The Power Of Branding: Apple (AAPL) iPhone’s Extraordinary Margins

Software is supposed to be a high margin business and hardware a sector in which most companies struggle with gross margins. Hardware components are expensive and there is almost no getting around that.

Apple (AAPL) does not live by the rules that the rest of the tech industry does, so it may not come as a surprise that research firm iSuppli says that it only costs $178.96 to make the new 16GB iPhone 3G S. Most industry experts report that carriers like AT&T (T) pay $600 for the units.  The iPhone has a 71% gross margin.

The iPhone’s profitability, which is probably unique in the handset industry, is a testament to the power of branding and the ability of well-developed brands to get premium prices. Apple has long been on the Interbrand list of the world’s 100 most valuable brands. It was valued at almost $14 billion last year, up 24% from 2007. The only other name on the list that posted a bigger gain than Apple was Google (GOOG).

Shareholders reward Apple by trading its stock at a level which values the company at 3.6 times sales. That is a “software company” valuation. Microsoft trades for 3.4 times sales and Oracle (ORCL) for 4.4 multiple.
Apple shareholders showed some initial concern when the company attacked the cell phone industry. Even industry giant Nokia (NOK) has modest margins. Apple’s management probably knew that the halo that the Mac and iPod had created could extend to another line of business, and they were right. The premium pricing that Apple gets for the iPhone could not be duplicated by any of the other firms in the industry, probably not even RIM (RIMM), the developer of the Blackberry.

The recession is less likely to do damage to Apple than it is most other companies. Consumers are willing to save money or use credit to buy something that they believe is a symbol of themselves, their class, character, or taste. The iPhone falls into that category. It is probably the same reason that Mac are sold for such high prices.

Apple’s enemy is not the economy, but, to some extent, its own success is. Apple can clearly count on significant growth in its handset business even if the BlackBerry and new Android-powered smartphones do well. Weaker companies in the industry like Sony Ericsson and Motorola (MOT) will continue to lose sales.

Mac and iPod revenue are almost certainly flattening out now. The iPod has already shown a leveling of sales as it reaches what is likely to be a point of market saturation. The Mac has been taking share from PC companies, but that trend has slowed and may be over. Dell (DELL), HP (HPQ), Lenovo, and Acer are all created new products and going to market with aggressive pricing.

Apple does not have a clear path to a next act. The TV screen and set-top box markets are huge, but, as Sony (SNE) has found, these parts of the consumer electronics markets are becoming commoditized.  Apple has a TV product, but it has not sold well. That leaves the video game market. Apple would have to decide it is willing to go up against Sony, Microsoft (MSFT), and Nintendo. Jobs and his company had the foresight and the gambler’s instincts to take on RIM, Nokia, Samsung, and a half a dozen well-funded and relatively large companies in the handset industry. The Apple video game console can’t be more than a year away.

Douglas A. McIntyre