Uh Oh! Is Apple Inc.'s iPhone Margin About to Drop?

By Markets Fool.com

Analyst Rod Hall recently put out a research note (via Barron's) suggesting that Apple's (NASDAQ: AAPL) upcoming iPhone 8 smartphone will carry lower gross profit margin than this year's iPhone 7 series smartphones.

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Image source: Apple.

Hall reportedly suggests that this margin degradation could be driven by a couple of factors. The first is that Apple's average selling prices may be set to come down due to the transition from an all-metal casing to the rumored "glass sandwich" design.

Apparently, Hall's fellow analyst Narci Chang says that "the market believes that the reduction in viewable metal area implies a lower [average selling price]."

Second, Hall expects that this "all-glass" design will be more expensive to produce due to a "20% increase in CNC machine hours" to produce the chassis.

"We think the [average selling price] for the next iPhone metal casing will stay at a similar level to iPhone 7/7 Plus on a like-for-like basis, but the 'blended' [average selling price] will rise as blended size becomes bigger," the analyst writes.

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Let's take a closer look at this to determine if Apple shareholders should worry.

What if Apple's iPhone gross profit margin dropped by 2%?

Let's suppose for this analysis that Hall is right and Apple's iPhone gross profit margin comes down some during the next product cycle. Let's further suppose that the margin reduction is about 2% and that in the coming product cycle, Apple's average selling prices stay flat (something that I believe is unlikely, but bear with me).

During fiscal year 2016, Apple sold 211.884 million iPhone units for $136.7 billion in revenue, implying an average selling price of approximately $645. Let's also suppose that Apple's average iPhone gross profit margin is about 45% (Apple doesn't break this out, but I assume that iPhone gross profit margin is better than corporate average of around 40%).

Based on these assumptions, Apple generated about $61.52 billion in gross profit from iPhone sales in fiscal year 2016.

A 2% reduction in iPhone gross profit margin percentage would translate into $58.781 billion in total gross profits, or a reduction of about $2.74 billion.

It may look as though Apple shareholders need to start bracing for a real drop in Apple's profitability, but that's not necessarily the case.

Balancing the revenue/margin equation

If Apple were to ultimately design its next-generation iPhone to carry a lower gross profit margin than the current ones, then it would likely only do so if the company felt that the added costs would make for a more compelling product.

Indeed, if Apple takes a 2% hit on iPhone gross profit margin, but winds up generating 10% more iPhone revenue than it did in the previous generation because of the new features, then Apple's total gross profit still moves up and ultimately garners higher net income for its shareholders.

It's worth pointing out, though, that significant cost structure increases can't be implemented lightly. Apple needs to have a high degree of confidence that the higher cost structure will translate into significant revenue growth to ultimately drive better profit growth than it'd be able to achieve with cheaper-to-build products.

Is a margin reduction guaranteed?

At this point, I don't think it should be taken as a given that Apple's iPhone margin next year will come down. After all, even in the face of a higher bill of materials, Apple could increase its selling prices to compensate.

Apple could also put the squeeze on its suppliers, ultimately hurting their margins to preserve Apple's. That's one of the reasons that Apple likes to have multiple sources for critical components -- more suppliers means greater leverage on Apple's part.

Having said all that, there's just not enough information available right now (either on the cost structure or on Apple's expected pricing) for anybody to be able to reliably predict changes in Apple's iPhone gross profit margin in its upcoming product cycle.

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Ashraf Eassa has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.