The iPad Mini Is Apple's Way Of Playing Offense With Defense

Jan.16.13 | About: Apple Inc. (AAPL)

In the late 1970s and early 1980s a sea change took place that turned the tide of the automobile industry. Cars from Japan were increasing in popularity, as Americans were demanding smaller, lower-cost cars with better gas mileage to help offset rising prices at the pump.

I don't know if the executives in Detroit didn't recognize that they needed to change their product to suit the shifting needs and demands of their customers, or if they simply chose not to do so out of some kind of misplaced arrogance. In the end it doesn't really matter. They didn't change, they didn't innovate or adapt, and they lost their grip on the American automobile market.

In 1961 nine out of every 10 cars sold in the U.S. were made by General Motors (NYSE:GM), Ford (NYSE:F) or Chrysler. Last year, according to the most recent data from Wards Automotive, less than half the cars sold domestically were made by the Big Three.

So now to Apple.

According to global market intelligence provider International Data Corporation, Apple (NASDAQ:AAPL) has controlled most of the tablet market since the inception of the iPad. However, Android-based tablets are gaining ground fast! And as demand has grown for smaller units with lower price points, they are expected to have increased their market share from 39% to almost 43% in 2012 alone. During that same time, Apple is expected to see its share of the tablet market decline to less than 54%.

I have to give Apple credit for quickly recognizing that a large number of consumers prefer a smaller, lower-priced tablet and for introducing the iPad Mini in response - but their insistence on a higher than expected price point of $329 may still mean they got it only half right. There are those who point to lower margins as the problematic result of lowering price, but how much margin do you have in a "No-Sale" when a potential customer chooses to buy that Android-based tablet - with retina display, no less - for $75 under the cost of your lowest-priced Mini?

Still, few people are more brand loyal than Apple users, and if nothing else, the iPad Mini gives these consumers a choice not previously available when they came looking for a smaller tablet in the Apple store. Of course, critics have claimed the Mini is "cannibalizing" sales of the standard iPad 2 and 3, but is that so bad? IHS iSuppli, whose business it is to tear apart electronic devices and estimate a Sum-Of-The-Parts cost, estimated that the 16 GB iPad Mini's components bill out at $188. Add another $10 to assemble, and if you throw in a couple of bucks for ancillary costs such as shipping and such, you get a total cost of $200. That means that the profit on the base $329 device is $129 or just around 39%, which happens to be slightly higher than the margins that iSuppli estimated the iPad 3 garnered when it came out in June.

Further, because it costs Apple almost nothing to add memory, the higher priced 32GB and 64GB units are estimated to expand their margins to 52% and 55% respectively. Not too shabby for something that's supposed to be bad for business!

Assuming iSuppli, whose estimate has been corroborated by others, is correct, Apple could have opted to price the base model of the iPad Mini well under the $299 price point the street was expecting, and still realize a tidy profit. However, Apple's aim has always been to make money on the hardware itself and let the ancillary sales of content and other services add to the bottom line. Let me say that again - Apple makes money on the hardware itself…and then more money on content and apps. This is why its margins are 40% and rivals struggle to make a fraction of that.

In contrast, rivals like Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN), sell (dare I say "cannibalize"?) their devices at close to cost - hoping to make money later on with software, music and app sales. As an example Research firm UBM TechInsights estimated Google's Nexus 7 device has a component cost of $184 per unit - and that doesn't include assembly or shipping. With a retail price of just $200, margins are pretty much break-even.

Rather than cannibalizing its own iPad sales, Apple has simply placed itself in a position to take market share from Android-based models that previously had zero competition from Apple in the smaller tablet space. The fact is that if you are in the market for a smaller tablet, whether you are already a part of the Apple ecosystem or not, you now have the option of buying an iPad at a price point that is the lowest of any Apple tablet and when you do, margins at Apple don't contract, they expand.

When the marketplace clearly demonstrated a demand for smaller tablets, Apple could have responded by ignoring that demand or assuming that its reputation and brand cache would protect it. Instead Apple chose to offer its own smaller tablet and in doing so protected itself from losing loyal customers and potentially gaining many more by offering a lower cost entry tablet while maintaining and enhancing its margins. Now, was that so hard?

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.