Apple FQ4 16A – Margin gadfly

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Margin pressure from product mix is not a problem. 

• Apple reported results that broadly met expectations although slight weakness in profitability is an indicator that some users are buying the cheaper iPhone 6s rather than the 7.
• FQ4 16A revenues / EPS were $46.9bn / $1.67 compared to consensus at $47.0bn / $1.66.
• Apple sold 45.5m iPhones which was in line with consensus at 45.0m but pricing was weaker than expected at $619 compared with consensus at $625.
• Mac shipments fell 14% YoY 4.9m units mostly due to the overall weakness in PCs and iPad was also weak declining 6% YoY to 9.2m units.
• Guidance was mixed with FQ1 17E revenues / gross margins expected at $76bn-$78bn / 38.0% – 38.5% compared to consensus at $75.4bn / 38.9%.
• It is the miss on gross margin that has triggered the disappointment as a combination of higher overall revenue bringing greater scale benefits and a full quarter of the iPhone 7 should help profitability more than Apple is indicating.
• This is especially the case as improving costs was the main reason for FQ4 16A gross margin strength which came in at 38% at the top of the guided range of 37.5%-38.0%.
• Although Apple remains supply constrained on the iPhone 7, I suspect that the reality is that there is a slight mix shift towards the older and cheaper models.
• Despite the new colours and no headphone jack, the new iPhone is not very different from last year’s model and the ecosystem experience for the consumer is the same as they run the same software.
• Furthermore, I think that some consumers are put off by the lack of a headphone jack which could be driving them to upgrade their older models to the iPhone 6s rather than the 7.
• Older devices have lower gross margins than new devices as the price falls more quickly than the cost to make them which could be responsible for this slight weakness.
• Overall, the weakness is very slight and Apple is continuing to increase the number of users that it has in its ecosystem.
• This is critical for its long-term outlook which I think remains pretty rosy as Google’s Android is still unable to offer much to induce users to switch away from iOS.
• Gross margin variation due a mix shift is a normal factor in every business and this is what I think Apple is dealing with.
• Gross margin pressure from competition is a far more serious problem and with Samsung is disarray and no real competitive threat from Google, I do not see this happening in the short-term.
• The net result is a company in a commanding position but one that is struggling to find growth as it has high share in the segments that it addresses which are themselves increasingly saturated.
• I do not see Apple going to lower tiers to find growth but instead it is looking for new product categories.
• Of these there is little sign meaning that the medium term is likely to be one of very low growth but mighty cash flow generation.
• For an income investor, this is a great place to be but anyone looking for short term capital growth should probably look to Microsoft, Tencent or Baidu.