What’s Really Behind Apple’s Extraordinary Profits
Business partnerships with Apple Inc. (Nasdaq: AAPL) produce abundant profits – but usually only for Apple.
Using its clout as a vendor of highly desirable consumer technology, Apple secures extremely favorable deals with suppliers, providers of goods and services, and retailers.
Such deals are a major reason behind Apple’s extraordinary profits.
“Can Apple continue to roll through industry after industry, soak up all the profits, and leave everything it touches as a smoking wreckage?” Craig Moffett, an analyst at Sanford Bernstein & Co. told the Los Angeles Times.
Despite increases in business volume, many companies that deal with the Cupertino, CA-company discover it’s usually a one-sided relationship when it comes to profits.
Apple has, in effect, become the technology world’s “vampire squid” — a term coined by Rolling Stone Matt Taibbi in 2009 to describe Wall Street behemoth Goldman Sachs (NYSE: GS).
An Apple Deal Carriers Can’t Refuse
Apple’s relationship with the U.S. wireless carriers – namely AT&T Inc. (NYSE: T), Verizon Communications Inc. (NYSE: VZ) and Sprint Nextel Corporation (NYSE: S) — is Exhibit A.
Such deals help explain how the iPhone eats up 75% of the global share of mobile phone profits despite having just 9% of the global market share for cell phones.
While each carrier has attracted new customers by selling the iPhone, the monthly revenue from their contracts has not been enough to make them as profitable as customers who buy less expensive phones made by non-Apple vendors.
AT&T, the first carrier to offer the iPhone, has been hit hardest.
The company’s operating margins from the fourth quarter – a blockbuster quarter for the new iPhone 4s model – shrank to 15% from 22.9% year over year.
“The AT&T wireless model is broken,” Kevin Smithen, a wireless analyst at Macquarie Securities, told the Los Angeles Times. “AT&T is basically subsidizing Apple’s revenues and profit growth.”
Verizon, which started to offer the iPhone last year, hasn’t fared any better. Its EBITDA (earnings before interest, taxes, depreciation, and amortization) margin, a measure of operating profitability, fell from an average of 46.4% per quarter in 2009-2010 to 42.2% in the December quarter.
Sprint didn’t start selling the iPhone until late last year with the launch of the iPhone 4s. After selling 2 million iPhones in the December quarter, Sprint’s adjusted wireless margin dropped from 16% a year ago to 9.5%.
“A logical conclusion is that the iPhone is not good for wireless carriers,” Mike McCormack, an analyst at Nomura Securities, told CNN Money. “When we look at the direct and indirect economics that Apple has managed to extract from the carriers, the carrier-level value destruction is quite evident.”
And yet no carrier has any plans to stop selling the iPhone because they fear losing customers. The most recent convert, Sprint, had found the No. 1 reason it was losing customers was because it did not offer the iPhone.
“It comes down to, ‘Do you want to be with them or bet against them?’” Sprint CEO Hesse told CNN Money.
Apple Takes a Bite From Retailers
Retailers such as Best Buy Co. Inc. (NYSE: BBY) and RadioShack Corp. (NYSE: RSH) have also struggled to make money selling Apple products.
Best Buy sells iPhones and iPads in its stores, but makes far less money on them than for rival products running Google Inc.’s (Nasdaq: GOOG) Android operating system.
For example, Best Buy will earn about $100 from each iPhone, but as much as $300 on a similar smartphone running Android. That translates to a profit margin of 100% on an Android phone versus only 17% on an iPhone.
“The profit margins on Apple products are thinner than other products, whether you are talking about an iPod versus another MP3 player, whether you are talking about an iPhone versus Android or BlackBerry handsets,” Anthony Chukumba, an analyst with BB&T Capital Markets, told Reuters.
The story is much the same at RadioShack; thinner margins on Apple products have pinched overall margins.
And of course the profit starved from the retailers is funneled back to Apple.
“There is just not a whole heck of a lot that a Best Buy or a RadioShack can do about it,” Chukumba said. “They have to carry Apple products from a sales perspective, a relevance perspective, and a customer traffic generation perspective.”
Apple Squeezes the Supply Chain
But Apple doesn’t reserve its profit pressure just for resellers. Companies on the other end – Apple’s suppliers – feel the pinch as well.
One of the uses for Apple’s nearly $100 billion stash of cash is to lock up vast quantities of components to ensure there are no hiccups in the production of millions of iGadgets each quarter.
Suppliers find that sort of cash almost impossible to resist, even when one of the conditions is lowering the price per component. And Apple uses its cash clout throughout its vast supply chain.
“Operations expertise is as big an asset for Apple as product innovation or marketing,” Mike Fawkes, a former supply-chain chief atHewlett-Packard Co. (Nasdaq: HPQ)and now a venture capitalist with VantagePoint Capital Partners, told Bloomberg Businessweek. “They’ve taken operational excellence to a level never seen before.”
Perhaps the best illustration of how Apple extracts profit from its suppliers is in NAND flash memory. Flash memory is used in virtually every Apple product, from Macs to iPods to iPads.
That’s a lot of memory; in fact, Apple purchases 23% of the world’s flash memory every year. With that kind of volume, it gets great deals. But the company can turn around and sell its hardware at a premium.
More importantly, the pricing grids for its mobile computing products are based on upgraded memory. You can bet that Apple pays far less for that 16 gigabyte upgrade than the $100 it charges customers.
“Apple earns nearly twice as much from reselling NAND than all the NAND suppliers combined, with NAND resale responsible for 20% of Apple’s total operating profits last quarter,” wrote Sanford Bernstein analyst Toni Sacconaghi in a recent note to clients.
Doing the math, NAND memory resales accounted for more than $3.4 billion of Apple’s $17.4 billion of operating profit last quarter.
And what Apple does to suppliers and retailers isn’t even the whole story.
For instance, Apple takes a 30% cut of every digital product sold from the iTunes Store, which includes songs, videos and books.
Even Google isn’t immune from the Apple vampire squid.
Macquarie Capital analyst Ben Schachter estimates that of the $1.335 billion in revenue Google earns from searches on Apple devices, it keeps just $335 million. The rest — $1 billion — goes to Apple.
“They’ve done it with music and handsets, and now they’re doing it to the carriers,” Sanford Bernstein’s Moffett told the Los Angeles Times. “The hard part is trying to figure out exactly what’s going to stop it.”
– David ZeilerSource: Money Morning
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