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There are secular tailwinds to the margins at Apple (NASDAQ:AAPL) from the declining prices of components (such as memory, touchscreens, processors, cameras, and batteries) and scale economies in manufacturing, and secular headwinds from competitive erosion.

At present, however, investors are focused on the effect of product strategy and, in particular, the mix-shift from the iPhone to products, such as the iPad Mini, with margins that are lower than the corporate average. This note argues that, while these products create challenging margin optics in the short run, they improve AAPL's pricing power in the long run.

Protecting the Floor with the iPad Mini

AAPL faces a strategic imperative to "protect its floor" through introducing products at lower price points. CEO Tim Cook articulated this on the April 2009 earnings call: "One thing we'll make sure is that we don't leave a price umbrella for people". As a strategic matter, Apple does not want to allow competitors to establish a beach-head at lower price points and then advance to compete in premium segments.

Blogger Mr. Ryan Jones represents this strategic imperative with an imaginative chart indicating the motivation for the base iPad Mini at a $329 price point. (We note the chart shows the base model of the third generation iPad, announced in March 2012 as the "new iPad," at the $499 price point since the fourth generation iPad, whose base model now occupies that price point, was announced in October 2012 after the article was published).


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The Role of Memory in the Pricing of Mobile Products

The above chart reveals the important role in pricing of a design feature of AAPL's mobile products not shared by its computer products: the memory of mobile products is not designed to be removed. Rather, additional memory is a defining feature of premium models. For example and from the chart, the "locked" iPhone 4S was offered at a $200 price point with 16GB of memory at a time when the 32GB version was offered at $300.

Aside from reducing pricing gaps available to competitors and influencing customer behavior by creating the impression that base models represent good value, AAPL's memory-based pricing strategy creates enormous margins. For example, on both the iPad and iPhone, AAPL typically charges an extra $100 for an additional 16GB of memory over the base model; at current prices, this additional memory costs the company just $10 or less.

The mark-up on memory is particularly "magical" given that many, if not most, early adopters purchase premium models. For example, at the time of launch, ~60% of customers purchased higher-memory versions of both iPhone 4 and iPhone 5. As shown in the data below from Consumer Intelligence Research Partners, this percentage declined to zero for the value buyers who purchased the iPhone 4 after the release of the iPhone 5.


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The Pricing Role and Critical Compromise of the iPad Mini

The role of the iPad Mini is to protect the floor in the iPad product line. It turns out, however, that AAPL was able to offer the lower-price product without compromising margins; in fact, the data suggest margins on the iPad Mini are higher than those on the third generation iPad when it was launched. In other words, rather than cannibalizing iPad sales, the iPad Mini may represent an up-sell.

Specifically, using March 2012 estimates from iSuppli, the manufacturing margin on the base iPad Mini is ~$130 (based on a tear-down cost estimate of ~$200, as shown below, and retail price of $329) versus ~$175 for the base iPad 3 when it was launched (based on a tear-down cost estimate of $325 and retail price of $499). We have not seen a tear-down analysis of the fourth generation iPad but expect the margin, as of the October 2012 announcement date, to be approximately the same as that on the iPad 3; we are assuming that manufacturing efficiencies pay for the processor upgrade (to the A6x from the A5x of the iPad 3) and the slight upgrade to the front-facing camera.

In percentage terms, then, the manufacturing margin on the base model of the iPad Mini is ~40% versus ~35% for the base models at time of launch of the iPad 3 and probably the iPad 4. In short, Apple was able to offer the iPad Mini at a new low price point for the iPad line without compromising the margins on the line. This was achieved by making an important product compromise: unlike the new iPad, the iPad Mini does not have a retina display. Including necessary upgrades to the processor and battery, this would have cost an additional $60 and reduced the manufacturing margin to an unacceptable <25%.

The Tough Margin Compare of the iPhone

It is one thing, through calculated design and efficient manufacturing, to offer an iPad at a lower price point without reducing margins across the iPad line; it is quite another to achieve the same result across AAPL's entire product range. As CEO Peter Oppenheimer commented on the iPad Mini margin during the last earnings call: "it is lower than the corporate average."

The reason is the enormous profitability of the iPhone whose base model (i.e. the 16GB iPhone 5) has a manufacturing margin of ~70% based on an iSuppli teardown in September 2012; as shown below, this assumes a retail price of $649 and manufacturing cost of $207.

Reported Margins Confirm iPhone's Extraordinary Profitability

AAPL's reported gross margins are lower than the "manufacturing" margins generated by iSuppli's analysis because of other costs; these include royalty payments and wholesale discounts (allowing resellers, such as the telephone carriers AT&T (T) and Verizon (NYSE:VZ) to generate a profit on hardware sales). Court documents, released as a result of the recent dispute with Samsung (OTC:SSNLF) over intellectual property, indicate that AAPL's margins on the iPhone have been between 49-58% while those on the iPad have been 23-32%.

While lower than the manufacturing margins generated from iSuppli teardowns, these reported gross margins confirm the critical conclusion: that margins on the iPhone are ~1.75x those on the iPad. Seeking Alpha contributor, Mr. Michael Fu, authored a painstaking article on AAPL's product margins which provided additional confirmation through one of the tables which we reproduce below:


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Sound Strategy, Challenging Optics

There was an interesting change in language in AAPL's annual report from 2009 to 2010. In the 2009 report, the business strategy places products first and is articulated as: "the company is committed to bringing the best personal computing, mobile communication and portable digital music and video experience to consumers." In the 2010 report, the customer experience comes first and the product descriptions are more general: "The Company is committed to bringing the best user experience to its customers through its innovative hardware, software, peripherals, services, and Internet offerings."

The report informs a discussion around whether AAPL is a "hardware" or "software" company raised, among other places, in a letter to investors of May 29, 2012 from hedge fund manager, Mr. David Einhorn: "Rather than view Apple as a hardware company, we view it as a software company that monetizes its value through the repeated sales of high-margin hardware." From its own reports, AAPL's perspective seems to be that it sells a "user experience" which is monetized through the sale of both hardware and software.

An important aspect of this user experience, at least for AAPL's economics, is that it extends over multiple products. The chart below, from a Goldman Sachs survey in May 2012, show the lift to loyalty if customers own multiple devices. Of the customers owning a single device, 62% say they are highly likely to purchase another AAPL device; this figure increases to 75% for customers who already own 2 or more devices.


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In short, if AAPL can sell you two devices, they are more likely to own you as a customer and all the repeat hardware, software, and downstream iTunes products (such as music, videos, and apps) that come with that. In the face of this customer behavior, the strategic imperative for AAPL is to sell an additional product, such as an iPad, to an iPhone customer; it may lower the margin in the short run but it leads to a more loyal customer, and hence greater pricing power, in the long run.

Conclusion

The strategic imperative for AAPL is to build pricing power through selling customers multiple devices. This enhances customer loyalty, presumably through engaging customers more in AAPL's iEcosystem and thereby increasing perceived switching costs.

The consequence is that selling an iPhone customer an iPad improves AAPL's long-run economics even though, in the short run and given the extraordinary profitability of the iPhone, it creates the optical challenge of a declining firm-wide margin.

Source: Apple: Margin, Pricing And Product Strategy