Apple Inc.'s profit margins are falling back to levels not seensince sales took off after the 2007 debut of the iPhone, ascompetition and lack of breakthrough products pressure the companyto lower prices.

Concern over falling margins helped prompt a 33 percent declinein Apple shares from a record high of $705.07 on Sept. 21, makingit the worst-performing stock in the Standard & Poor's 500Index in the same period. Last week, Apple said the board andmanagement are discussing the return of more money to shareholders,after a proposal by Greenlight Capital Inc.'s David Einhorn to payout more of its $137.1 billion in cash and securities, possiblywith higher-yielding preferred stock.

The latest quarter's drop in gross margin to 39 percent from 45percent a year earlier was caused by the introduction of the iPadmini, other products with higher costs and price cuts for existingproducts, Apple said. Unless Chief Executive Officer Tim Cookunveils a revolutionary new gadget with premium pricing, Appleshares will remain under pressure.

“It will be almost impossible for Apple to maintain the marginsit's had in the last few years,” David Yoffie, a professor atHarvard Business School, said in an interview. “They've been ableto charge pretty much whatever they wanted for their products, butcompetition is increasing.”

A central challenge is slowing sales of the iPhone, Apple'sbest-selling and most-profitable product that accounts for 56percent of revenue. Samsung Electronics Co., HTC Corp. and otherrivals are introducing cheaper and feature-laden smartphones andtablets based on Google Inc.'s Android software.

Steve Dowling, a spokesman at Apple, declined to comment.

Apple rose less than 1 percent to the equivalent of $478.91 inGerman trading at 11:09 a.m. Frankfurt time after closing at$474.98 on Feb. 8 in New York.

One product with the potential to be profitable enough to slowthe margin slide could be an Apple-branded watch that also makesphone calls, accesses the Web and provides location- trackingservices, said Poonam Goyal, an analyst at Bloomberg Industries. Awatch with these features might retail for much less than $200,keeping it within the price range that is the fastest-growingportion of the time-piece market and also the most profitable, shesaid.

Apple could sell millions of the watches, and generate a marginof about 50 percent, she said. That's about twice the margin Applemight earn by making a TV or selling an inexpensive phone forless-affluent shoppers, said Michael Morgan, an analyst at ABIResearch.

The company is developing a wristwatch-like device using curvedglass, the New York Times reported yesterday, citing unidentifiedpeople familiar with the situation. Natalie Kerris, an Applespokeswoman, declined to comment on the plans.

Projected Decline

Apple is also seeking new customers in China, where it will beharder to charge premium prices. New products such as the iPad miniare also being priced at relatively lower points, eating intomargins.

Gross margin, or how much Apple earns after paying for rawmaterials, labor and production to build iPhones, iPads, Macs andother products, is projected to decline in fiscal 2013, accordingto the company's Jan. 24 filing with the U.S. Securities andExchange Commission.

It predicted gross margins for this quarter would be 37.5percent to 38.5 percent, down from 47 percent a year earlier. Thetwo new products that Apple will probably introduce this year, atelevision and a lower-priced iPhone, will be much less profitableand drag down margins, according to Morgan.

Cash Plan

After Apple on Jan. 23 reported its slowest profit growth since2003, more than 20 analysts lowered their price targets. While Cookmade it clear on the earnings call that he's not considering anymajor strategic shifts, he promised that Apple was developingseveral new products.

“We're working on some incredible stuff, and the pipeline ischock full,” Cook said. “We feel great about what we have instore.”

Apple said on Feb. 7 that the board and management areconsidering Greenlight's proposal and are actively discussingdisbursing more money.

Apple's cash balance includes $16.2 billion of cash and $23.7billion in short-term investments. The rest is invested inlong-term marketable securities.

“We remain committed to having an ongoing dialogue with ourshareholders to get perspectives around return of capital anddriving shareholder value,” Apple said in a statement.

That suggests Apple is softening its stance on the preferredshares, after previously saying in its annual proxy that therearen't any plans to issue them.

Apple may also be considering a payments system that would letit keep an extra cut of every device, song and software applicationsold that might otherwise go to credit-card firms, said AnandSrinivasan, a senior analyst at Bloomberg Industries.

Another approach that Apple may take is to introduce more fullyloaded configurations of existing products. An iPad with 128gigabytes of storage went on sale this month. Since the cost ofdoubling memory is less than the $100 extra charged for the device,the profit margin is higher, said Srinivasan.

Brisk sales of older models are also causing some investorconcern. Last quarter, the new iPhone 5 made up only half theiPhones sold by Verizon Communications. The rest were the 16-month-old iPhone 4S and its predecessor, the iPhone 4. While oldermodels contain cheaper parts and lift margins, they also hamperApple's ability to realize maximum economies of scale on newerones.

After commanding a premium for most of the past decade, Apple istrading at a discount of 28 percent to the Standard & Poor's500 Index on a price-earnings basis, according to data compiled byBloomberg.

Profit Trade-Off

“They need to do something eye-opening, but nothing is going tohave as high a margin as the iPhone,” said Erick Maronak, chiefinvestment officer at Victory Management Inc. Apple's gross margincould easily shrink to 35 percent, he said.

Rather than milk its position for every last dollar, Appleshould accept lower profits to keep growing revenue and marketshare, said Yoffie. Since its 2007 introduction, the averageselling price of an iPhone has remained above $600, twice that ofrival devices. A slimmer margin on a $300 iPhone sold to hundredsof millions of price-conscious shoppers would bring in more cashthan a 50 percent margin on current models, he said.

“If they want to maintain or build market share, they can'tsustain prices that are in the neighborhood of 100 percent higherthan rival products,” Yoffie said.

Apple may also be speeding up the frequency as well as thevariety of its product introductions, to prevent Samsung and othersfrom grabbing share while Apple plans its next blockbuster annualannouncement, according to Walter Piecyk, an analyst at BTIG LLC.That may explain Apple's decision to revamp all of its mainproducts — iPhones, iPads, Macs and iPods — in the second half of2012.

More frequent product introductions and a longer service lifefor older devices will complicate Apple's formula of selling ahandful of products in massive volumes, and churning out profitsover time by driving down costs. The shorter the gadget's life, theless time to maximize income, said Piecyk.

Apple is also finding it more difficult to forecast demand andprepare its supply chain as the variety of devices expands. Appleuncharacteristically produced too few iPad minis, iPhone 4s andiMacs during the last quarter, according to Ben Reitzes, an analystat Barclays Capital Inc.

“Manufacturing issues seem to be occurring in so many productsthese days,” Reitzes wrote in a research note.

With revenue projected to rise 17 percent to $182.9 billion inthe current fiscal year, the trick for Cook will be to refocusinvestors' attention to dollar profit instead of margins, saidYoffie. At that rate of growth, Apple would reach $400 billion inannual revenue by 2020 — more than $1 billion a day — and be ableto churn out far more actual dollars of profit, even if marginsdecline.

“Apple's goal should not be to maintain their margins, but toincrease sales and increase profits,” said Yoffie. “Apple allowedexpectations to get way out of line. They let people think it couldgrow as it has in the past.”

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