There has been a lot of focus recently on Apple's (AAPL) gross margins and how they have been declining. After reaching a high of 47.4% during Q2 FY 2012 (and an FY 2012 average of 43.9%), gross margins have steadily declined to 37.5% during the Q2 FY 2013 report. This article investigates what caused the gross margin decline, and what implications it has for future earnings reports.

Projected Gross Margins Based On Product Mix

The below chart shows what the projected margins for Q2 FY 2013 were using the segment gross margin estimates from 2012. As we can see, mix changes between the various segments have little impact on Q2 margins. The high-margin iPhone segment represented about 53% of Q2 revenues, versus 51% in FY 2012. The iPad segment represented about 20% of Q2 revenues, versus 21% in FY 2012. These changes in segment proportions were minimal and did not lead to the gross margin changes.

Based on the product mix for Q2 FY 2013, we would have expected gross margins of 43.95% if we used estimated FY 2012 segment gross margins. Instead, gross margins came out to 37.5% for the quarter. Some of this 6.45% difference in gross margin is due to the introduction of newer products with lower margins (iPhone 5 and iPad Mini) and price reductions on older products (such as the iPhone 4 and 4S).

Taking a deeper look into the financials however, we find that warranty accruals and depreciation and amortization account for a significant proportion of the difference.

Warranty accruals came out to 3.56% of revenue in Q2 FY 2013, versus 1.40% in FY 2012. Depreciation and amortization came out to 3.88% of revenue in Q2 FY 2013, versus 2.09% in FY 2012. Between the two items, they reduced Q2 FY 2013 gross margins by 3.95% compared to FY 2012.

That leaves a 2.5% decrease in gross margins that are attributable to reduced margins on the actual products, either due to reduced prices or increased component and manufacturing costs. A 3% decrease in gross margins for the iPhone and a 4% decrease in gross margins for the iPad would get us to that point. So going forward, we could use a 55% gross margin estimate for the iPhone and a 29% gross margin estimate for the iPad, with adjustments upwards as the products mature.

Warranty Accruals

The increase in the warranty accrual rate appears to be driven by a combination of increased warranty accrual rates for new products (as Q1 FY 2013 accrual rates were also elevated), plus changes to Apple's service policies. The latter item had an impact on retroactive warranty accruals to the amount of $414 million. If we subtract that amount from Q2 FY 2013 warranty accruals, we get $1.137 billion as the remaining total, which is 2.61% of revenues. We can use this number going forward, although there is a reasonable chance this percentage will be reduced as it gets more accurate with its estimates on the new products.

* As mentioned above, excluding warranty accruals related to previous periods would make Q2 FY 2013's warranty accrual rate 2.61%

Depreciation and Amortization

Apple has been making significant purchases of property, plant, and equipment recently, with nearly $10 billion spent in the last four quarters. This has led to some major increases in depreciation and amortization, which rose from $740 million in Q2 FY 2012, to $1.692 billion in Q2 FY 2013. Assuming that the rate of purchases remains similar, we'd expect depreciation and amortization to increase to around $1.8 billion in Q3 FY 2013. Since revenues are expected to be lower during that quarter, depreciation and amortization will make up a higher percentage of revenues.

Q3 FY 2013 Projections

Based on Apple's guidance in the Q2 earnings release, we have come up with a projection for Q3 FY 2013 earnings and revenues. Gross margin for the iPhone and iPad lines (excluding the impact of warranty accruals and depreciation and amortization) increases by 1% each from the assumed Q2 FY 2013 numbers. This reflects some improvements in costs with the existing products and no new products that would decrease margins. The warranty accrual is the same as Q2 and reflects the 1.21% increase against the old average from 2012. Depreciation and amortization is set at $1.8 billion and due to the lower revenues in Q3, it represents 5% of revenues, versus only 2.1% in FY 2012. We assume that revenue is slightly above the guidance range, and with the product mix below, gross margins should fit within their guidance range.

With the other information given in the earnings release, Q3 EPS is estimated at $7.45 assuming that buybacks during the quarter keeps the number of shares outstanding constant. Share buybacks could potentially reduce the number of outstanding shares by 5-10 million.

Projections For The Future

Since depreciation and amortization has increased significantly, it reduces the chance that Apple can generate 40%+ gross margins for the foreseeable future. As we have seen above, in a $36 billion revenue quarter, increases in depreciation and amortization can knock off nearly 3% from gross margins from FY 2012 levels, and the changes to warranty accruals reduce gross margins by another 1%.

However, the effect of depreciation and amortization is mitigated when revenues are high. Here's a scenario where Apple releases some new iPhone and iPad products at the beginning of Q1 FY 2014. Gross margins for those product lines drop by 3% (due to the effect of new products), but the increase in product mix to favor high-margin iPhone sales, plus the 2% drop in the effect of depreciation and amortization (set at $2 billion for that quarter) serves to increase overall gross margin to 39%.

Apple would be then be able to set a new EPS record even without decreasing outstanding shares. If there is a significant buyback by that time, EPS could reach $16 to $16.50. This is contingent on delivering low-double digit growth for the iPad and iPhone lines though vs. a strong Q1 FY 2013 quarter with similar high profile product launches

Conclusion

Changes in Apple's gross margins are largely due to increases in warranty accrual and depreciation and amortization. Apple's actual product margins (excluding those items) have gone down slightly with the introduction of new products, but that only accounts for 2.5% of the 6.95% decrease (36% of the total decrease) in gross margin from FY 2012 to Q2 FY 2013. That means that competitive pressures such as competition from Samsung and the introduction of lower-priced products such as the iPad Mini have not forced Apple to sacrifice margins anywhere close to as much as it seemed. The sacrifice of margins to increase competitiveness may happen in the future, but Apple has not gone down that path yet. Hence, further major decreases in gross margin are not anticipated at this point in time.

Depreciation and amortization is expected to remain at current or higher levels for a while as Apple continues to purchase new property, plant and equipment. However, the effect of depreciation and amortization on gross margin is mitigated in high-revenue quarters since it is a non-variable cost, which should allow Apple to come close to 40% gross margins during those quarters, even allow for reduced margins on new products.

There is also some upside in gross margin if the warranty accrual rate is decreased. Actual warranty claims versus the accrual is something to monitor in future quarters, as it seems that Apple may be overestimating warranty claims on the new products. Even allowing for recent changes in warranty policies, there may be a 0.5% upside in gross margin due to future reductions in the warranty accrual rate.

Apple's gross margins are likely to remain in the 36-40% range for the foreseeable future, assuming a regular stream of new product introductions that have margins reasonably in line with current products.