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

Jan.30.08 | About: Apple Inc. (AAPL)

By Carl Howe

I read two articles Wednesday morning from mainstream news sources that made me realize most people writing about Apple (NASDAQ: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 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, 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 (NYSE: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, 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.