The Nexus 7: A Threat To Apple's Current Business Model?

| About: Apple Inc. (AAPL)

As any investor or electronics enthusiast should know by now, Google's (NASDAQ:GOOG) Nexus 7 has officially arrived. The tablet went on sale weeks ago and started shipping last week to customers that have pre-ordered.

Much of the initial analysis surrounding the Nexus 7 was whether or not it was a real competitor to the iPad. Most reviewers have mentioned pros and cons of the device, but the overall opinion seems to be quite favorable; MG Siegler at Techcrunch, who's (perceived) Apple (NASDAQ:AAPL) favoritism is famous, wrote a very positive Nexus 7 review titled "An iPad Lover's Take on the Nexus 7." His overall thoughts can be summed up with his quote:

Normally when I get a review unit of a non-Apple product, I have to force myself to use it to get a sense of how I might use it in the real world. But with the Nexus 7, I actually find myself wanting to use it. That point can't be overstated. I actually want to use an Android device. It's a brave new world.

So it seems to be clear that Apple's iPad is no longer the hands-down tablet choice for an average consumer. (I'd argue that there have been other suitable options for a long time, but the Nexus 7 may be the first tablet with mass-market appeal that many consumers are familiar with and may directly compare to an iPad.) That, alone should be a scary thought for Apple investors.

For years, Apple longs have benefited from Apple's devices being market leaders, first in terms of technology and eventually market share. When the iPhone debuted, BlackBerrys (RIMM) dominated the smartphone market, but iPhone's unique touchscreen interface and associated platform quickly displaced the increasingly-old fashioned BlackBerry. However, today, over half of American smartphones run Google's Android operating system and the iPhone's market share growth has decelerated; it is through the expansion of the smartphone market (domestically and internationally) that iPhone sales have continued to grow.

The iPad's share of the tablet market has not eroded as significantly, yet. Though the iPad was once pretty much the entire tablet market, it is still estimated to make up about 60-70% of all tablet sales. That figure would have been much higher just six months ago, before the low-priced Kindle Fire began to lure bargain-seekers. Additionally, higher-quality Android tablets from many manufacturers have continued to flood the market. Google's Nexus 7 now seems like it was almost inevitable; there was no reason why Apple should enjoy a higher share of the tablet market than it does in the smartphone market.

However, this competition is not the main concern for Apple shareholders. As was the case with the iPhone, Apple could still produce outstanding profits for shareholders even if Google (or Microsoft's (NASDAQ:MSFT) Surface, or other devices) erode share; the size of the tablet market is still increasing rapidly enough that sales can increase while share stagnates.

The real reason why this should be a point for Apple shareholders to reevaluate investment strategy is that margin compression seems inevitable for Apple in the next few quarters.

As MG Siegler (and many others) have pointed out, a 7" iPad seems all but guaranteed at this point. The Kindle Fire and Nexus 7 (and even BlackBerry Playbook) have made consumers realize that 7" is a great size; in his Nexus 7 review, Siegler says that:

...a 7-inch tablet is different. The iPad is clunky to read in bed, for example. The Nexus 7 is perfect for that. More broadly, the 7-inch tablet further opens the door to true mobile computing. I find myself constantly using it while walking around the house (as opposed to sitting on the couch). And I don't think twice about shoving it in my bag when I take off for the day.

In the world of one month ago, a 7" iPad would have been something Apple shareholders could have gotten excited about. Apple would have probably introduced it at pricepoints about halfway between the iPod and iPad (meaning about $350 for a base model and maybe $600 for a top model) and still have been able to enjoy its usual gross margin of 40-50%. But I don't think that this is possible anymore, thanks to the Nexus 7.

Google has now directly shown consumers that they are overpaying for Apple devices. Sure, everyone has "known" that for a long time; often times, in comments sections of electronics websites, people even brag about liking to pay the premium that Apple devices command. But Google has now directly demonstrated that premium electronics don't have to cost that much, and it's going to become much more painful for the marginal tablet consumer to justify paying a large premium for an iDevice.

I anticipate that Apple will end up releasing its smaller iPad at a price more similar to the Nexus 7 - a base model may retail for $200-250. Assuming that Apple's estimated cost is the same as Google's ($175 for the base model) and a $250 price tag, Apple's gross margin on a mini-Pad would be just 30% - great for most companies, but not for Apple, especially because that sale would have been at a higher margin and for a higher dollar value in the past.

And such a trend will only continue affecting the rest of Apple's product lines. While carriers still heavily subsidize the iPhone, they will be less likely to do so in the future as Android (and potentially Windows Mobile) phones draw the attention of more consumers. (Samsung's Galaxy S3 just claimed the title of highest launch sales for any smartphone - iPhones inclueded.) Also, now that the iPhone is carried by three of the big-4 carriers, there is less incentive for carriers to try to use the iPhone as bait for consumers. While Apple's computers are still adored by fans and respected as best-in-class examples of product design, ultrabooks (NASDAQ:INTC) and all-in-ones are now encroaching on the space. Once again, some consumers on the margin will be won over with the PC's lower pricepoints (driven by the manufacturers' lower margins).

I think that Apple's margins will hit a high-water mark this year. As growth of the smartphone and tablet markets slow and eventually peak, so will Apple's sales and profits.

Apple is so inexpensive right now that shorting it probably doesn't make sense. However, entertaining the idea of trimming one's long position sometime in the near future may make sense for multiple reasons. If margins decline, profits will eventually follow, and Apple's 15 P/E may creep higher without much appreciation in shares. Additionally, (and this is also one of the reasons why Apple shares do not trade at a higher P/E right now) ownership of Apple (by both individuals and institutions) is already so widespread that there are not many marginal buyers, but there will be marginal sellers. Mutual funds that have held Apple shares forever (and now are holding a very high percentage of funds in Apple) will eventually have to pare positions when performance stagnates or declines.

While I think that this margin compression and decline is inevitable, it's understandable if one is a bit more skeptical. If that's the case, just keep an eye on gross margins in the first quarter after the smaller iPad comes out; it should be evident whether or not it is indeed a threat to Apple's current high-margin business model. At that point, if shares are more richly valued than they are today, it may be worth considering a short (via puts) position in Apple.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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