The Outlook for Apple's iPod Business

This article focuses on Apple’s (AAPL) iPod business. The iPod has contributed significantly to Apple’s growth the past several years. However, iPod unit growth has been slowing, as nothing can grow forever. Apple has made some modifications to its iPod line which should help boost iPod demand. Apple announces Q2 results today, and unit sales growth as well as iPod ASP will be areas of focus.

Deceleration of iPodsales growth is pointing to a market approaching saturation. Considering Apple has sold more than 140 million iPods, it’s not inconceivable to think that the PMP market is maturing. The iPod segment was Apple’s primary growth engine for FY05 and FY06 representing 58% of the dollar sales increase both years.

As iPod sales began to cool last year, Mac growth accelerated becoming the primary growth supplier. While investors aren’t expecting the iPod to be the chief source of growth going forward, sales still need to keep rising to not become a drag on Apple’s overall growth.

Apple will have to depend more heavily on the iPod customer base as a source for continued iPod demand. The introduction of the iPod Touch, and the Shuffle’s reduced price point, should help support iPod growth in the near-term. The Touch boosted iPod average selling price per unit in Q1. If Apple can continue to boost ASP, then the slowdown in unit volume growth will less adversely affect overall revenue.

iPod Sales
iPods were the primary growth engine for FY05 and FY06, responsible for roughly 58% of Apple’s total revenue growth for both years. In FY07, iPod segment generated only 14% of overall sales growth. As a percentage of total revenue, iPod accounted for 33% (FY05), 40% (FY06), and 35% (FY07).

It’s not a surprise that sales of iPods have been slowing. Since we live in a world of limited resources, growth cannot persist indefinitely. As iPod sales have grown to staggering heights, the Law of Large Numbers takes effect. To continue its FY07 31% unit growth rate, Apple would need to sell close to 70 million iPods in FY08, which is one-half the 140 million total sold over 6 years. At that growth rate, iPod sales would be 200 million FY12. It’s Highly unlikely that annual sales volume would ever achieve that level. Unit growth has been trending towards a rate in the teens, possibly single-digits.

Last quarter, Q1 2008, units increased 5%, compared to 50% growth in Q1 2007. Yr/Yr 2007 growth rates were 24% (Q4), 21% (Q3), and 17% (Q2).

Unit growth was 31% in FY07, compared to 75% (FY06), 409% (FY05), 371% (FY04), and 149% (FY03).

iPod unit sales only grew 5% (y/y) for Q1, but dollar sales increased by 17% due to a higher average selling price (ASP). After 8 consecutive quarters of declining ASP, the Touch reversed that trend as ASP rose last quarter to $181/unit. You would have to go back 6 quarters to find a higher ASP. Boosting the ASP is a very positive sign in light of the slowdown in volume. Going forward, ASP will be the key metric to focus on. (Click charts to enlarge.)

Product Life Cycle:
iPod sales have mirrored the S-curve, which generally depicts the product life cycle. There are 5 stages in the PLC. Initially, sales growth is flat and then begins to increase in the introduction stage. The product enters the rapid growth stage, where sales increase at an accelerating rate. In the slowing growth stage, sales increase at a decreasing rate, finally to a point where sales turn flat as the product enters the maturity phase. Sales growth turns negative in the decline stage.

To avert the Decline (or mature) stage, product innovation is needed to rejuvenate sales growth. Introducing improved models with new features can sprout a new curve from sales growth reaccelerating. The S-curve then takes on a more scalloped shape.

To eliminate the seasonal effects, I have charted cumulative 4-quarter iPod sales. The resemblance to the de-facto S-curve is apparent.

iPod Growth Strategies

Sales can only come from 3 sources:

1. Non-users of product category
2. Competitors’ customers
3. Firm’s current customers.

Saturation occurs when the market can no longer expand from the addition of non-category users. Often, a industry shake-out occurs from firms switching focus from attracting new category users, to stealing competitors users. Weak firms are pushed out of the industry and a competitive equilibrium results. Capturing sales from competitors' users becomes increasingly difficult. A much greater focus is then placed on extracting more sales from current customers. A firm can revolutionize a mature product (making current obsolete) to start a new life cycle.

3 Sources for Increasing Sales

1. Non-Users- Don’t use product category: Attract new users.
   
   The number of consumers who don’t own a PMP but potentially would buy one is dwindling. If a consumer hasn’t purchased a PMP by now, the likelihood of purchasing one in the future is relatively low. With 140 million iPods sold and likely more than 200 million total PMPs sold, it’s increasingly difficult to keep expanding the market to new users. Yet the market will continue to expand, albeit at a much slower rate.
   
   In sum, Apple can’t depend on new users to supply the sales volume as in previous years.
   
   The new Touch has the potential to expand the market since it’s not exclusively a music/video player. For those with little interest in music, then the web browsing, e-mail, and PDA features may be attractive.
   
2. Other’s Users- use competitors’ products: Increase market share
   
   Apple’s iPod has more than 70% of the unit share of the PMP market. That number has held steady for past several years. With such a large share, Apple has already taken business from its competitors, thus less remaining to take now.
   
   The iPod has roughly 90% of the market’s dollar, thus competing devices are the most part cheaper and target more price sensitive consumers. Apple just recently cut iPod Shuffle prices from $79 to $49 making iPods more competitive among lower-priced devices. I expect Apple may slightly increase its market share, but not to an extent large enough to boost sales growth significantly.
   
3. Current Users- iPod owners: influence to buy multiple devices / buy new device more frequently
   
   iPod owners represent the largest source of potential sales. They outnumber competitors’ users and non-users likely to purchase a PMP in the near-term. Apple’s sales strategy will increasingly focus on selling more iPods to current owners since they represent the largest source of potential sales growth.
   
   Motivating current customers to buy a new iPod more frequently and/or buy multiple units are the primary methods for boosting sales among current iPod owners.
   
   PMP devices aren’t similar to printer ink, where more usage leads to more sales. Since usage doesn’t cause product consumption, the replacement cycle is longer. Speeding up the replacement cycle is more difficult than other products whereby it’s advised to “change every 3,000 miles” or “lather, rinse, and repeat” and “best if used by x date.”
   
   Device enhancements from adding new features and expanded capabilities speed up the replacement cycle. A number of iPod owners buy a new generation model because of better features even when their current device works fine. Innovation is key driver in the replacement cycle for this type of product. New enhancements have to be so compelling to motivate the upgrade.
   
   There is little need to have more than one PMP device since a user can only listen to one device at a time. Since devices are highly portable, there isn’t a need to buy multiple devices for use at different locations.
   
   Differentiation of the iPod model line encourages the purchase of multiple iPods. The introduction of the Touch and reduction in size and price of the Shuffle has reduced overlap of features. This may lead to iPod owners purchasing an additional model since the functionality is different.

iPod Product Line

Primary attributes of iPod models:
Touch: PDA w/ internet & wide screen video
Classic: massive storage
Nano: video w/ size and price
Shuffle: size & price

One of Apple’s key strengths is innovation and the ability to improve its products in short time. This is evidenced by the five upgrades to the Classic model since originally introduced in late 2001. There have been 5 generations of the “Mini or Nano” model since 2004. The advances in functionality have been very significant, all one has to do is compare the Touch to an early iPod model.

The iPod took a giant leap with the Touch. The display is much larger than other iPods and includes touch screen navigation. Touch iPods also include WiFi, users can access the web, e-mail, and utilize the widgets to grab updated weather, stock prices, maps, as well as watching YouTube Videos. It also has PDA applications, such as calendar and notes, as do other iPods, but the Touch’s qwerty keyboard significantly enhances functionality.

The evolution of the iPod line creates a higher possibility that an iPod owner would want more than one model. For example: Touch for PDA/internet, Classic as repository to store all content, Nano (or more likely a Shuffle) for carrying a small device (during exercise).

The iPod potential market is expanded by the Touch’s new capabilities, which may attract new consumers who had little interest buying a device strictly for music and video. Current iPod owners may buy a Touch for its PDA and web functionality. When third party applications arrive in June, the Touch will be revolutionized into an entirely new device as it will receive a massive boost in capabilities.

The first iPod models only differed in capacity. In 2004, a smaller model “mini” was added at a significantly lower price point. Being just music players (later video added), consumers would choose an iPod based on desired capacity and price. Most likely, that would be the only model he/she would need/want. The introduction of the Touch changes that scenario with its PDA and web browsing attributes. The Shuffle’s diminutive size, measuring 1 in x 1.5 in and weighing ½ oz, make it ideal for physical activity. Priced at $50, it’s attractive to current and non-current iPod owners.

iPod Outlook

The Touch presents the opportunity for attracting new PMP users plus influencing current owners to “trade up” to a device at a higher ASP. The Shuffle should appeal to price sensitive consumers who previously weren’t willing to pay the high prices for iPods. These two factors should strengthen demand in light of a maturing market.

Eventually, the iPhone will cannibalize a sizable amount of iPod sales, specifically the Touch. However, since a single carrier in the US offers the iPhone and only available in few foreign markets, the Touch provides most of the iPhone features to consumers who can’t feasibly buy an iPhone. This is especially beneficial for consumers who are locked in a wireless contract with a carrier other than AT&T, or for someone working at a business that doesn’t support iPhone. The Touch lets them become acquainted with a device similar to the iPhone, and when conditions permit, enhances the likelihood that they will purchase an iPhone. I am basing that assumption on the high rates of customer satisfaction.

For the upcoming quarters, investors should focus on the trend in unit volume in the context of ASP. If unit volume is sluggish, we want to see a high ASP. If ASP is weak, we will want to see very robust unit volume.

Comments

[Dr. Dan:]

Good analysis overall, but there are a couple of points that I think were missed. First, the chart doesn't really show an S curve, it shows three of them - and each time the leveling off became pronounced, an innovation or upgrade shifted it back to the high-slope region for at least a quarter. The slope on the chart for most of '07 is virtually identical to that for most of early '06. This doesn't mean that saturation isn't a problem (each flattenning area is longer than the last one), but it means that accurate forward projections need to aim much higher. The bump in late '06 not only added 20% to the total, but also delayed the flat-to-declining section of the curve.

Finally, I have no interest whatsoever in an iPhone, both because AT&T is a company I happily abandoned some years back, and because I want a small, very portable phone with great battery life that won't be cannibalized by other uses. But, as soon as the Touch gets better PDA functions I'm racing to the store to get one, for everything it has in addition to the phone. I think there are many people like me - in love with the iPhone concept but not the phone part - and others who don't want to spend the extra money and pay monthly fees (which makes it a tough gift to present.) I think the phrase "the iPhone will cannibalize a sizable amount of iPod sales" is exactly backwards.

2008 Apr 23 02:36 PM

[WaveNet Pharma:]

That the iPhone will cannibalize a sizable amount of iPod sales is more likely than the reverse. That being said, the assumption that a touch-screen interface and a larger display will continue to propel iPhone into unimaginable heights needs revisiting. Most corporate users do NOT want to have the imprecise touch- screen input and every mobile unit manufacturer has larger-screen models available.
The exclusive relationships that Apple has obtained to launch iPhone might well end-up being an obstacle to growth over time. At this moment it is still unclear that iPhone is poised for unimpeded growth until and unless the market outside the US shows real traction.

2008 Apr 23 02:58 PM

[Grumann:]

Really good work. Thanks for the chart of unit and revenue growth. Basic information like that is often referred to but rarely provided.

2008 Apr 23 03:11 PM

[JeffDubya:]

"Most corporate users do NOT want to have the imprecise touch-screen input..."

You must be talking about a device other than an iPhone then. I switched from a Palm Treo and have never looked back. My increase in useability and functionality is easily tenfold since switching. Additionally, I show my iPhone to friends who work in larger corporate environments all the time and all they do is lust and drool. The only thing stopping them at this point is exchange support, and that is coming in June. I would not be surprised to see the iPhone market share DOUBLE in the next several years.

Also, the only way I see iPhone cannibalizing iPod sales is if Apple starts loading it with more memory. I have two iPods and an iPhone, each does different things for me. The nano is my iPod on the go, what I use for working out, etc. My classic is 160 GB of movies and a portable backup of my entire digital music library, I use it more when I travel. My iPhone is pretty much a cross between the two, my iPod for the car.

I can't ever see using the iPhone for working out as it's a bit large for that, and I wouldn't want to take the risk of dropping it. PLUS, I want to get away from the phone now and again!

It will be interesting to see what Apple does with this evolving technology. The only weak part about this otherwise excellent article is failing to recognize how Apple is constantly able to innovate and create new and exciting products that customers desire. Not everyone needs a new iPod, but if Apple continues to improve the product, people will just want it.

2008 Apr 23 04:13 PM

[BlogCruiser:]

Much of your analysis makes sense. However, assuming that ipod sales have reached a saturation point ignores the huge international market that can be reached with a lower priced product (like the nano). There are plenty of potential ipod users in China, India, Central America, etc. who are in the non-users category who would buy an ipod at the right price. That said, Apple has traditionally ignored international markets ....

2008 Apr 23 04:47 PM

[Murphy Mac:]

Agree or disagree, this article has too much rational thought to be featured on Seeking Alpha.

As for the iPhone cannibalizing: The article said specifically the touch will be cannibalized. I'd have trouble arguing with this. I'd sell my touch the same day if I had an iPhone.

2008 Apr 23 04:49 PM

[Murphy Mac:]

Demand for a physical keyboard sounds like people who want to dial and text while driving. I can bang stuff out pretty fast on the touch keyboard. Don't condemn me - I see the physical kb benefits - but to me they're not worth the cost.

2008 Apr 23 04:54 PM

[Turley Muller:]

Some excellent comments here.

@ Dr. Dan- I totally agree that there are 3 S-curves underlying the entire curve.

Your comments explain my statement " Introducing improved models with new features can sprout a new curve from sales growth reaccelerating. The S-curve then takes on a more scalloped shape." I should have tied that into the 3 mini- S-curves. But in all, growth has been slowing, yet it's inevitable. However, with product innovation, Apple can keep iPod growth continuing.

2008 Apr 24 04:56 PM