Apple Shows Massive Cost Saving

Apple (AAPL) has been able to keep costs under control in the recent cycle. A recent teardown by IHS has shown a marginal increase in bill of material, BOM, compared to last year’s iPhone X. While the retail price of the iPhone XS Max has increased by $100 in comparison to the iPhone X, the BOM has seen only a $20 increase. The BOM cost for the iPhone X was $370 while the BOM cost for the iPhone XS Max is $390. Hence, the BOM makes only 35.48% of the total cost in the iPhone XS Max. In the iPhone X, this percentage was 37%.

Despite a higher SDRAM and a shift to 7nm processor technology, the cost increase has been quite low. The same report mentions that a Samsung Galaxy S9+ had a BOM of $375.80 with a retail price of $840. This shows that the S9+ had a much higher BOM cost of 44.73%. In addition to better margins on the iPhone XS Max, Apple is also reported to be performing better than last year’s cycle in terms of unit sales. This should certainly provide a strong tailwind to overall margins of the company. It is possible that Apple is able to break its eleven-quarter streak of falling year-on-year operating margins.

Better pricing

Many analysts believed that Apple would go with a lower pricing in this iPhone cycle. The upward price move was a bit of a surprise but it has helped Apple improve its gross margins in this segment. We can see from the IHS teardown that there has been over a 150 basis-point of improvement in the BOM margin of the XS Max compared to the iPhone X of last year. The touchscreen display cost is the biggest component in the overall BOM. This year, the display cost has remained close to last year’s cost of $120, even though the screen size has increased.

Apple cost savings on Xs Max

Fig: Major bill of material components in the iPhone XS. Source: IHS

Before the launch of this iPhone cycle, many reports suggested that Apple will maintain the $999 price level for its most expensive model. At this price range, the BOM of the XS Max would have increased to 39% of the retail price. All eyes are now on the unit sales generated by XS models and the reception of the XR model. Between the XS and XS Max, it seems that the XS Max has the upper hand. The incremental price is only $100 and many customers have a preference for bigger screens. This is especially true in China where bigger screens help in easier navigation of one-stop ecosystems.

It would be important to see if Apple can keep up this improvement in the XR model. The teardown of the XR model by IHS will happen within a week of the launch of the device. Although the XR model has a retail price which is $250 less than the XS model, several component costs would also be much lower for Apple. The biggest cost saving would be on display.

The cost of an LCD display is usually around $40-$50 which gives a cost saving of $70 from the OLED version. Another big component cost is the camera. In the XS Max, the camera cost is $37.60. The XR will have a single rear camera while the XS has a second telephoto lens. If the XR’s BOM cost is 36% of the retail price, the XR would have a total component cost of $270. This is $120 less than the XS Max.

Most of the projections estimate that the XR would corner over 50% of total unit shipments in the current iPhone cycle. There is a historical trend to support this forecast. CIRP estimated that the iPhone X sales were less than 20% of the total unit sales in June. This trend could be repeated in this cycle, which should boost the sales of the lower-priced XR. Hence, it would be very important to see the BOM of the XR and the level of cost saving which Apple can deliver in this model.

Source: CIRP

Growth in Services and margins

The Services segment has been showing good growth rate for the past few quarters. The trailing twelve months revenue from the Services segment is over $35 billion. Even at this level, Apple is able to deliver over 30% YoY growth in this segment. However, the Services segment is made up of revenue streams from several different businesses with huge differences in margins.

For example, it includes revenue from both the App Store and Apple Music. According to estimates, the App Store has a gross margin of close to 90% while Apple Music has a gross margin of 15%. Faster growth in lower margin businesses will improve the overall growth rate of the Services segment, but will not help in increasing the margin.

This is one of the reasons why Apple’s operating margin has been falling for the past eleven quarters.

Fig: Fall in operating margin of Apple on a YoY basis for the past eleven quarters.

The product mix in the Services segment will further shift towards lower-margin businesses as Apple grows its digital content offerings. Hence, it is very important that the iPhone segment continues to show improvement in gross margins by keeping the BOM under control. Investors should also note the sales mix within the iPhone segment. We can see from the CIRP image that there was a considerable decrease in the percentage share of the latest models compared to earlier cycles.

In this image, the latest models made close to 50% of total sales in June 2018 while in the earlier cycle, the latest models made over 80% of total sales mix. Apple has reduced the number of iPhone models available in this iteration. This should give the flagship models a better chance to improve their percentage share.

If Apple can limit the bill of materials for its iPhone XR model, we could finally see a break in the falling operating margin trend.

Investor takeaway

Apple has shown an improvement in BOM for the iPhone XS Max model according to a recent teardown by IHS. The BOM of this model is 35.48% of the retail price compared to 37% for the iPhone X in the last cycle. Apple could show a similar improvement in the XR model by controlling the cost of display and camera. If the sales mix in this cycle moves heavily towards the newer models, we should see significant improvement in margins from Apple.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.