Quick Thoughts: Apple – Will Product Line Expansion and Shorter Cycles Mean Lower Margins?
– Apple’s announcements today accelerate its annual product upgrade cadence, keeping better pace with the state of the art, but risking margins with a narrower window to amortize development costs.
– The iPad Mini was widely leaked, but there were some surprises: a mid-cycle iPad refresh, adoption of hybrid SSD/HDD storage drives for Macs, and a higher than expected iPad Mini price point
– Uncharacteristically, several products, including the updated iMac, will ship weeks from now suggesting pressure on an Apple supply chain already strained by a slow ramp on the iPhone5.
– As monetization of devices is changing with competitors selling tablets at cost to sell content and/or earn ad revenue, Apple faces a future trade-off between its margins and its market share.
Earlier today, Tim Cook took to the stage at the historic California Theater in San Jose for a second Apple special event in as many months and it was predictable … well sort of. Widespread pre-announcement rumors of the iPad Mini were fairly detailed and turned out to be as spot on as they had been for the iPhone 5. Similarly, blog chatter about a Mac line refresh including a 13-inch MacBook Pro with Retina display and updated Mac Mini were right on the money. Lately, Apple has not been living up to its reputation for CIA-level secrecy – its supply chain partners have spilled more beans this year than the world’s clumsiest Starbucks barista. Over the past few months, the steady flow of unauthorized prototype product photos and preliminary spec sheets left Apple’s dog-and-pony shows a bit anticlimactic. All in all, it’s a shocking contrast to the heavy-handed DEFCON 1 response two years ago, when Gizmodo got their hands on a pre-release iPhone4 that an Apple employee had left in a Cupertino bar.
But this time, Apple did manage to keep a few things under wrap. Most notable was the 4th generation iPad, which looks almost identical to the previous two generations of the iPad and likely slipped under the radar of would be leakers (tech site BGR did leak a photo of an updated iPad 4 camera yesterday, but had no idea what product it was for). Also surprising was the announcement of a newly redesigned iMac, which likely didn’t leak because it hasn’t hit production yet in China.
The mid-cycle revamp of the iPad is a bona fide shocker. As I’ve written before, one of Apple’s main weaknesses has been its long and predictable product refresh cycle. Apple fanboys mark the seasons by the fever pitch of new product anticipation: iPads in spring and iPhones in the fall, but this past spring demand for the then flagship iPhone4S, both in anticipation of the pending iPhone5 launch, but also because the 4S was beginning to look a bit pedestrian next to a wave of newly introduced Android smartphones. Apple’s single model strategy and 12-15 month refresh cycles squeeze a lot of profit out of its lean product development budget, but the competition is offering broad product lines that are updated every few months. It took a couple of years for the Android ecosystem to close the hardware gap with Apple, but Tim Cook now has to take the stage with the knowledge that his products will only enjoy a spec sheet advantage for a quarter or two. The 4th generation iPad acknowledges this reality and ups the ante for would be competitors aiming at the model that was just introduced this past march. It may look the same, but the guts are different: a faster processor, a better front facing camera, and an updated LTE baseband chip. Perhaps, this will be the new cadence for Apple product updates.
The iMac refresh, a 21.5 inch model available in late November and a bigger brother arriving a month later, is also interesting since Apple hasn’t announced a product shipping more than a month in advance since the original iPhone in 2007. Steve Jobs always seemed to take particular glee in announcing that the product in question would be available for pre-order on Friday and would ship a week after that. This is different. One explanation is that Apple is going ahead with the product announcement in advance of actual production since its leaky supply chain would likely have photos up on tech blogs in a week or two anyway. This would make sense since the iMac is a lower volume product, although early product announcements risk that customer excitement dissipates and competitors can get started on their response. Alternatively, the expected launches in November and December could mean trouble in the supply chain. Though it is not a retina display, the thinner display may be subject to some of the well documented screen shortages or steep manufacturing learning curves affecting the iPhone 5.
Also interesting with the new iMac is the hybrid SSD/HDD “Fusion Drive.” These drives contain both solid state and spinning disk elements managed as single storage unit and have been on the market for some time, but have not sold as well as dedicated SSD or HDDs. Hybrid drives put mission critical applications such as the OS onto flash memory to boost performance and startup times while storing less frequently used items to the mass storage spinning disk such as content: music, movies, photos, etc. A hybrid drive is more economical than pure flash storage while maintaining some of its performance characteristics. At the same time, hybrid drives are more expensive and higher margin than traditional hard disks. Apple’s blessing of this architecture could spur copy cats to the great benefit of disk drive manufacturers.
Tim Cook saved the long awaited iPad mini for last, assuring that the web cast audience would hold on to the bitter end. Rumors of a small iPad have been swirling for over a year, and over the past few weeks few details remained secret. As expected, it sports a 7.9-inch screen with the same 1024 x 768 screen resolution as the pre-retina display iPad2, meaning that most apps will run on the mini right out of the box. Phil Schiller, Apple’s SVP of Worldwide Marketing touted the iPad Mini’s screen as larger than the competition – Amazon’s Kindle Fire and Google’s Nexus 7 – but the pixel density on the iPad Mini is lower at 163 ppi versus 216 ppi for both of the other devices, leading some journalists in attendance to call out the quality of the picture. Surprisingly, Schiller presented a side by side comparison to what was presumably the Nexus 7 – the typical Apple presentation refuses to acknowledge that competitive products even exist. Schiller highlighted the iPad’s aluminum bezel versus the competition’s thicker plastic before going into a side by side app demonstration to show how the iPad’s fixed screen ratio yields a far smoother user experience on many of its apps when to compared to the Android universe’s myriad of native screen resolutions and app rescaling.
The biggest secret of the iPad mini was pricing. The rumor mill’s consensus price was $299, but the actual pricing came in $30 higher at $329, precipitating a momentary beat down on Apple’s share price. In the context of Apple’s overall product line, the price point makes perfect sense – the similarly featured, but much smaller iPod Touch was just announced at $299. Moreover, aluminum bezels and 7.9-inch screens don’t come cheap. Looking at recent comparable bill of materials estimates from IHS iSuppli product tear downs, a 16GB iPad 2 costs $245 to manufacture versus $167 for the Nexus 7. Arguably, the iPad mini is closer to the year old iPad 2 than it is to the relatively bare bones Nexus 7. Furthermore, Apple is accustomed to capturing fat margins – gross margins on the iPad are believed to be about 35%, while the iPhone 5 fetches about 65% including carrier subsidies. Apple would like to defend its dominant market share in tablets, but history suggests that as much as it may like market share, it likes margins even more. Apple believes its product is worth a significant premium, and at $329, it is asking a 65% premium over the entry level Nexus 7 or the similar Kindle Fire HD. Checking back to the benchmarks, it seems likely that the actual iPad mini gross margin is north of 30%.
It remains to be seen whether price sensitive consumers will be willing to pay the extra $120 over a Nexus 7 or Kindle Fire for the Apple experience. Neither Google nor Amazon care about the margins on their tablets and are willing to price near cost with Google expecting to make its money from advertising and Amazon looking to promote e-commerce and content sales. In this context, Apple’s premium pricing strategy is risky. Google was able to push Android to a commanding 68% share of global smartphone sales in the most recent quarter on the back of its policy of licensing the software for free. By insisting that iPads sustain their profitability on device margins alone may invite a similar scenario for tablets in the future. An alternative approach could be to rethink its monetization strategy beyond devices. Arguably, Apple services such as iTunes, the App Store, iCloud and others are underdeveloped as sources of revenue, while its iAd advertising initiative has been a significant disappointment. Building these potentially lucrative revenue streams could free Apple to respond to price competitors more aggressively.
Returning to Apple’s long product life cycles, an acceleration in the pace of product introductions could also pressure the company’s margins from the cost side. Designing new products require R&D, launching them requires marketing spending, and cutting the useful life of each model can only drive expenses higher. It will be interesting to see if the quick timing of the 4th Generation iPad is an aberration or the new normal. The other red flag for Apple investors comes from the supply chain. While management hails the iPhone5 as its fastest selling iPhone ever, that distinction should be a given, just because of the overall growth in the market. Verizon was the first carrier to announce its iPhone5 results for the first 9 days of its availability – 651,000 units fell well short of the 1 million unit consensus, with Verizon pointing to supply constraints and indicating further uncertainty for 4Q. Foxconn touts the iPhone5 as the most complicated product that it has ever made, perhaps evidenced by the problem with scratched bezels that slowed production and resulted in early product returns. Supply constraints from display makers and chip foundries have caused more bottlenecks. Oh, and worker rebellions also shut down production for a couple of days at some plants. For a company that is very dependent on a small number of flagship products with limited windows of competitive advantage, these constraints are particularly painful. New customers unable to buy iPhones because of supply chain bottlenecks may not wait for Apple to meet demand. They will probably buy an Android.
For our full research notes, please visit our published research site.