailing 24m and various studies/surveys on churn/intent). Thanks for considering (or even if not).

    • Chaka10

      Here’s the sheet

      • Johnny

        Haha

        Where is the Windows RT touch version of Excel. I’ve been waiting for it since my 2003 Windows convertable tablet. They still didn’t release it in late 2012 with Surface RT. I guess that’s MS

      • Sacto_Joe

        Chaka, I would think that, ideally, each previously sold iPhone would come up for renewal on the quarter of the two year anniversary. So I’d expect to see 3Q07 sales come “due” in 3Q09. Instead, you seem to be showing nothing for 3Q09, and don’t start until 1Q10, and then list 3,726 instead of 2,315.

        Anyway, I graphed it as I thought it should be ideally, then did a simple subtraction to come up with the theoretical net new customers. Graphing the actual combined customers, the potential net old customers, and the theoretical net new customers, yields the steepest progression for the potential net old, the next steepest progression for the actual combined, and the shallowest progression for the new theoretical net new.

        At that point I realized that there was something else to add to the equation: Each iPhone model has a specific upgrade date. Therefore, we can expect that the quarter or two before the upgrade, people will be “waiting” for the upcoming upgrade, even if it means not updating their plans right away. Also, some people who have plans that end after the refresh date may decide to end their plans early, moving some of these upgrades into the previous quarter. Now, 2 years back, the upgrade was sold in the 4th quarter, where now it sells in the 1st quarter. So that needs to be taken into account as well.

        To take that into account, I adjusted the “upgrade” sales to 50% before the upgrade quarter and 75% after, adding the difference to the total for the quarter of the upgrade. I further adjusted the Q3 ’12 sales to 75%, since the “expectation” at the time was that the iPhone 5 would come out in June, and added that in as well. The result shows, as can be predicted, a spike in old customer sales in Q4 ’11, Q1 ’12, and Q1 ’13. Interestingly, that suggests a fall back in new customers in Q4 ’11, but not in Q1 ’12 or Q1 ’13, those last two almost certainly due to the big move towards the holidays for the iPhone release date.

        Finally, the net old customers jumped pretty good for Q2 ’13, suggesting strongly that that’s the source of the revenue spurt that surprised Apple this earnings report. Beyond that, if you’re right, Apple should see about 20 million iPhone sales from old customers alone in the existing quarter. I’d also estimate something on the order of about 21 million new customers based on this data. That assumes, of course, that T-Mobile doesn’t add to the net and that China Mobile continues to play coy.

      • Chaka10

        Thanks Joe. For the reasons you cite and other complications as well I’m sure, these estimates are far from precise — as I said, they are “very rough of course, but meant to show potential RELATIVE replacement tailwinds in different periods”. I think it does illustrate the lag in replacement demand — from the quick ramp and from having to look back down the ramp at historical sales for potential demand from the existing installed base. I think it also illustrates that the potential replacement demand “tailwind” will be much higher in the upcoming holiday quarter as purchasers in the massive launch of the 4S come up on 24 months.

        My second column attempts (roughly) to do some of the same adjustments to simple 24 mo look back that you do. It represents iPhone unit sales in the prior 24 mo quarter, plus 50% of each of the quarters before and after (to capture some contribution from those who wait and those who accelerate). Whether 50% is right, or should be 50/75 for before/after as you do, and whether the adjustment should be made only on launch quarters — those are refinement assumptions, I think.

      • Sacto_Joe

        Excellent! We’re on the same page! Since 20.34 M iPhones were sold in Q3 ’11, then a 100% upgrade would yield the same number. See http://www.yankeegroup.com/ResearchDocument.do?id=60321 . Per this group, 91% of Apple users plan to stick with Apple. That indicates that (20.34×0.90=) 18.3 million users will consider upgrading to the 4s or the 5 next quarter. Since both phones have Siri and the 4 doesn’t, the only question becomes; are they willing to wait until the end of September to upgrade? According to my estimates, on the order of 20 million new orders were added in Q3 ’12. In the previous 3rd quarter after a release (Q2 ’11), the estimate suggests about 15 million new orders were added. This gives me a minimum and a maximum new orders of 20-25 million in Q3 ’13. Assuming between 75% and 100% of the upgrades materialize, that would be a range of 34 million and 45 million iPhones sold this quarter.

      • Chaka10

        I don’t know that it can be calculated with any precision but I do think looking at prior period iPhone sales can give a sense of potential replacement demand, and in this holiday quarter there may be a significant base of folks who bought iPhone 4Ss in the massive launch in the holiday quarter 2011

      • Sacto_Joe

        Something else to keep in mind: New upgrades will probably go to the iPhone 5. Since we know that half the sales went to the iPhone 5, that suggests that ALMOST ALL iPhone 5 sales are to existing customers!!

        It also suggests that 2 years from now, all those iPhone 4 and 4s owners will upgrade to the iPhone 6, assuming it doesn’t come out, as I suspect, until September of 2014. This is also a very surprising outcome.

      • obarthelemy

        That’s extrapolation though. It assumes churn rate stay the same, which may or may not happen, and then go one way or the other.

    • James Katt

      Selling a cheaper iPhone won’t grow margins. It would shrink them since the component prices will be the same. The iPhone already has minimum hardware.

      Critics who say Apple should sell a cheap iPhone model are wrong. All it would do is shrink Apple’s profits just like clones did for Macs. The only solution out of that is to reduce the component prices. But then how?

      • Walt French

        @James Katt wrote, “ Selling a cheaper iPhone won’t grow margins.”

        It’s mathematically possible, if the iBargainPhone has higher margins than Apple’s lower-margin businesses, whether it displaces them or merely makes them a smaller share of the total, and doesn’t displace the share of even higher-margin business by a disproportionate amount. (Yes, a tidge complicated.)

        But stepping back a bit: margin growth is all well and good, but better to have growing top line and growing bottom line, which can be done as long as margins don’t fall faster than revenues grow. In fact, margins growing faster than revenues would be a sign of the famous “retreat upmarket” that many have been predicting as Apple’s end-game before Google checkmates.

      • markrogo

        In fact, all this targeting of gross margin percentage is a fool’s game of the highest order. Apple was achieving great gross margins which allowed for great profitability on — relatively — small unit sales. That was then….

        In the now, where the company isn’t being given any credit (valuation-wise) for what happened then anyway, they have a clear chance to make a clean break from that rubric. “We will not pursue gross margin for the sake of gross margin, but will instead focus on growing the company.”

        Against that backdrop, a cheaper iPhone with a 30% margin that is positioned cleverly enough to cannibalize few ~50% margin iPhone sales but allows volumes to very approximately double (all these numbers have wiggle room, but all should be close to achievable) ought to be Apple’s endgame. Why? You can’t be checkmated with that much market share.

      • http://twitter.com/snookasnoo Idon’t Know

        They already sell a cheaper iPhone. The 4 is usually free and the 4s is $99.

      • RAZ

        That’s how it works for us in the US and a few other places. In much of the world, though, iPhones and other devices are bought at an unsubsidized price and not on a contract. So prices are higher – and for the iPhone – much higher. It’s here the cheaper iPhone would likely mean something.

      • RAZ

        Logically I don’t see the problem. If you can sell lots of high end iPhones at a 50% margin and lots more lower end (but still worthy of the Apple name) iphones at say a 30% margin why wouldn’t you want to? Until the downside of the lower end model cannibalizing the high end sales outweighs the benefit of the additional sales from the lower end model why not do it? Yes, the average margin is reduced, but the net profit is increased. Isn’t that more important?

      • obarthelemy

        No.
        Apple can lower component and assembly costs: ditch unibody, ditch retina, lower-spec camera… I’m guessing $50 savings are achievable, which means $100 lower prices if the margin is kept the same.
        Profitable sales increase revenue. IS that less important than margins, within reason ?

  • http://fortune.com/apple20 Philip Elmer-DeWitt

    When asked during the conference call Tuesday what drove margins down, Peter Oppenheimer didn’t blame component costs (in fact, he suggested costs were coming down):

    “In the March quarter, our gross margin was 37.5%. It was at the low end of our range. We had a few items that on balance resulted in us reporting at the low end. They included mix, in particular, selling more iPads than we had planned, including getting iPad mini into our four- to six-week channel inventory range, some changes in our service policies that required us to make provisions for prior quarter sales, and we had some unfavorable adjustments. As I look forward to the June quarter, we’re guiding gross margin to be down between 50 basis points and 150 basis points sequentially. We see two factors impacting gross margin sequentially. First and the largest of the two is the loss of leverage on sequentially lower revenue; and second, a different product mix. We expect both of these headwinds to be partially offset by better cost in the quarter.”

    Horace, can you unpack what he means by “the loss of leverage on sequentially lower revenue” — the largest factor driving June’s margins down.

    • Walt French

      I took it as fixed costs applied to a smaller shipments number. That could be equipment depreciation, for example; perhaps Development (“&D”) of new production that mightn’t be amortized over time.

      The mix strikes me as distinctly secondary, at least if it’s across product lines. Making a quick’n'dirty spreadsheet of the sequential quarters, and putting in fixed 48% and 28% margins on iPhone and iPad, (and fixed $600/$450 ASPs)—and ignoring utterly EVERYTHING else—I got…

      iPads went from 32% to 34% of units
      …from 26% to 28% of revs
      …from 33% to 35% of expenses
      …so from 17.3% to 18.5% of contribution,
      Dropping margin from 42.7% to 42.4% (ho hum).

      When I laid it out, I thought the big difference in iPhone vs iPad margins highlighted above would drive the margin drop, but I don’t see it.

    • Walt French

      I took it as fixed costs applied to a smaller shipments number. That could be equipment depreciation, for example; perhaps Development (“&D”) of new production that mightn’t be amortized over time.

      The mix strikes me as distinctly secondary, at least if it’s across product lines. Making a quick’n'dirty spreadsheet of the sequential quarters, and putting in fixed 48% and 28% margins on iPhone and iPad, (and fixed $600/$450 ASPs)—and ignoring utterly EVERYTHING else—I got…

      iPads went from 32% to 34% of units
      …from 26% to 28% of revs
      …from 33% to 35% of expenses
      …so from 17.3% to 18.5% of contribution,
      Dropping margin from 42.7% to 42.4% (ho hum).

      When I laid it out, I thought the big difference in iPhone vs iPad margins highlighted above would drive the margin drop, but I don’t see it.

      • Chaka10

        Just to check some math, on a SEQUENTIAL basis (Horace’s analysis is YOY),iPad share of total revenues went from 19.58% ($10.674bb/54.512bb) to 20.06% ($8.746bb/43.603bb), correct? That’s from the Apple Summary Data Sheet, i.e., essentially unchanged, correct? iPhone went from 56.24% to 52.65% (almost 4 percentage points). iTunes, etc went from 6.67% to 9.44%, which accounts for most of the change in iPhone share.

        Tiernan Ray’s blog discussed Milonovichs’ analysis on sequential margins pointing at China and D&A (http://blogs.barrons.com/techtraderdaily/2013/04/25/aapl-ubs-models-40b-debt-raise-ponders-margin-pressure-in-china/)

        I think the share change in iTunes illustrates an important point — Apple management clearly went out of their way to mention this product segment, and this board has seen some debate on whether it’s a profit center, or just device value-add. Well, what is it? If it’s the latter, then it doesn’t help margins when that business grows.

      • Walt French

        Thanks for noting the importance of iTunes. From Horace’s earlier work, we know that iTunes, whatever its role in the company’s Grand Plan, has very low margins on media. That’d explain the nice beat on revenues but the in-line EPS.

        BTW, your link looks 404′d.

      • Chaka10
    • http://twitter.com/RAuguste Robert Auguste

      The margins have been spectacular but the thing that is never discussed is operating leverage. You always have a set fixed cost per product. In the supply chain you tend to know what products and what lines have the highest fixed costs. If you ship a product that is a dog, you have a manufacturing line that is fairly idle because of low demand, and you have equipment and resources on low demand. So you may see other products start utilizing that line. This is not a dog but a case for improving a line is the form factor on Apple airport similar to Apple TV.

      In this situation, leverage comes into play for product launches or loading for inventory. If your fixed costs are set for 100 units at $100, but you utilize the line a 2x for 200 units, your fixed costs are now half the cost and flow to the bottom line ($1 a unit for 100 vs $0.50 a unit). Thats leverage and you manage it per demand and where your fiscal year ends.

      So this is just speculation. Apple launches iPhone 5 in Q4/Q1. Q3 was soft for i4. They ramped up for mini, but talked about strong demand. If they forecast 100 units but need 200.You get favorability from the fixed cost leverage but you do get hit on the cost side from your variable costs like materials. But if you assume the stories, that they buy their suppliers inventory in advance then materials cost is minimaL or manageable. No one discusses shipping and all those stored units that get Fedexed. So if you have a $3.00 in fixed costs across materials, manufacturing, and logistics for those 100 units but ship 200 there is your favorability. But if I know demand seasonality will reverse in my Q3 and I am back on my forecasted plan, you assume leverage is out and I’m back at normal rates.

      If most the product lines have the new form factor, it is easier to now manage the costs for launch. You can announce in Q4 and lever up, depending where you want to time the leverage for results and inventory build. Even then if demand exceeds your own projections, you keep running the lines to the right balance point. In Apple’s case, it is never more then 4-6 weeks of inventory.

      • http://twitter.com/asymco Horace Dediu

        Thanks for this explanation.

    • http://www.asymco.com Horace Dediu

      Loss of leverage sounds like higher component costs, but I could be wrong. I’ve never heard “leverage” applied in this context. I can only assume it’s related to economies of scale. I would draw attention to the interesting clue in the “change in service policies”. That change means that they had to put aside more money for warranty expense, including for prior quarters(!). It also seems to be related to the change in warranty policy for China (due to the public campaigning done there by the authorities). It does not mean that they’ll actually spend the warranty reserve. It’s essentially being put aside as a liability and a cost of sale. Would be interesting to figure out what might happen if/when those warranties expire.

      • http://www.linkfest.com/ StreetEYE (@streeteye)

        I think he may mean operating leverage. You have fixed costs and spread them out over a number of units. If the volume of units goes down, your fixed cost per unit goes up, puts pressure on margins.

      • http://twitter.com/asymco Horace Dediu

        Makes sense

      • Chaka10

        Question is, of course, what are the fixed costs in COGS. I would guess D&A, ie, this is where Apple’s substantial increased CapEx for “product tooling and manufacturing process equipment” flows back into the income statement.

      • http://www.siatomiclabs.com/ RAuguste

        I would think they would put that reserve on its own line on the P&L that sits away from COGS.

        Leverage, operating leverage, or measuring contribution margin is still very common for manufacturing companies that still own their own plants like consumer packaged goods. Having worked in supply chain finance for one of these companies, you set volume, rate, and mix plan and you tried to beat it or managed to it.

        Apple has contract partners for manufacturing. You tend to have a cost + relationship with these vendors. Apple owning the tooling and utilization is a fixed cost but you still can negotiate some leverage rate. Hon Hai assembly is probably all variable.

        Volume is king because leverage and favorable mix can juice your performance. Are materials going up? Possibly, but if it is very dramatic, you plan a year in advance and have a warning from your vendors and see the bills flowing through or an unfavorable rate impact. You manage to the cost as actuals meet, exceed, or beat plan. This is how your building guidance. Plus you always hedge a % of your costs and manage performance to a target.

        Tim Cook is an ops guy and seems like he wants to see operations clear of other noise costs. I maybe wrong but that is why when I listen to him and Peter speak about costs there is COGS vs other costs. They always build a crawl back to the previous quarter to a certain point of delivering the story. Yet they never give you enough detail to cost it out on your own, without having to make making to many assumptions.

    • http://www.asymco.com Horace Dediu

      From the 10Q (page 17) : Accruals for product warranty for the three months ended March 30, 2013 include $414 million associated with product sales in prior fiscal periods reflecting the impact of changes to certain of the Company’s service policies and other estimated warranty costs. Of this amount, $224 million is associated with product sales in the first quarter of 2013, and the remainder is associated with product sales in 2012.
      So $200 million was effectively added to Q1 costs for products sold in 2012. Adjusting for that means Gross Margin would have come it at about 38% (boost of about half of one percent.)
      Put another way, half of one percent of Apple’s Gross Margin disappeared due to the retroactive application of a change in service policy in China. http://files.shareholder.com/downloads/AAPL/1268196664x0x656152/cd6a3789-1507-4496-9361-be5b7c26f221/Q2_2013_Form_10-Q_AS-FILED.pdf

      • Walt French

        I haven’t followed the timing or impact, (and you’ll forgive me if I’m a bit off on the facts) but I took the Chinese changes as minimal, while a court in Italy found against Apple for trying to ignore EU-mandated warranty rules. It’d seem the European changes would be more impactful.

  • dorkus_maximus

    I think if Apple took in all the world’s liquid assets in gross profit but reported lower margins, most of the so-called “experts” would be calling for Tim Cook’s head.

  • CarloVBA

    What the hell happened to Microsoft’s operating margins before Q3-2012?
    It fell almost to zero…

  • Jurassic

    The reaction to Apple’s latest quarterly report only shows that some analysts and investors don’t know what they want.

    For months, there has been clamoring for Apple to follow its competitors and start selling more low-priced products… and this is exactly what Apple did by introducing the iPad mini, and selling more of the older, less expensive iPhones internationally.

    Of course, the result of doing this is that the low-priced products partially cannibalize the high-priced products. And since the margins on the low-priced products are smaller than on the high-priced products, Apple sold more units and had higher revenues, but overall margins and profits were lower.

    This was to be expected. But after almost demanding that Apple follow this route, and knowing that Apple’s competitors who sell low-priced products have lower margins and profits, many analysts and investors are acting “surprised” and criticizing Apple’s lower profits this quarter.

    Apple sold many more units last quarter, and gained significant market share especially in the USA, but in order to do this it was necessary to lower margins.

    People ranted that Apple’s products are too expensive, and that the company needs more low-end products like Apple’s competitors to gain market share, but when Apple does this, they are dismayed that overall margins are lower.

    Were they expecting Apple to sell less-expensive products, but at a higher margin than the more expensive products???

    Some analysts and investors don’t know what they want. When they get what they asked for, they are unhappy about it.

  • http://www.facebook.com/xof711 Xof Michot

    Compelling analysis…

  • http://www.facebook.com/mani.ghasemlou Mani Ghasemlou

    Apple is massively investing in aluminum milling equipment, hence the pressure being put on margins.

    They are transitioning their entire product lineup, from Mac to iPod to being based on a unibody aluminum enclosure.

    Unibody milling was first practiced on a mass scale with the unibody Macbook Pro a few years ago. It turns out that they were just testing the waters. Building a few million large size components per quarter is not the same as building tens of millions of small size units per quarter. It appears that they achieved this capability with the introduction of the iPhone 5 and the latest iPod Touch.

    With this new infrastructure for mass scale milling of iOS device enclosures, Apple is disadvantaged with the current product mix which includes iPhone 4/4S. The unexpected success of these products means that the fleet of CNC mills acquired for iPhone production are being under utilized – thus driving down margins as the depreciation per unit is high.

    There is a light at the end of the tunnel. At some point iPhone 4/4S will be retired from the iOS lineup. When this happens, and Apple is fully utilizing their CNC milling capacity we will see margins tick back up, potentially even surprising us to the upside.

    The most important point I have to make is that this milling equipment is programmable. Future form factor revisions will involve uploading a CAD file to the fleet of milling equipment. In the past, a form factor change meant significant changes to processes, materials, training of personnel etc. This kind of manufacturing/assembly “reboot” may be a thing of the past with the next few generations of Apple devices.

    It is also possible this same equipment can be used to manufacture enclosures for new product categories that no longer exist.

    I believe this is part of what Tim Cook was alluding to when stating that Apple is making short term sacrifices and thinking more toward the long term.

    • Walt French

      Certainly sounds of the type. But how much do these machines cost, and what is their throughput? And is milled aluminum really such an obviously superior choice for all future products (including value-priced ones) that they’d spend so much on them as to put a dent in their costs?

      • JohnDoey

        Aluminum Unibody is responsible for the existence of MacBook Air. That is the only way they got the MacBook that thin. Same thing applies to the other products. They can make them thinner with Unibody.

        Aluminum is very light, very recyclable. It makes sense for portable/mobile devices that have 2 and 3 year lives and then you upgrade the entire hardware.

      • Walt French

        Yeah, yeah. I love my milled MBP (except for those nasty sharp points that keep jamming into my wrists). It’s tolerated being jammed into a bag twice or more a day, a couple of thousand open/closed cycles so far, being knocked off my lap by passers-by and my resting my feet atop it until we hit 10,000 feet, so I don’t have to jam it into some tiny overhead.

        And light that shines thru holes you can’t even see? Charming.

        But still, can we have some costs?

      • mieswall

        The beauty of what Manu says is that Apple is building a long term, flexible, extremely productive manufacturing infrastructure. Based on processing raw material of inherent higher quality (and making Apple products all the more difficult to copy for Koreans).

        Future developments will be much more easy to put in practice at shop, due to these current investments and trial and error period. Margins necessarily going up, even with higher quality products. And a process that nobody else would be able to replicate easily.

        This is just one more point in my view of Cook, not as a boring guy, but as cold-blooded CEO with all what is happening (with the stock) planned since long time ago. Pair this known (for them) manufacturing friction, with the need to get rid of Samsung, all-at-one product introductions, etc, and the supply issues of iphone5 and iMacs start to sound like they were not that unexpected…

        If those shortages, in turn, are paired with special one time costs (guaranty policies, maps start-up problems, IOS transition, etc), we got a low GM and unsupplied demand => stock meltdown, just-in-time for the unavoidable buybacks they knew they had to face (and which I completely agree, btw), that would be impossible after this revenue machine is properly oiled again.

      • mieswall

        sorry, perhaps you refer to milled vs die-cast aluminum regarding throughput? Or the very aluminum if the issue?

    • darwiniandude

      Unibody milling débuted on the original Early ’08 MacBook Air 5 years ago. 10 months later it came to the Pro.

      • http://www.facebook.com/mani.ghasemlou Mani Ghasemlou

        You are right. Thank you for the correction.

    • Chaka10

      I have no independent assessment whether this is right, but sure reads like a coherent explanation.

    • Chaka10

      By the way, HTC (and reviews) are making much of the fact that it’s Al uni-body.

      • http://www.facebook.com/mani.ghasemlou Mani Ghasemlou

        I am intrigued by the HTC One. Can they build it in quantity? I wonder if we’ll ever get some kind of shipped units number for this device.

        It is almost certainly Foxconn that is building this device. They do have a great deal of experience building devices with aluminum enclosures thanks to Apple.

    • Watcher

      “Apple is massively investing in aluminum milling equipment”
      Or are they? =)

  • Bill Esbenshade

    Great post Horace! It seems like Apple doesn’t have fixed priorities/values (ala Christensen) re margins. They drop margins on great products they think they can sell in high volumes, like the iPad Mini and the iPod, but pursue higher margins for other products like the MacBook Pro, iPhone, etc. Because they don’t have fixed, predictable margin priorities, they’re very hard for low-end entrants to disrupt. They don’t follow traditional rules of Christensen disruption theory (Christensen has noted that Apple behaves like a “freak” in its willingness to move downmarket and cannibalize itself).

    I think this explains why, at Tuesday’s earnings call, Oppenheimer noted that the iPad Mini and the iPod were deliberately priced below average/normal margins, and that “we [Apple] are managing the business for the long term and are willing to trade off short-term profits where we see long term potential.”

    • http://twitter.com/asymco Horace Dediu

      The ability to act this way is probably due to a functional organization structure.

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  • mac

    per usual, you’ve missed a critical element. check out the warranty reserve for the quarter.

    • http://twitter.com/asymco Horace Dediu
      • mac

        per usual, hbs grads don’t understand accounting.

        per usual, your skill to arrogance ratio remains below 1.

      • Tom

        What is your problem dude, relax. You get called out for being wrong and then start with personal attacks?

      • mac

        I wasn’t wrong. the word “warranty” was nowhere to be found on this blog before my comment, but HD gives thanks to PED. This is not the first time HD has taken breadcrumbs from the comments section and given wrong attribution/no attribution.

      • LTMP

        You might be very skilled (or not), but your arrogance is apparently infinite. So I guess that means that your skill to arrogance ration is effectively zero.

      • mac

        sorry for being rude.

        but what’s asymco’s job to be done?

        dazzle the masses by lifting hints from the comments section?

        again, not the first time.

      • LTMP

        Why is it wrong to listen to your commenters and then expand the discussion when they point out something valuable?

        That seems like anything but arrogance.

      • mac

        You’re absolutely right.

        However, there’s an overarching lack of ownership on HD’s part for mistakes and misunderstandings, and I think this is a fundamental flaw with asymco.

        Mistakes and misunderstandings could be completely forgivable and actually an endearing element of this site if not for 1) HD’s lack of acknowledgement and 2) HD’s lack of attribution to the people who tip him off, make corrections and contribute behind the scenes.

        I should not have lobbed personal insults at HD. If I could take those comments back, I would. But the gap between what this site is and what it could be is maddening – particularly because the biggest reason for this gap is HD’s personality.

        I know people know what I’m talking about because this site’s readership is inquisitive and engaged, and is truly asymco’s greatest asset.

        That’s all I’ve got to say. Sorry again to HD for the personal insults.

      • http://www.asymco.com Horace Dediu

        I apologize if I did not attribute you on the post. I try to be careful about attribution, (it is one of the top rules of my site) but don’t expect that I read comments in a particular sequence. I may skim and then read more closely. PED’s comment was something that caught my eye enough to follow-up on. If you would have made a more complete argument with a different tone perhaps I might have noticed it first. (Also it helps if I can make an attribution to a person who identifies themselves).

      • Walt French

        There *IS* a mission statement if you care to look.

        Also, I’m pretty sure that it’s *NOT* to provoke people into slinging insults; those reduce the signal-to-noise ratio and I beg all to respect other readers. Personal issues can be taken up elsewhere.

        This site is great for learning opportunities, which sometimes means trying out ideas and getting useful criticism/feedback. It’s not a competition for upvotes and pull quotes, though.

      • http://www.tumblr.com/blog/his-divine-shadow His Shadow

        “You suck because you failed to do/say ‘A’,”

        I did/stated ‘A’ right here….

        “You now suck for another reason I can’t specify.”

        Lather. Rinse. Repeat.

      • mac

        you’ve missed the sequence of events.

  • Markus Stefan Knittel

    I assume that the shift from Samsung to other suppliers is generating costs on various levels. And what about the costs (and lack of revenues) for all the new server farms?

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  • Mark Jones

    Horace, in your estimated drop of iPhone gross margin from 58% to 48%, are you attributing that mostly to component cost increases, or to change of iPhone mix (more older models than newer)?

    In reading the conference call transcript (from Seeking Alpha), Cook/Oppy said the following relative to margins. In most cases, they referred to mix and the iPad mini.
    - “Last year, our business benefited from both high growth and demand for products and a corresponding growth in channel inventories along with the richer mix of higher gross margin products, a more favorable foreign currency environment and historically low cost. This comparison was made further challenging until we had anniversary the launch of the iPad mini, which as you know, we strategically priced at a lower margin.”
    - “In the March quarter, our gross margin was 37.5%, was at the low end of our range. We had a few items that on balance resulted in us reporting at the low end. They included mix, in particular, selling more iPads than we had planned, including getting iPad mini into our four to six week channel inventory range, some changes in our service policies that required us to make provisions for prior quarter sales, and we had some unfavorable adjustments.”
    - “We’re very pleased with the progress that we’re making on getting down cost curves and this will help to partially offset the loss of leverage and the different product mix that we expect to see in the June quarter and we have factored these cost improvements into the guidance we’re providing for the quarter. The iPhone ASPs were down sequentially about $28 million as you noted. And this was driven primarily by mix. The largest factors we’re going to increase in the iPhone 4 mix, which resulted from making the iPhone 4 more affordable in many markets.”
    - “let me tell you how we think about gross margin and hopefully this will help. We are managing the business for the long-term and are willing to trade off short-term profit where we see long-term potential. The iPod is a great example of this. When we launched it in 2001, its margins were significantly below the margins of Apple at that time. Four years later, the iPod and the iTunes Music Store comprised half of Apple’s revenues and inspired us to build the iPhone. The iPad mini is another great example. We have priced it aggressively and its margins are significantly below the corporate average. However, we believe deeply in the long-term potential of the tablet market and think that we’ve made a great strategic decision.”

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  • andy

    you’re missing a big factor; changes in warranty reserves explain almost all of the GM% compression over the last two qtrs (product pricing and COGS likely explain the rest on a y/y basis). The change in warranty policy in china caused them to increase warranty accruals by $414M in FQ2. on top of that, the base-line accrual rate has increased to 2.5% and 2.6% in the last two qtrs, from 1.0%-1.5% for most of the last 4 years.

    This brings up as many questions as it answers tho, including:
    - Why has the accrual rate increased: are things really breaking more and/or more costing more to fix, or will the accruals be reversed in future periods?
    - Why is the guide for FQ3 GM% so low (effectively a 150-250bps guide down q/q rather than 50-100bps after adjusting for the one time China impact)?
    - Why didn’t they call this out more on the call? they seemed fine allowing people to think the margin softness in the qtr and compression in recent qtrs is normal course of the business right now.

    • http://twitter.com/asymco Horace Dediu

      Very good questions. I picked up the clue on warranty revenues and wrote a follow-up post. But the guidance remains perplexing.

      • Andy

        They clearly expected the iphone 5 to either break more or be more expensive to fix. but, it sounds like actual costs havent been as bad as they expected, at least so far. I think the simple explanation on the guidance is that fixed costs are higher than they used to be because of the increased capital investment, so there’s more deleveraging. It does sound like accruals will calm down. Doubt they’ll return to the previous range next qtr, but they could decline slowly (as a % of revs) over the next several qtrs and provide a tailwind.

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