Apple 2.0

Covering the business that Steve Jobs built

The cost of 14 million iPhones

October 19, 2010: 9:02 AM ET

Apple must have paid a heavy penalty to ramp up production so rapidly

Source: Company reports

Two of the biggest surprises in Apple's (AAPL) Q4 earnings report Monday were the sharp rise in the number of iPhones Apple sold in the quarter (14.1 million, up 91.4% year over year) and the drop in a key measure of the company's profitability: gross margin (GM), which dropped to 36.9 from 39.1 last quarter.

The two are related, suggests Financial Alchemist's Turley Muller, a blogger-analyst whose estimates regularly beat the professionals (see here and here).

"Where in the hell did Apple get that production capability?" Muller asks rhetorically in an e-mail sent overnight. "There is no way Apple could have turned out 14.1M units without materially added expense."

"I surmise Apple paid through the nose to escalate the ramp; given the new form factor there would be considerable MOH (overhead) costs related to casting new molds, tooling, new machinery, etc. In short, relatively more human involvement and capital investment. However, this should abate significantly. I will remind you that the 3G first Q had a GM of about 46-47%, yet if rose in subsequent periods to north of 60%. The 3GS benefited from no change in form factor, thus the molds. tooling, assembly process didn't change.  iPhone 4 required a significant modification to the production process. (Foxconn CEO mentioned having to order thousands of specialized machines not found anywhere else around the globe.)"

Muller also has a theory about why the iPad numbers were so low.

Photo: Apple Inc.

"I can envision a scenario where Apple would desire to announce lower iPad units just to keep entrants from salivating. Apple knows adoption is occurring. and occurring at a pace much greater than the typical curve. Keeping competitors apprehensive and hesitant will allow Apple to capture more market which subsequently translates into lock-in due to the Apple ecosystem.  Then it becomes too late for competitors all together.

"Take iPod for example -- very expensive, only worked with Macs (latest with firewire). Then USB solution came, but still PCs didn't have iTunes, thus significant work arounds required. Nobody took Apple seriously on iPod -- too expensive & minute addressable market.

"Couple, three years later -- all in rapid succession -- Apple releases iTunes for Windows, iTunes Music Store, cut prices and introduced the iPod mini. Within 9-12 months iPod share exploded from 20-30% to 70-80%. Just like that Apple had sewn it up. It was too late for competitors. None of any valiant attempts were able to dent iPod share thus they folded their hands in concession. iPod created a new market.

"I think Apple views the iPad market similarly. An integrated ecosystem will drive adoption, but Apple wants to downplay the opportunity so that potential entrants will deem the segment to be a niche, hence too small to vindicate establishing a presence."

[Follow Philip Elmer-DeWitt on Twitter @philiped]

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About This Author
Philip Elmer-Dewitt
Philip Elmer-DeWitt
Editor, Apple 2.0, Fortune

Philip Elmer-DeWitt has been following Apple since 1982, first for Time Magazine, and now on the Web for Fortune.com.

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