Could rising iPod sales hurt Apple's margins?

SAN FRANCISCO (Reuters) - Apple Computer Inc has a runaway hit with its market-leading iPod digital music player, but could the device's success actually hurt the company's profitability over the longer haul?

"It's an excellent question," said Shaw Wu, an analyst at American Technology Research, who estimates the gross margin average of all iPod models is about 22 percent, narrower than the margin earned on its higher-end Macintosh computers. "You look at last quarter, their gross margin went down a bit sequentially."

Gross margin, or the percentage of revenue left after subtracting product costs for Apple in its September-ended quarter was 28.1 percent, narrower than the 29.7 percent in the June-ended quarter. Gross margin is one common metric analysts and investors track to gauge the health of a business and how much to pay for a company's stock.

As Apple's business shifts more to consumer electronics items like its iPod -- sales of iPods now account for nearly a third of total Apple sales -- that means the sales of its more profitable Mac computers make up less of the total.

"As music and iPods continue to outpace computer hardware sales we expect that shift to drive lower profit margins," said Deutsche Bank analyst Chris Whitmore. "But that will continue to translate into pretty strong operating-income dollars and earnings per share."

On 11 October, Apple reported a fourth-quarter profit that quadrupled to US$430 million as sales jumped 56 percent to US$3.68 billion and it sold 6.45 million iPods, the 10th consecutive quarter of sequential unit increases. In fact, due largely to the iPod's success, Apple has more than doubled its annual revenue in the last two years.

That torrid growth rate in has led to a 74 percent increase so far this year in Apple's stock price, after it tripled in 2004, leading to a stock that's highly valued relative to other fast-growing tech firms such as Dell.

Shares of Apple now trade at 32 times its estimated earnings per share for fiscal year 2006 ending in September, compared with Dell's price-to-earnings ratio of 17 times EPS for its fiscal year 2007 ending in January.

Factors that can help to push gross margin one way or another in a quarter include what Apple pays for flash memory chips, which are used in its recently introduced iPod Nano and the iPod Shuffle. Those costs will likely decline over time, analysts said, as more flash memory chipmaking capacity comes online in factories in Asia and elsewhere.

"As those costs go down, Apple's likely to respond by lowering prices because they're anxious to fend off competitors," said Roger Kay, principal of market research firm Endpoint Technologies Associates.

Although Apple has about 75 percent of the US market for all MP3 players, there is no shortage of portable music player makers vying to take share from the market leader, including products from Creative, Sony, Dell and others.

And being a consumer electronics company also brings additional risks, analysts said.

"Apple has now really become much more of a consumer electronics company and the dynamics in terms of the boom-bust cycle with consumers and their fickleness is going to create a challenge," said Barry Jaruzelski, lead partner in Booz Allen Hamilton's global technology and electronics practice. "How do they manage those much more aggressive upticks and downticks of demand in a way that pleases Wall Street."

But even as Apple's gross margin declined in the fourth quarter from the third and year-over-year, there are other things Apple is doing in its business that may hearten investors: it's spending less on research and development, sales and marketing and other costs as a percentage of revenue.

Operating income as a percentage of revenue in its most recent fourth quarter was 11.4 percent, more than double the 5.5 percent in the year-ago quarter, although down from 12.1 percent in the third quarter.

"Apple has offset the gross margin pressure by managing its business better," Wu said.

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