Apple-related (NASDAQ:AAPL) articles seem to attract comments full of vitriol regarding Apple's prospects in the face of new Samsung products, growing sales of devices running Google's (NASDAQ:GOOG) Android, or products based on as-yet unreleased operating systems from Microsoft (NASDAQ:MSFT) or Research In Motion (RIMM). Certainly, these competitors must be considered by anyone attempting to understand Apple's business. However, the question for investors is not how a particular Apple product should be expected to compete against an individual model of a competitor's product; the investor's problem is how Apple's product lineup will compete against all comers - and what effect the cumulative effort of competitors will have on Apple's profit. Apple has demonstrated in the mobile market - and continues to demonstrate - the implementation of a product lineup capable of denying competitors significant breathing room in nearby market segments. By preventing competitors a safe haven from which to stage attacks on Apple's profitable business segments, Apple keeps competitors in a largely price-based competition in what is apparently a commodity market of non-Apple mobile devices.
How It Works
The basic premise of the strategy is this: why give a competitor a safe haven market segment from which to derive profit that can be directed into an assault on a market segment from which Apple derives profits? By creating a product lineup that covers the entire range of profitable price points, competitors are prevented from gaining exclusive access to segments of customers who are potential Apple customers. Denying competitors the ability to market themselves as "the only alternative at $___" keeps customers free to consider options.
Once a customer is considering an Apple product, Apple has an opportunity not only to sell the customer the product whose price point attracted the customer, but also to upsell the customer to some other Apple product or service. Competitors who are forced to compete with Apple on price may lack Apple's supply-chain mastery and thus lack Apple's margins, precluding equal profit even at equal price points. Using a price segment just below Apple's to fund unchallenged an assault on the next price tier becomes impossible when Apple offers similar (or better) products at the same price (at higher margins). While markets have some potential overlap, Apple has managed to implement this strategy (as described in an earlier article "Apple Has Already Won The Tablet Market") in at least the markets for music players (and later perhaps bluetooth headset music players) and cell phones.
Apple has a history of successes creating product lineups in music players and phones that cover so much of the span of product prices that competitors are unable to gain an unchallenged foothold in a market segment in which Apple isn't competing. The fact that the company competes at a broad range of price points prevents Apple from becoming irrelevant to anyone in the market. The company slowly went from having a single model of music player that was more expensive than any competitor, to having music players at every price point from $50 to the top of the music-player market. In what safe market segment will competitors acquire profit from which to attack Apple?
Apple's iPod results from the second quarter (the quarter ending March 2012) show that after more than a decade following the launch of its first portable music player, Apple has acquired and retained over 70% of the music player market. This isn't a market in which Apple was ignored because of the market's insignificance: it's a huge market in which Apple has been beset by competitors on all sides for years. (Including most notably Sony (NYSE:SNE), which shuttered its music store and with it the entire ATRAC file format, and Microsoft, whose Plays-For-Sure format plays no longer. Lesser contenders, unable to make good their escape, lie still on the field of battle.) The iTunes Store, created to protect Apple's music players from the predation of incompatible file formats, destroyed the market for crippled music as it rose to dominance, and last quarter took in $1.9 billion in revenue.
Now, to address that sniggering from the back row - the heckling that iPod sales growth is now negative. The author would remind the gentle reader that every iPhone is an iPod. When Apple upsells former iPod buyers into a more expensive, higher-margin Apple product that also makes phone calls, it laughs all the way to the bank about the "negative" iPod growth.
The iPod is not a one-off occurrence, but a demonstration of a broader Apple strategy. When Apple first reduced the price of the iPhone, it learned that some customers really flocked to the product once its price had been reduced $200. Now, Apple offers iPhones at retail prices ranging from $0 (with a 2-year contract) to the top of the market. Apple may not have a lot of share in the cell phone market broadly, it seizes profits far out of scale with its share by targeting the high end of the smartphone market. Apple seems to be replicating in iPhones the product pricing strategy that served it so well in iPods - so far, to outstanding result.
What Apple Is Doing Now
Apple's product lineup is still being created in the tablet market. When Apple announced its latest iPad on March 7, it also lowered the price tag of its entry tablet offering. The iPad 2 continued to be available following the launch, with a new, lowered price. Now, less than two months later, Apple is introducing to the same iPad 2 the improvement of smaller processors. The same Apple-designed A5 processor always used in the iPad 2 is being built now on the 32-nanometer process previously noted on the new AppleTV. With its processor shrunk from the 45nm process to the 32nm process, the lower-end iPad will have significantly better battery life.
Apple does not make product specs its leading sales pitch. Apple makes the Apple product experience its leading sales pitch. Rolling new technology quietly into products the market already knows and understands allows Apple the advantage of the new processors' lower cost as production capacity is ramped up, while maintaining pressure on competitors who thought Apple would present a standing target until 2013. It does these things without requiring Apple to invest either in new marketing or in the expenses associated with new-product ramp-ups. Apple's margins improve as Apple grows the improved parts' fraction of all shipping parts. Apple's lowered costs improve pricing flexibility in the model as Apple works on future products that will overtake Apple's higher price points.
Apple remains free to improve the new iPad later in the year as it, too, gets a refresh from 45nm. For example, in time for the holiday season and atop competing products newly launched by one of Microsoft's hardware partner commodity vendors to run Microsoft Windows 8 RT. (The prospect of a tablet running BlackBerry 10 from Research In Motion seems dimmer following the apparent paring of BlackBerry 10 hardware down to a single phone model.)
Improving products at the same price and rolling old products to lower prices is exactly how Apple covered all the price points in the phone market. The range of prices among phones and music players is suggestive of how Apple can be expected to cover the tablet market over time (not in exact price points, but in price point coverage).
The Effect Of Apple's Product Spacing
By spacing products strategically across the price range, Apple prevents customers from writing off Apple as "too pricey". Instead, anyone willing to consider Apple products will see it's got a product in the customer's intended range and at least look. The customer willing to check out Apple's product is what Apple had lacked as the '90s wore on (because Apple's product was reputed to be costly and incompatible), so just getting the customer in the door is an enormous improvement from that was status quo at Apple only a decade or a decade and a half ago. Also, getting the customer to consider Apple's product is a huge advantage for a company famous for quality user interface and boasting the highest satisfaction in the industry. Apple has apparently mastered customer satisfaction, earning high satisfaction rankings in PCs (#1), smartphones (#1), and online vendors (among "top").
What does this product strategy mean for the bottom line? The effect on market share has been chronicled by such observers as NPD and Gartner, but Apple's unit sales share in the global smartphone market has generally been described as eroding while Apple and Samsung vie for the top spot in unit share. This competition must be killing Apple's margins, right?
Horace Dediu of Asymco presents a graph of eight smartphone vendors' profit share:
The graph illustrates that at the close of 2011, Apple and Samsung held 99% of the profits being made in smartphones worldwide. The collapse of profits in these two firms' competitors aren't purely a function of a couple of hit devices, but reflect the competitive advantages these firms hold over other competitors. Based on recent quarterly results for Research In Motion and Nokia (NYSE:NOK), the firms continue to be unprofitable as reflected in the graph above. Yet Apple and Samsung aren't simply poaching business from competitors. As Mr. Dediu's next graph shows, these firms have not so much stolen share as they have grown the pie:
This graph is particularly interesting as it gives scale to the losses besetting those of the industry's losers with a history of being major unit-volume participants, while illustrating that Apple and Samsung aren't so much taking an existing share as creating new opportunity. For our purposes it is critical that Apple - which does not make even a single device that competes in the 250-million-device-per-quarter feature-phone market - is not slashing margins to take share. Indeed, the evidence of mid-product-cycle component improvements suggests that Apple is improving its technology to widen margins.
Apple's complete absence from the non-smartphone market means that Apple is a minority vendor in cell phones just as it is a minority vendor in the PC market. As with the PC market, Apple's cell phone profits outstrip its share.
Cast in the light of its successful iPod strategy, Apple's recent success in iPhones and iPads seem unlikely to be adequately explained as the result of first-mover advantage or a the fluke of a product that happened to catch the updraft of a fad. Competitors have been viewing, using, and disassembling Apple's phones, tablets, music players, and computers for years without managing to match its margins. It is difficult to credit the assumption that suddenly - just as Apple has experienced share multiplication in China of 5x from the year-ago quarter - Apple will lose its unit sales volume, margins advantages, or market power. Apple's demonstrated ability to grow in the PC market even as competitors slowed suggests that Apple is more successful in resisting adversity than is credited to it by critics who seem to assume that Apple's success in the marketplace can be attributed to a fad.
A look at the iPod launch video doesn't depict Steve Jobs attempting to build a fashion brand in order to ride a fad for a few years. The video (linked above for the iPod launch) depicts Apple deliberately approaching a huge market to become its leader. In the intervening decade we saw Apple's growth in iPods dismissed as temporary (pending "real competition"), then eclipsed by its growth in iPhones (essentially an iPod Touch that also makes phone calls), only now to be overshadowed by Apple's relatively recent (~2y ago) entry into the tablet market. Apple is steadily building in iPads what it has built in the iPod and iPhone line: a product range covering all the relevant price points, denying sanctuary to competitors in any market segment in which there exists a profit to be made.
The take-home message is that the primary bear message offered for Apple - that its doom lurks around the corner because of the new introduction of real competition - is pure FUD. Apple's every competitor is fighting tooth and nail in PCs, smartphones, music players, software, and everywhere else Apple profits. This competition has existed as long as Apple has been active in the markets. (The alternate bear message, that Apple is a bubble after its long run-up, is simply bad math. Check the P/E ratio. What else with Apple's growth has a P/E so low?)
The evidence on Apple's competition in the international markets for consumer devices reveals that Apple weathers such competition successfully. Apple has maintained industry-leading margins and substantial profit share even in markets like PCs and cell phones in which its unit sales share remains below 10% globally. The broad movement of consumers from the feature-phone segment to the smartphone segment of the cell phone market couple with margins advantages to signal outstanding opportunity. The evidence from the tablet market likewise suggests that competing with Apple will get harder rather than easier.
Apple's strategy for positioning products across the markets in which it competes will continue to deliver both profits and profit growth in the segments yielding material bottom-line results.
Disclosure: I am long AAPL.