Yesterday we teased the problem of Apple’s steadily declining hardware gross margins. Today we want to walk through some of the possible reasons for the decline.
The first thing to note is that gross margins peaked in 2015 and have been trending down ever since.
A few people asked us if their services business was the culprit. Apple began a serious push into music, video and content around that time. Several people pointed out that Netflix, Spotify, XM and other content companies all had to sustain weak gross margins early in their life. The problem with this theory is that Apple’s services gross margins are both higher than corporate average and have been growing while the hardware margins are declining.
Services include more than the content business. The segment also contains Cloud Services, Apple Care and Advertising. As far as we know Apple’s ad business is too small to move the needle much, but we imagine it is fairly profitable. Apple Care is an extended warranty business, insurance basically, and common wisdom will tell you as a consumer to never buy the extended warranty, because it is always priced for the seller to make (a lot of) money. Cloud Services is largely about selling cloud-based storage for what we, as customers of this particular service, find to be an exorbinant price. Apple storage costs $9.99/month for 2TB of storage. Apple probably made enough on these to cover the initial start-up costs of the content business, and now content is profitable in its own right, as borne out by the numbers.
The next most obvious cause would be an increase in component costs. But this seems unlikely. True, during this period Apple was upgrading the screens and RF components and much of its Mac line. This may have had an impact, but given Apple’s past operations practice it is hard to see this alone being the big driver in costs. If the screen really cost that much more we imagine Apple could have held off upgrading for a period, smoothing out the hit. Similarly, the increase in RF content has been taking place for almost ten years, since Apple started adding 4G. There is nothing that leads us to believe Apple has conceded much on any component pricing.
So the next place we would look is product mix. The chart below shows revenue growth by product category, with 2013 as the base year. During this period, Services and Wearables really took off. However, we already know services was not the culprit. That leaves Wearables, and here we may have found our first clue.
Apple launched Apple Watch in 2015 and Airpods in late 2016 (in Apple’s 2017 Fiscal Year). When Airpods first came out, it was hard to buy them, with multi-month wait times. At the time, many ascribed the delay to the popularity of the devices, and they were very popular. However, a more likely reason for the delay was that Apple was having a hard time manufacturing them. Something about production, maybe the perfectly rounded case or maybe the miniaturization of circuitry in the earbuds, was driving up defect rates. Another way to spell manufacturing problems is increased cost of goods sold. If 10% or 20% of devices are defective, that can often be enough to wreck the profitability of a device, and our guess is that Apple’s initial manufacturing rates were worse than that. Apple Watch seems to have less problems in manufacturing, but we suspect these also had poor gross margins to start out.
We believe these devices are now manufacturing at good yields. But there is the possibility that the margins on these products are poorer than the average iPhone or Mac. And as they have grown strongly, it is possible that they are weighing down margins. And this leads to our next suspect – mix shift.
Mix shift refers to the blended gross margin. If you are selling high margin products and then start selling lower margin devices, the average price of your devices falls . No discounts or price reductions involved, but prices, and thus gross margins, fall when everything is averaged out. As noted above, part of this is the growth of possibly lower-margin Wearables. But there is more to the story.
The graph below shows revenue growth by geography, again the base year is 2013. The standout feature of this chart is China. A combination of Trade War patriotism and resurgent strength among Chinese brands drove a reduction in Apple’s growth in China. This is important as we believe Apple’s iPhone sales in China skew heavily towards higher priced devices. So declines in China also likely brought down blended gross margins.
This is borne out further by Operating Margins, as shown in the graph below. We had to double check the data on this one because it so closely mirrors the graph above. Just as Apple’s China sales slowed, so did their operating margins in the region. Given that there was no obvious change in regional operating expenses during this period, the most likely explanation for a fall of this magnitude is that decline in sales and gross margins.
One other important thing happened in 2016 – Apple began selling the iPhone SE in that year. The SE was the company’s first foray into sub $400 devices. Apple does not break out unit sales anymore, let alone sales by model, but the launch of this device seems very likely to have affected the company’s gross margins. However, the situation is not quite as straightforward as that. At the time, Apple noted that the new models actually boosted gross margins. We believe the SE was designed with this in mind. That being said, while the SE alone probably did not cause the decline in margins, but we believe it did signal a new approach from Apple towards pricing and market segmentation. Just as Apple began launching >$1,000 phones, they also opened up the flood gates to lower priced devices, growing their addressable market.
There were suspicions about this at the time, and not long after Apple stopped disclosing unit numbers. When they did that we had the strong suspicion that they were trying to mask something unpleasant. And it now seems likely that Apple was moving towards a lower-weighted price band, and unit numbers would have made that glaring.
So after all that, our best guess is that mix shift is the leading cause of Apple’s gross margin decline, with some element of a shift to more expensive components and casing a contributing factor.
In our next piece we will review what Apple can do to address this.