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Apple: Excessive Providers Margin Deceptive

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When it comes to the future of technology giant Apple (AAPL), everyone likes to talk about the company’s services business. While this segment probably has the best long term growth potential currently, there are often some misconceptions here, primarily in regards to the segment’s high margins. Today, I want to examine this issue, because I don’t want investors relying on it to make their primary investment decision.

First of all, it is true that the services part of the business reports a higher gross margin percentage than the products side. Apple started breaking out these margins earlier in this fiscal year, so we only have two data points and their prior year counterparts. Also, as I discussed at the most recent earnings report, Q2 services margins didn’t show as much growth as Q1’s giant leap, which may have helped to fuel this overall margin overreaction.

At the moment, it’s also slightly hard to look at the services segment in a true light, just because Apple reclassified its revenue reporting. As I discussed in a previous article, this really boosted fiscal 2018’s service revenues for each quarter, making this year a much tougher growth comparison. It also makes looking at longer term trends a little harder, because you are making an apples to oranges comparison, no pun intended.

So what I did for the charts below is go through Apple’s reported SEC filings going back to fiscal 2012. The company has reported two quarters of its fiscal year so far this year, so the charts below only represent the first half of the detailed fiscal period. On the left is the percentage of total revenues coming from the services line, while the right chart shows Apple’s overall operating margins for the six month period.

(Source: Apple 10-Q filings, seen here)

Keep in mind that at less than 10% of revenues for a number of years, Apple’s services segment likely didn’t have a dramatic impact on overall margins. One good or bad iPhone year could have had a much more significant impact on overall results, just like we saw in the Christmas 2018 fiscal quarter. The key point here though is that operating margins are not what they used to be.

Now the reason that I say Apple’s high services margins are misleading is because everyone focuses on that gross margin number. Unfortunately, that only tells part of the story, because we don’t know how much is spent on the operating side. There are many companies out there with high gross margins that spend a lot more on operations, and perhaps even lose money. Let’s look at a few specific examples.

I cover BlackBerry (BB) quite a bit on this site as my readers know, and it reported fiscal Q1 results last month. The company reported a gross margin percentage of 71.7% in the period, and that was actually below some prior periods like one that topped 80% recently. The company’s total cost of sales was just $70 million in this period. However, it reported over $240 million of operating expenses, which actually meant the company reported an operating loss for the period! For BlackBerry, this has been the case for several quarters, yet management and its supporters continue to talk about high gross margins as if they are extremely important.

Another good example is credit card company Mastercard (MA). According to Yahoo! Finance statistics seen here, this name has a gross margin percentage over the past twelve months that’s just under 98%. That means that there is almost no cost of revenues, but operating the business is another story. Yahoo shows the company’s operating margin at 57%, a much different number than the nearly pure profit number reported for gross profit percentage.

So let’s circle back to Apple now. In the first half of fiscal 2012, operating expenses represented 7.65% of the period’s revenues. Since that time, operating expenses have risen by 161%, while total revenues have only increased by 66%. That results in operating expenses as a percentage of revenues jumping quite a bit as seen below.

Just take a look at the current quarter’s guidance to see how this evolves over time. Management is calling for revenues of $52.5 billion to $54.5 billion, as compared to $53.265 billion a year earlier. Operating expense guidance is expected to be in a range of $8.7 billion to $8.8 billion, compared to $7.8 billion last year. Even if we do see the company report some revenue growth, operating expenses will likely rise at a much faster pace. Holding all else equal, that means that operating margins will decline.

As I mentioned above, operating expenses are only part of the picture. We can say the same thing about gross margins, other income items, tax rates, etc. Apple recently was able to pad a decline in certain margin lines when we got to the bottom line thanks to tax cuts, but we’ve started lapping those periods now. The earnings per share numbers are also boosted by the buyback, which at times has overshadowed net income declines.

I don’t want readers to get the impression today that I am bearish on Apple or claiming the company is doing anything wrong. Those thoughts couldn’t be further from the truth. What I wanted to do is to educate those on this situation just because it doesn’t show the whole picture. As the examples I showed above definitely detail, companies can have substantial gross margins but that’s because operating expenses are the key item. It’s not wrong to invest in Apple today because of the potential of the services business continuing its strong revenue growth in the future, but investors should realize that doesn’t necessarily mean profits will soar in step.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.

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