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Is Apple's Epic Run Over? The Key to the Company's Pricing Advantage

Sunday - 12/30/2012, 10:00pm  ET

Apple has gone from Wall Street darling that couldn't miss to a contrarian play trading at earnings multiples well below the broader market. 

With iPhones still flying off the shelves and the Mini an early hit, many investors are left wondering there are deeper problems with Apple that they're missing, or whether the current sell-off makes Apple a screaming buy. 

We've created a brand-new report titled "Is Apple's Epic Run Over?" that gives investors a comprehensive look at Apple. It answers whether the bears are right, or if Apple has huge advantages investors are overlooking. Following is a sample section of the report that focuses on Apple and its hidden cost advantages compared to competitors.We hope you enjoy this preview content from our premium Apple report.

An amazing supply chain in action: Apple and cost of sales

Cost of goods sold of selected companies

Company

Percent of Sales

Apple

56.1%

Samsung

64.3%

HTC

73.8%

Nokia

72.9%

Research in Motion

70.6%

Dell

78.6%

Lenovo

88.4%

Microsoft

24.8%

Google

40%

Source: S&P Capital IQ. All values for the past 12 months as of Dec. 1, 2012.

Cost of sales is the single largest expense for Apple, and is at the heart of the debate over whether or not the company can continue to grow in coming years.

Diving deeper into cost of sales
What's in cost of sales? Primarily, components costs, but any number of areas could make it into cost of sales, including certain costs from:

  • Component costs and manufacturing
  • Shipping and handling costs
  • Warranty costs
  • Licensing costs
  • Employee costs (As an example, Apple allocated $265 million in share-based compensation costs to cost of sales last year.)

This clarification is especially important, because a common mistake made by investors is seeing published reports of the cost of materials in phones and inferring that's the company's gross margin. For example, here's a breakdown from researcher IHS iSuppli on the cost of all the components inside an iPhone 5:

Cost Driver

Total Cost in 16GB
iPhone 5

Memory (DRAM and Flash)

$20.95

Display and Touchscreen

$44.00

Processor

$17.50

Camera(s)

$18.00

Wireless Section

$34.00

User Interface and Sensors / BT and WLAN / Battery / Power Management

$24.50

Mechanical & Electro-Mechanical

$33.00

Box Contents

$7.00

Total Component Costs

$199.00

Manufacturing

$8.00

Total Component and Manufacturing Cost

$207.00

Source: IHS iSuppli, September 2012.

The quick read on this situation would be to take the wholesale price of an iPhone 5 not on contract -- $649 -- and divide the costs above to arrive at its gross margins. Under that quick and dirty method, you'd arrive at Apple selling a device with $207 in costs for $649, an astounding 68% gross margin.

However, that analysis fails to take into account the myriad other costs that can go into gross margins. Take licensing costs, for example. They can be an absolute killer in the mobile world. Google purchased Motorola last year mainly for its patents. The company is now engaged in litigation asserting that companies using its patented technologies – many of which are essential to the operation of wireless technologies like LTE – have to pay 2.25% of the phone's price in royalties. That's over $10 on a $500 phone.

That adds up fast when you consider that Motorola is just one company attempting to enforce its patents. Qualcomm's portfolio of patents on 3G and 4G has led to the company charging royalties upward of 5% on phone prices.

The troubling outlook on Apple's gross margins
Rising cost of sales are most troubling because they can quickly wipe out earnings growth even if a company's sales are exploding. The table below shows Apple's sales and earnings growth projected by analysts for next quarter, relative to its recent history.

Growth from prior year

 Metric

Quarter Ended September 2011

Quarter Ended December 2011

Quarter Ended March 2012

Quarter Ended June 2012

Quarter Ended September 2012

Quarter Ending December 2012 (Projected)

Sales Growth

39%

73.3%

58.6%

22.6%

27.2%

17.7%

Earnings Growth (EPS)

52.1%

115.7%

92.6%

19.6%

23.1%

(4.1%)

Gross Margin

40.3%

44.7%

47.4%

42.8%

40%

36%
(Apple guidance)

Source: S&P Capital IQ. Company estimates.

Your eyes aren't fooling you: In spite of almost certainly record-breaking demand for iPhones and iPads, the company is expected to post earnings that are in decline this holiday quarter.

The reason for this situation is simple. When Apple last released earnings, it offered guidance for investors next quarter that pointed to deteriorating margins. Apple is notorious for low-balling investors with guidance it easily crushes, but its forecast was low enough that it put outsized focus on a topic that's constantly wondered about in the tech world: How long can Apple keep up its huge margins as it faces a sea of competitors getting cheaper and cheaper?

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