Contrary to Some Opinions, Apple Doesn't Do Loss Leaders

I read two articles Wednesday morning from mainstream news sources that made me realize most people writing about Apple (AAPL) don't really understand its marketing and how it sells its products. Secondly, both articles show a remarkably poor understanding of product businesses overall.

First, I read TheStreet.com claiming that because of the upcoming recession, Apple should slash prices on iPhones to guarantee it makes its sales goal of 10 million phones by the end of 2008. The second bit of fiction I read was from Silicon Valley Insider claiming that at current prices, Apple is subsidizing Apple TV purchases through movie rentals, because iSupply claims the parts cost of the 40 GByte device is $237 and the device now sells for $229.

Based upon these articles, an uninformed reader might conclude that Apple has a new strategy of selling loss-leading devices and relying on revenue from services to keep its profits aloft. That uninformed reader would also be horribly wrong.

Read my lips: Apple doesn't sell products at a loss. Why? Because its a very risky and largely unprofitable marketing strategy, for one. And even worse, it would undermine the marketing value of their products that they have labored for decades to build up. Frankly, it would be a stupid move, and Apple isn't stupid.

So where do these analyses claiming that Apple is doing stupid marketing come from? Well, theStreet.com seems to lay the blame at the feet of "some analysts", although the quotes cited are more muted about price cuts than the title implies, only claiming that there is room for a price cut. And in an attempt to balance the coverage, the second page of the article does note that the sales to date don't imply there's any lack of demand:

"The 4 million phones sold in the first six months is also double the initial run rate of the Motorola Razr," says Abramsky. "From our perspective, the early performance of the iPhone is nothing short of remarkable relative to other historic phone launches."

So if the iPhone sales are arguably the best phone launch in history, why does Apple have to cut prices? To become like Motorola (MOT) (given Motorola's trajectory, I don't think that's a good idea)? And why is $399 so high a price for an 8 GByte Apple product when 8 GByte Nokia (NOK) N95s are selling for $599?

What about the Apple TV article? Well, the key to that article is to read the footnotes on those parts costs. While iSuppli does claim that the parts and manufacturing cost of the 40 GByte Apple TV are $237, the analyst specifically notes that "the processor is a big unknown for us." I argue that the entire motherboard/processor combination, which iSuppli costs at $138.10, is overpriced by about 50%. If I surf over to NewEgg.com, I can find Intel micro ATX motherboards with 1.8 GHz processors and graphics controllers for $67; the Apple TV processor is only a 1 GHz Crofton, so its price is presumably lower. Add on the 256 MBytes of DDR2 memory for $10, and I'm at $77. And those are retail prices; I guarantee that Apple doesn't pay Intel retail prices. Subtract that $62 from the parts cost, and you're looking at a total parts cost of $176 and 24% gross margins for Apple. And that parts cost is probably too high because of the older and slower Crofton processor Apple actually uses.

I've argued before that the number of examples of companies buying market share profitably are nearly nil. The best counterexample is the Playstation 2, which Sony sold at a loss for a year or so while making a profit on the games it sold. But to the hundreds of other product managers who plan to sell their product at a loss and make it up in volume, I have a news flash: you aren't Sony. Most businesses using loss-leaders don't make profits, but simply reduce the amount of money they are losing.

The bottom line: Good businesses focus on making money overall. Great businesses make money on every single product and service. Apple didn't get to where it is today by settling for "good."

Disclosure: Author is long AAPL.

Comments

[Tom B]

4 million in 2 quarters, projected out, actually gets you to 12 million by the end of 2008-- well above 10 Million target. Recession or not, I think they'll beat 12 Million.

I agree with you, Carl. It would be brain-damaged to cut the price of the phone. People conceptualize cell phones as "free"; I see a high-end iPod with advanced Internet and phone capabilities. And I understand iPods are not "free".

[sane_man]

So, is this the same Carl Howe who opinioned that iphone is going to take over the world because he was able to browse the web thro' iphone from church? Irrespective of whether Apple slashes its prices or not, it is in a difficult situation. If Apple wants a high margin of around 34% for consumer products, it is living in its own world. What is the price of a walkman today and what was it 10 yrs back? Same thing will happen to MP3 players. The option is between devil and deep sea for Apple. As, I said before, if Apple lowers the price of oits products, its stock will go down because of margin reduction. If it does not lower the price of its products, competition will dump cheap alternatives and Apple will be toast. Apple pumpers have to take a U turn soon. They will do that just after dumping their holdings on this stock.

[Tom B]

You get what you pay for. The margins on junk, like Dell PC's or SanDisk MP3 players are lower because the products are inferior.

The exception, of course, is MSFT, a company that consistantly achieves absurd margins on awful products (Windows and Office) because of monopoly power.

[Thomas A, Gaughan]

Carl Good article,
Anything to with the street .com, It always throws a Red Flag up for me, That's because of one person JIM CRAMER, we all know Kramer worries more about his Hedge Fund Buddies, than the average retail investor, Right now Kramer been saying to sell Apple. Before earning he was telling everyone to buy Apple, Now he saying apples 4th quarter was horrible. He use His Show , to promote stocks, I believe his hedge fund buddies tell him. One day telling people buy then he telling people to sell in the after noon. He forgets that thier are people that purchased apple at 190, 200, and so on. So the street .com does shareholders a disservice buy doing their terrible reporting.

Thomas A. Gaughan

[User 128952]

@sane_man

Apple schooled EVERYONE on how to do EXACTLY what you are talking about. Just look at the iPod. They will intro new versions of iPhones and drop the price of the current version . . . slowly . . . to maximize their return. They will go above and below the current iPhone to protect their market AND their margins. Can you say Shuffle. Even at the lower end of the product range they own the market . . . because they slowly built the eco-system to support it. That is what the SDK for iPhone is all about. It takes time to build a solid business, not price adjustments. A cheap version of an iPhone made by someone else without the hundreds of capabilities that the SDK will bring will be worth about as much as that old walkman you mention. I'll keep my apple stock thanks . . . and if it go's a smidge lower I will by more.

[taojones]

I'm much more interested in why al gore exercised his options for 1000 shares today!

[User 128952]

. . . and if it GOES lower I will BUY more.

Sorry . . . typing too fast.

[Tom B]

"I'm much more interested in why al gore exercised his options for 1000 shares today!"

Selling shares with Apple stock currently in the toilet seems foolish. Were they due to expire? Do you have a link?

[dithers]

Apple have as much as 90% of the MP3 market revenue and about 75% in numbers sold. This suggests that people will pay more for quality.
(zune, anyone? LOL!)
They have 20% of the Smartphone market - and thats with ONE carrier and mostly US sales.
They grew their Mac computer market by 47% from a year ago.
Their market share is growing rapidly.
They have never dropped prices - why should they, they have a superior product line.

Lets not forget that Apple is the ONLY real alternative to the rubbish from Microsoft - the market is theirs for the taking.

They will go to 25% market share in pc's within 5 years.

[ANON123]

I think you are 100% correct. Steve Jobs is everything but stupid. And selling lots of copies for a 5 cent produces lots of losses. Look at Motorola. They tried to buy market share by lowering the cost of RAZR and in the bargain (a) lost market share (b) lost money every quarter (c) destroyed the brand. It was a loss loss for everyone.

[Tom B]

Keep this always in mind: there are MANY people who profit financially by attacking Apple. Putting out the idea that Apple "has to drop the price" creates the impression that iPhone sales are low which, I believe, is not true.

[.crazylegs..]

Apple is kicking everyone's ass in everything they do right now because they have the most elegant software combined with extremely well designed hardware AND very smart marketing. A cash balance of $18.5B (and growing) provides a nice cushion too. Argue all you want, but I would rather bet on a company with low (and increasing) market share, excellent end user satisfaction, and sticky customers. I don't know anyone who has switched to a Mac and willingly switched back.

Their competitive advantage is in the end-to-end model where they create both software and hardware. Going forward the margin of superiority will increase as ALL of their products will fall under one core OS which will make all those devices play very well together.

The seeds for their future growth were sewn when NEXT was purchased by Apple, Steve came back, took over, and installed NEXT's unix OS as OSX. Watch as Apple uses this to push further ahead in innovative software with more great hardware while msft drags all of their legacy, bloated spaghetti code along. I guess Windows 7 is due out sometime in 2011? Ouch. I can't wait, because it will cause even more folks to choose a Mac than the nightmare they call Vista.

[.crazylegs..]

Just wanted to own the above comment instead of the anonymous user143430 name.

[.crazylegs..]

weird. wouldn't let me put my name, let's try one more time.

[top_tier]

Good post Carl,

A couple points. One should basically boycott all street.com news, they make money off of clicks (ads viewed). Most of it is FUD as described by a previous individual. Cramer made it be known how he and his hedge fund buddies operated in his hedge fund days youtube.com/watch?v=GO... Cramer still operates this way and Mad Money and Street.com are his tools.

In reference to the street.coms mention that Apple "needs" to lower its iPhone price to make the 2008 10 million goal is another example of how thier FUD is used. This article creates doubt (purposefully), it makes no mention that Apple will have more channels for sales as the year progresses (asia), it says nothing about the 3G phone coming out mid year that many probably are holding off purchase in wait for. Do you think they do not know this?

So, as Apple moves through the year the iPhone will be enhanced aka SDK. A 3G will come out. They'll open up to much broader markets. None of these are subtle things, all these points will likely be huge drivers of iPhone sales. And there is a chance Apple will lower the price of the current breed of iPhone when they launch the 3G variant min 08.

[artman1033]

Excellent points Carl. I still think aapl will earn a decent return on the movie downloads. What do you think Carl?

[James Cullen]

>>>"4 million in 2 quarters, projected out, actually gets you to 12 million by the end of 2008-- well above 10 Million target. Recession or not, I think they'll beat 12 Million."

How can you use a simple linear model to make the 12 million prediction, given how front-weighted those sales were around launch date? It's like a movie premiere - opening weekend is best...