Well, It Looks Like One Of Apple's Biggest Risks May Be Starting To Hit Home...

tim cook

Photo: AP

One of the biggest risks to Apple’s stock price and profit growth, ironically, stems from one of the company’s most amazing strengths:Its shockingly high profit margin.

Profit margins for hardware companies are normally in the single-digits, because hardware is generally a brutally competitive business. The big profits, meanwhile, have gone to the software providers–like Microsoft–which have low cost-of-goods sold and can sell the same product to different hardware manufacturers.

By building integrated hardware and software devices, however–and achieving enormous scale and market share–Apple has turned this normal relationship on its head.

And with the mind-blowing success and profitability of its biggest product, the iPhone, Apple’s profit margin has steadily increased–to the point that its margins now blow away those of most software companies.

Here’s a chart from Y Charts showing the steady increase over the last couple of years through March of this year:

Apple profit margin

Photo: Y Charts

Those margin gains have helped Apple’s stock price blast to $600 and beyond… because there’s nothing the market likes more than a fast-growing company with expanding margins.

But all good things usually come to an end, and margin expansion has to stop–if not reverse–somewhere.

One of the big risks for Apple’s future stock performance, therefore, is the threat that its profit margins will now either peak, or, worse, begin to decline.

And there are many reasons to think that that may happen sooner rather than later:

  • Apple’s profit margin has now hit an amazingly high level for a hardware company, and nothing goes up forever (especially profit margins). Apple’s margin is now nearly 30%, after tax. This is nearly unthinkably high.
  • The competition is getting much, much better. Apple is able to generate this profit margin because it usually has the highest prices and lowest unit costs in the industry. But the latest generation of phone from Samsung is arguably better than Apple’s current iPhone (which may be part of the reason for Apple’s weak iPhone sales this quarter) and Google’s latest tablet, meanwhile, is getting rave reviews–and will sell for half the price of the low-price iPad.
  • Apple’s sales mix is shifting toward lower-priced products. One of the reasons for Apple’s weak June-quarter results and low margin guidance for the September quarter is the mix of iPhone and iPad sales. Both products are seeing a higher percentage of unit sales coming from lower-priced versions than the state-of-the-art versions. This suggests that price will become more and more of an issue, especially with smartphones and tablets further penetrating the mass market and the competition rapidly improving.
  • The next 1-billion smartphone and tablet buyers are going to be much more price-sensitive than the first 1-billion. There are now about 1 billion smartphones in the world, out of a total of about 6 billion cell phones. Smartphone growth, therefore, will continue apace–but the incremental buyers are likely to be much more price sensitive than the first generation. Why? Because they have a lot less money.
  • The iPad is accounting for a bigger and bigger share of Apple’s overall revenue–and iPad margins are lower than iPhone margins. The average selling price of the iPad also dropped sharply year over year, on account of the mix of lower-priced and higher-priced versions. Apple’s iPad unit sales jumped 84% year over year, but revenue only rose 52%.
  • Apple may be planning to roll out a new smaller table to compete with the Kindle and Google’s Nexus 7, both of which are priced at $200.  It seems highly unlikely that Apple will generate the same profit margin on this device than it does on the current iPad.

Put all of this and other important factors together, and we have just seen the first quarter in recent history in which Apple’s profit margin declined year over year, albeit very modestly. (Given the shortfall in iPhone sales, it’s actually remarkable that Apple’s margin didn’t decline even further).

Specifically, Apple’s profit margin declined to 25% in the June quarter, versus the 25.5% posted last year.

There were also several seasonal and macro-economic factors that hurt the company this quarter–namely the upcoming product transition to the iPhone 5 and economic weakness in Europe. And the company’s margin will likely leap again in the December quarter, after the iPhone 5 arrives.

But, overall, it seems as though big clouds are gathering with respect to the outlook for Apple’s future profit margins. And that risk will continue to weigh on the stock price. Because as much as the market loves expanding margins, it loathes contracting ones.

SEE ALSO: The Europe Mess Just Hammered Apple–Or Is It A Deeper, Darker Problem?

Watch Below: Is This A Real Change For Apple Or Is It Just A Blip?


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