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Why Apple's Gross Margins Are So High

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Apple's numbers are stunning when contrasted with Dell's disappointing first quarter gross margins. Here's why.

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After Dell (DELL) delivered its first-quarter earnings report on Thursday, investors' attention quickly turned to the company's disappointing gross margins, which contrasted greatly with Apple's (AAPL) stunning recent numbers. And so when a reader asked me why there's such a big difference between the two, I decided to dive in and do my best to explain.

The gross margin is among the simplest financial concepts to understand. It's simply revenue minus cost of goods sold (the direct costs associated with the products and services driving that revenue), divided by revenue.

So if Company A sells $100 worth of stuff that cost $50 to produce, then Company A has a gross margin of 50%.

There are a variety of factors driving gross margins for companies making physical products. But assuming companies have access to similar materials and manufacturing methods, difference in gross margin are driven primarily by uniqueness and branding.

In any given geographical area, gas prices are pretty much the same because all gas is pretty much the same, and there are a lot of people selling it. That means low mark-up and a low gross margin because people have no reason to pay up.

But there are a lot of things that will make people pay sums that are well above what it costs to produce those things -- like Starbucks (SBUX) coffee, Coach (COH) handbags, and Nike (NKE) sneakers. Why? Because they're differentiated brands that people like and trust. That creates value in consumers' minds, and a reason to open the wallet. A shiny new $400 Coach bag costs very little to produce, but the feeling of strutting around with one is worth $400 to a lot of women.

And as far as computers go, the first point to understand is this market is incredibly competitive. All computers running Microsoft's (MSFT) Windows 7 operating system are basically identical, and you have hundreds of models to choose from. And since PC companies can't or are unwilling to set themselves apart with design or customer service, their products are commodities, no different from generic toilet paper.

Apple of course, is the exception. In its fiscal second quarter (ended in March), its gross margin hit an incredible 41.7%. In other words, Apple sells $583 worth of stuff for $1,000. For Dell to hit $1,000 in sales, it has to offer up $824 worth of parts. Yes, Dell has to pony up for a Windows license from Microsoft, but that costs about $65.

So why are these numbers so wildly different?

First, there's a major product portfolio difference. In addition to lower-margin computers, Apple makes high-profit items like the iPhone and iPod. But then again, Apple's gross margins are higher than gadget companies selling related devices, including Nokia (NOK), Motorola (MOT), Sony (SNE), Netgear (NTGR), and Logitech (LOGI).

So let me present a scenario that explains why Apple's margins have been so strong:

You walk into your local electronics retailer on a Saturday morning looking for a new computer, and every logo on every model has been mysteriously covered with duct tape.

And there's a challenge. If you can identify a computer's brand without seeing the logo, you take it home for free. You only have one try.

I'd be willing to bet that the first words out of your mouth would be "that one's a Mac," and you'd be right.

You know an Apple product when you see it. Apple's designs simply demand attention, whether you're interested in them or not.

And let's look at Apple's major accomplishments in the past 10 years. Apple has single-handedly revolutionized the computer, mp3 player, smartphone, digital music, electronics retail, and tablet markets. In doing so, it's mastered the gentle art of making powerful products that are easy to use -- the perfect complement to great design.

Embedded deep in Apple is a willingness to ignore critics, break the rules, and make products that change the world. It's the uniqueness of the brand that makes Apple different from all of its competitors, and that's why its products sell for a hell of a lot more than the sum of their parts.

Companies making Windows PCs are forced to price according to competition, effectively ceding control over a very important part of the profit-margin equation.

And that's why I worry about Dell. Last week's margin disappointment was blamed on component shortages. Those types of problems can hit anyone, but in a commodity market, there isn't much flexibility to raise prices.

Hewlett-Packard
(HPQ) bought Palm (PALM) because differentiated products are what people care about, and what really drive margins.

The PC business isn't what it used to be. Since the democratization of the web in the 1990s, there's been no major societal force driving mass adoption of computers.

Those content to ride the wave are destined to decay.

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Position in AAPL.
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