Chinese wage growth hurts Apple's margins and limits upside

• Risk in Apple is increasing as wage growth eats into margins
• High revenue growth not equal to high earnings growth anymore
• Stock price potential is becoming more limited
  
  

I have on several occasions pointed out that Apple (NASDAQ:AAPL) is really a hardware producer rather than a media or software company. This has very important implications for what to expect from Apple’s margins in the medium to long term. I see a substantial risk of a disappointment in Apple's 2013 earnings growth based on wage pressure in China and increasing component expenses. In this article I will look into the wage growth risk.

All in all investors should become more alert as Apple is no longer a one way ticket higher. If earnings growth is questioned then the market will also question valuation going forward.

What is going on in Gross Margins?
We have seen Gross Margins rapidly declining from 47.1 percent in March 2012 to 38.9 percent in September 2012, see chart 1. I have seen several arguments concerning new chip sets taking a toll on margins, but in the big picture this is actually a minor element.

Over the history of Apple's Gross Margin trend since 2001 there have been rising Gross Margin periods and also some periods where margins markedly declined. Take note for example of the periods after June 2007, December 2009 and March 2012 and after brand new product launches. In June 2007 the first iPhone was released and it was like nothing Apple had made before. In spring 2010 Apple launched the iPad, a complete new product range. Apple launched the new iPad in March 2012 and I am a bit reluctant to pin the declining Gross Margin on this event. Upgrades of existing product lines have historically not altered the Apple's Gross Margin development, as shown in chart 1. Some of the effect could stem from larger Bill of Materials (cost of components) in the new iPad combined with a lack of price increases. But Bill of Materials cannot account for the whole decline.

Wage increases are haunting Apple now
I see wage increases at Foxconn, Apple's manufacturer, which is located in mainland China, as the primary reason for the decline in Gross Margin now. I assume that in the following calculations wages comprise 15 percent of Cost-of-Good-Sold (COGS). In step 1 to the left in table 1 is a proxy for Apple's revenue and cost structure. USD 100 in revenue must cover 56.3 percent in Cost of Goods. That leaves a 43.7 percent Gross Margin. Selling, General and Adminsitrative (SG&A) costs eat 8.6 percent of sales which leaves 35.1 percent Profit-before-Tax (PBT). Tax is around 25 percent and this results in a Net Profit of 26 percent per good sold.

In step 2 Cost of Goods Sold is split between materials (85 percent) and wages (15 percent). This is equal to USD 8.5 per USD 100 of revenue.

Wage increases
In early 2012 there were riots at some Foxconn factories and this attracted attention to working conditions and wage levels. Since then there have been a series of wage increases and more are coming in 2013. These represent quite substantial changes.

In early 2010 the average monthly wage per worker at Foxconn was about Yuan 900 Yuan or USD 145 a month and after a 25 percent wage increase in February 2012 this amounted to around Yuan 2,100 or USD 340. This is the equivalent of about a yearly increase of more than 50 percent for two years in a row. A further 100 percent wage increase will come in 2013 if Foxconn CEO Terry Gou keeps his promise, taking the average monthly wage per worker to Yuan 4,400 or USD 700. A wage increase of this size would set Foxconn mainland China wages on par with Taiwan which makes the proposal credible.

Going back to table 1, step 3 increases the wage component by 50 percent (average if 100 percent is met by the end of 2013). Only the wage component is changed to highlight the effect. The Cost of Goods Sold would increase to 60.5 percent and this would lower the Net Margin to just above 24 percent, down from 26 percent, as seen in the lower right corner of table 1.

Earnings are hurting
Consensus expects Apple to generate USD 192 billion in revenue for the 2013 fiscal year and also a Net Margin of 24.7, equivalent to a USD 47.5 bn net profit, see table 2. This corresponds to an earnings growth of 14.1 percent. But assuming wages take a big chunk of Net Margins, as highlighted above, then Net Margin would decline to 22.9 percent and result in a Net Profit of USD 44 bn. This is equivalent to only 5.7 percent in earnings growth.

Consequences
When investors begin to understand that Apple probably has seen the best of very cheap production in China and that earnings growth will be substantially less than revenue growth then valuation will be contested. Apple is not a “sure” buy anymore. Investors should expect the volatility and therefore beta to increase going forward as investors will become less aligned.

Conclusion
This is one of a number of articles digging into what is important for Apple investors to understand going into the fiscal 2013 year. Investors will become increasinlgy aware of how much of Apple's revenue is based on hardware and what this means for earnings and valuation.

These initial calculations highlight that wage growth is putting pressure on Apple and this will probably continue even after 2013 as China is changing. Maybe valuation looks on the low side at 11.5 times consensus earnings but given that my calculations are right then P/E increases to 12.5, calculated on a stock price of USD595.

 See also:

1. Is Apple like Mircosoft or more like Samsung or Nokia?
2. iOS6 and the implications for Google, Facebook, Skype etc
3. No iPhone high 5 but coupled with 4s Apple stays strong
4. What are analysts saying about its stock after iPhone5?
5. Apple maps mishap shows management comes before vision now

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