The Cost Of Product Cannibalization Dooms Apple's Growth

| About: Apple Inc. (AAPL)

Say what you want about Apple (NASDAQ:AAPL) being undervalued or overvalued. The fact of the matter is that the company is entering a very slippery slope of product development that could spell the end of the growth phase of Apple.

That does not mean that the company is falling off a cliff, or becoming another Kodak or Polaroid. What it means is that the search for the holy grail of sales growth and margin expansion, by any company, reaches a point, or an apex, where the company looks inward to fit price needs rather than innovation. I believe Apple has reached that inflection point.

I do not care how Tim Cook postures the apparent launching of a new, cheaper version of the iPhone, the pure marketing fact is that when a cheaper product of the exact same ilk, is produced by the company that already has the more expensive product, sales will be taken from the higher priced product. As this occurs, margins will drop.

What Actually Is "Product Cannibalization"?

Investopedia defines cannibalization in this way:

Market cannibalization can have a negative effect on a company's bottom line, forcing an existing product's life to end prematurely because sales shifted to the new product, rather than tapping into a new market as intended. At times, market cannibalism is used as a strategy (called a cannibalization strategy) if the company wants to increase its market share, and hopes that the introduction of the new product will harm its competitors more than it will harm itself. Market cannibalization occurred, for example, when Apple introduced the more feature-rich iPhone and iPods that ate up sales for its lower-end iPods, including the nano, shuffle and classic series.

It is interesting to note that Investopedia actually uses Apple as an example of a positive product cannibalization approach. It is positive when the products are actual upgrades, at a premium price, which gives the company higher margins, ergo, higher profits. Revenue would naturally increase as well because not only is another market opened, but existing markets can be tapped at higher average price points.

In the reverse type of cannibalization, a lower priced product more often than not, will hamper markets already opened (higher price points) and not make up in revenue for the decline in margins and profits.

If sales do not reach a specific level to offset the decline in sales of the existing product, then revenues will decline in lock step. Combine that scenario with higher costs to actually produce and execute a new product launch, and what we have is a company that is no longer growing. The company is seeking to maintain its pace, and ring the register with flat profits month after month, by simply expanding an already impressive product line, with a price approach.

Expansion of product lines is a growth oriented strategy, but NOT in the face of declining margins, profits, sales, and market share.

As noted in this report:

In the past year Apple's share of the tablet market has dropped nearly 20 points, from 56.8% to 38.8%, with Samsung and Amazon gobbling up Apple's market share, according to a new report from Citi. Perhaps not surprisingly, the market has seen a "particular slowdown" in 10-inch tablets, caused in part by Apple's very successful iPad Mini. Speaking of the Mini, Citi warns that "innovation of this nature is insufficient to reverse share loss." It's also sparking a drop in average sales price, with the iPad selling for an average price of $467 this quarter versus $535 last quarter.

With another lower priced product potentially coming to the market, the average price point of all of the iPhones will drop, as will margins and profits.

Why Is Apple Taking This Approach?

I believe that the management teams at Apple are taking a look at the following trend, shown here in a fairly straightforward graph:

This chart comes from a report from Gartner Research, noted in this article.

....if the chart.... from Gartner (link is to report that is for sale) is to be trusted, Apple is losing its grip on being the lead dog at least from a sales perspective. Actually, let's just be honest here and say they have lost their grip.

The increase in Android device sales from Q4 2011 to Q4 2012 is almost staggering.

The products that have been selling have taken a large bite out of Apple's dominance, and I believe that since Apple has not come up with any new groundbreaking product, their sales divisions are under pressure to reach more "sensitive" price points to take back some market share.

Pacific Crest has also chimed in as reported in this article, noting that the "illusion" of a cheaper iPhone being just as good as the premium phones is quite misleading.

Pacific Crest's Andy Hargreaves this morning confronts what he calls "the illusion of a low-cost iPhone," writing that there wouldn't be much profit from a dramatically cheaper model of the device.

Writes Hargreaves, who has a Sector Perform rating on the stock, "the concept of a cheap iPhone violates Apple's core operating principles," because "we cannot think of a single thing that a low-priced iPhone would do better than the current iPhones."

Hargreaves goes on to offer a rather dismal profit picture with a cheaper iPhone as well:

"We do not believe Apple could build a low-cost iPhone of reasonably acceptable quality for less than $180. If we reason that the company would have to price a low-cost iPhone at $250 or less to open up significant new unit share, this suggests that the device would generate maximum gross profit per unit of approximately $70, which compares poorly to our estimate of current gross profit per iPhone of $295."

Obviously Apple feels that they can make up the dramatic difference in profits with a dramatic rise in sales. If the above profit picture is accurate, Apple would need to sell more than 4 times the number of cheaper iPhones just to keep profits even. That also assumes that a cheaper iPhone would take one sale away from each potential sale of the premium phones. It could be even more staggering if the cheaper iPhone cuts into existing sales by a 2-1 margin.

Could Apple sell 8 times the number of cheap phones as they have in the premium phones?

Personally, I do not see how it is possible. That being said, perhaps Apple is taking this approach simply because they fear further deterioration in market share, from Android competition. I get the feeling that someone in marketing has come up with the brilliant idea that since Apple is so huge, and has so much money, that the company can commoditize the smartphone business just by making a cheaper version.

If Apple can commoditize the business, then that means that price will then take center stage, and push innovation into the background. I have seen this before in companies that have fallen flat on innovation and believe they can live off of their brand name to thrive until they can once again dominate with the next greatest thing. General Motors (NYSE:GM) comes to mind with the Cadillac Cimarron back in the mid 1980's. GM lost market share with their premium car, so decided to gussy up a cheap car with the Caddy logo and sell it for less. Not only was it a huge flop, but it also further tarnished the Cadillac brand.

Apple has already cannibalized the iPad, by coming out with the iPad mini, and Tim Cook had this to say:

"If we don't cannibalize it, someone else will," Cook said of concerns that the iPad mini is eating into the traditional iPad's sales.

In a world that has every business fighting for every consumer dollar, I can understand why so many companies follow this line of thinking. I also happen to believe that protecting a brand is a far better long term growth strategy than one that focuses on price.

Quality and innovation has created Apple to what it has become. Price, duplication, and cheapening down the brand, can reverse that course quicker than anyone might want to believe.

So What Is The Answer?

I think that Hargreaves states it precisely the way I would when he said;

"The high-end smartphone market is finite, and iPhone's extraordinary success is driving it very quickly toward saturation, in our view," he writes. "However, we believe the company would be much better served by continuing to focus on capturing and maintaining share of the most profitable customers in the world rather than moving down market, even if it means sacrificing unit and revenue growth."

The Bottom Line

I have Apple shares in both the Team Alpha and Young and Restless portfolios. While I am not giving up on the Apple "story" of growth just yet, I am beginning to see the definite signs of a mature company moving from the growth stage to the value stage.

I actually feel more positive about the dividend potential of Apple, for the Team Alpha portfolio, than I do about the growth potential in the Young and Restless portfolio.

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