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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Friday, September 7, 2007

Positive Aspects to Apple's iPhone Price Cut

Here are several of Apple's advantages for pricing the iPhone high initially, and the benefits to later cutting price:

1) Attract more non-AT&T customers to switch carriers. Apple receives bonus revenue for new subscribers. Eventually, Apple will have to offer the iPhone to other carriers, but while it’s exclusive to AT&T Apple can capture high margin revenue. Service revenues fall straight to the bottom line, thus it makes sense for Apple to ramp up adoption as much as possible before their exclusive carrier agreement expires.

2) A high initial price meant that the early adopters would be mostly “die-hard Apple loyalists.” This consumer segment has significant Apple bias, thus those users will talk very positive about the product, hence generating significant buzz. In addition, loyalists won’t focus on any drawbacks, for they focus on all the strong points of the device. Thus, Apple is less likely to receive negative word of mouth from the product release.

3) The initial high selling price means fat margins that can be allocated toward the recapture of up-front development costs. The sooner these development costs are recovered, future margins will expand at a faster pace.

4) The new iPod Touch is essentially an iPhone, without the phone capabilities. Thus, both the new iPod and iPhone will share the same components which will drive scale efficiencies. The shared costs between the two products will aid in offsetting the margin decline stemming from the lowered selling price. Increase in volume spreads fixed costs over more units, which improves the incremental profit margin per unit.

5) The lower price point of the iPhone should dramatically boost adoption. According to a ChangeWave Alliance survey of 3,000 non-owners, one-third stated “high price” as the reason for not buying an iPhone. Roughly 25% of those respondents indicated they would “likely” purchase an iPhone in the future, which one-third said they were waiting for the price to come down.

6) Apple is switching from a price-skimming strategy to a market penetration strategy. Apple will be able to expand market share quicker; this will strengthen competitive barriers.

A skimming strategy is defined by an initial high selling price followed by gradual decreases. The concept is to capture all the demand at the highest price point, and when that demand is exhausted, the price is reduced slightly to capture demand at the lower price point. This continues until no additional demand can be generated at a lower price point.

A penetration strategy, on the other hand, is setting price lower than product costs or competitors’ price. The objective is to drive volume rapidly which will enhance economies of scale and reduce unit cost. If there are high switching costs involved, then a penetration strategy is most appropriate. An excessively high selling price just invites competitors to offer similar devices at the lower prices consumers are willing to pay.

After a consumer buys an iPhone, it’s likely they will not be looking to buy a phone for two years. Additionally, given Apples strong brand and customer loyalty, once a consumer gets his hands on an iPhone it will be very difficult for a competitor to pull them away. Apple can repel competition with the adoption of more users since it’s doubtful that other firms will want to spend the effort in pursuing satisfied iPhone users. It hasn't worked for those firms seeking to convert iPod users.

I don’t think the move by Apple is a suggestion that iPhone sales were soft. Analysts closely following iPhone sales had been reporting that sales were tracking as expected. There was a disconnect between expected sales and consumer interest.

Customer satisfaction is extremely high, yet given the underlying positive perception, adoption hasn’t seemed to develop as sentiment would suggest. The high price is certainly a barrier. Surveys and polls indicated there is significant demand potential, but the steep cost has been a formidable barrier. Lowering the price will have an immediate impact on sales, immediate.

In my social circle, the majority of my friends say they are waiting for the price to drop. Or, they were waiting for the second generation (and a cheaper price tag). I got the impression that it’s a widely-held belief that Apple would release something better and cheaper soon which made folks hesitant to take the plunge. It was bound to happen. But, no one expected it would come this soon and the price reduction would be so great.

I wonder if this price reduction isn’t preparation for a future model with enhanced functionality.
An improved camera function would seem most logical. The current camera is pretty sweet for a phone device, yet it’s still far from a digital camera. Apple already has incredible software applications- iPhoto and iMovie, which can sync with the iPhone, thus improving this feature would really make the iPhone a slam dunk.

Apple’s iPhone revenue will certainly be lower than previous forecasts since projections were assuming $550-600 average selling price. Unit volume will be much higher, it’s doubtful that volume will be great enough to completely offset the decrease in price. Service revenues should be significantly higher, and margins should recover modestly from increasing economies of scale.

The exact magnitude the price reduction has on demand will be an important indicator. If demand reacts sluggishly then Apple has a serious problem. Thus, it will important to pay close attention to how Apple’s new move plays out in the consumer market.


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