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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.

Wednesday, April 23, 2008

A Look at Apple's iPod Business

Apple Inc, (nasd:AAPL)- This article focuses on Apple’s 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 April 23rd, and unit sales growth as well as iPod ASP will be areas of focus.

Deceleration of iPod's sales 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.

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 5 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.


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