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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, December 19, 2008

Apple Inc (AAPL): Taking a Look at Mac Pricing

MAC DEMAND CONCERNS:
For past couple months, Wall Street’s concern du-jour for Apple has been Mac demand. No PC/consumer electronics firm is immune to this economic downturn, but many analysts believe there is substantial downside risk for Mac sales. Analysts claim the contracting economy is causing changes to the complexion of industry demand that could have further negative implications for the Mac segment. Specifically, the slowdown in consumer spending will cause industry demand to contract, and within the computer industry, demand will shift away from Mac to lower-priced PCs. This double-blow presents a considerable threat that Mac sales will come in way below expectations. Some argue the popularity of netbooks and other low-price PCs present a major challenge for Apple since Macs’ price points encompass the high-end of the spectrum. Thus, Apple lacks a low-price offering within the price range where demand has been and will continue to be strong.

Given the pullback in spending and the shift to lower-priced PCs, analysts have been calling for Apple to introduce a cheaper Mac to become more competitive. Many were expecting just that when Apple unveiled its new MacBooks last October. Missing from the event were price reductions. The legacy white plastic, low-end MacBook received a $100 price cut ($1099 $999), but the mid-range model’s price ($1299) was unchanged, and the high-end MacBook price increased $100 ($1499 -> $1599). This was a disappointment for those who were expecting price cuts of $200-$300, at minimum.

There was ample speculation for Apple’s Black Friday discounts. Most analysts/journalists were predicting larger than usual discounts, 15% compared with Apple’s typical discounts of 5%-10% from previous years. However, Apple offered modest discounts that were inline with its previous Black Friday promotions. Some were disappointed, notably Shaw Wu of Kaufman Brothers: “We would have hoped that with its nearly $25 billion net cash position and very favorable component pricing environment, that Apple would have taken slightly more aggressive action on pricing given that consumers are still hurting from the tough credit environment.” Ben Reitzes of Barclay’s Capital says “like to see Apple get more aggressive in terms of pricing.” The crux of the matter is that if Apple believed steeper discounts would significantly lift demand then it would have cut prices more aggressively.

Aside from the Mac Mini and legacy plastic MacBook (October price reduced to $999), Apple doesn’t offer a sub-$1,000 model. In September, Kathyrn Huberty at Morgan Stanley cut her price target on Apple citing slowing global PC sales. The next Monday, Huberty cuts her rating on Apple, and slashes her price target to $115 from $178 based on the concern that “PC unit growth is decelerating and the remaining source of growth is increasingly in the sub-$1000 market where Apple does not play.”

According to NPD, Apple had 66% market share for the above $1000 price category, and 14% overall. In an August 2008 NPD study, Apple’s market share for the past 12 months in the above $1500 price segment was 69%, up from 41% in the August 2007 survey.

Huberty points out that revenue for the premium segment has been declining (y/y) every month since the winter, and that the sub-$1K market’s revenue has been growing. She concludes that consumer demand is shifting to the low-end, where Apple does not have a presence. In addition, Huberty claims Apple is at risk because it’s highly exposed to the premium-end, where demand has been falling. However, Mac unit sales grew nearly 40% for 2008, and its share in the premium segment almost doubled. Mac sales have been growing roughly 3x the market.

Therefore, it’s Windows PC demand that is shifting to the lower-end.

If the overall industry is trending to lower price points, how does Huberty reconcile the sub-trend of increasing Mac demand, which is mostly confined to the premium segment? If Mac demand runs counter to the premium segment’s overall trend, one can’t make the assertion that there’s a strong correlation. There is a convincing relationship between ASP and growth for the industry, but not for Macs. The PC industry is comprised almost entirely of Windows PCs, thus demand for Windows machines determines industry demand. In short, Macs and Windows PCs are not similar product offerings. Some analysts, notably Huberty, appear to conflate the two. Macs are Windows machines, for one can install Windows OS on Mac hardware and use it just as if it were a Dell or HP. But, PCs such as Dell and HP can’t run Mac OS.

MAC VS WINDOWS HARDWARE:
The reason why demand has shifted towards cheaper PCs is because of substitution. A $1500 Windows PC may not be noticeably different from an $800 machine for most users. With economic fears engulfing the consumer, a less expensive PC still can do everything that a higher-end PC does, albeit with less performance. However, many consumers are not heavy users where such a difference would be detected. Even so, for most users, less performance can be tolerated. Therefore, the question is “What more do I get from spending more? What I am sacrificing by spending less?” For many, the answer is “nothing.” In short, there isn’t much difference. The consumer isn’t going to pay more if he/she doesn’t have to, especially in a tough economy.

Windows machines increasingly compete on price, and price alone. PCs have become commodities; there is little, if any differentiation among hardware manufacturers, especially desktops. Essentially, the sole proprietary aspect of a Windows machine is the brand name; most of the hardware components are sourced from 3rd party manufacturers. Whether it’s Dell, Gateway, HP, or Sony hardware makes little-to-no difference.

I understand why consumers aren’t paying-up for Windows PCs. How are HP, Dell, Acer, Toshiba, etc different from each other if they all use Intel chips, run Windows, and have many other of the same components? Consumers don’t see the value in paying a higher price for a Windows PC versus another. For a significant portion of consumers the main purpose of owning a computer is internet/email access, as well as ability to create documents. Any computer accommodates those needs, thus for many, price is the most relevant attribute. I believe this is the driving force behind netbook popularity. Many consumers desire a computer capable of performing basic tasks, such as email, internet, etc. Netbook CPUs are low-powered, and are not suitable for heavier usage, such as graphic intense games or spreadsheets containing complex formulas.

Consumers perceive less differentiation among Windows hardware, thus they are more likely to select whichever brand offers the best price for the desired configuration. Consumers are not necessarily shifting to cheaper PCs solely based on price. Consumers trade down because there isn’t sufficient value-added to justify paying a higher price.

Conversely, there is a stark difference between spending less for a Windows PC (or any amount) opposed to buying the higher-priced Mac. Mac OS X and the associated user experience are significantly different from Windows. Hardware isn’t the differentiating factor; it’s the OS. PCs are not substitutes for Macs. People who desire Macs have to spend more, but those who don’t care for Macs don’t have to pay the high prices due to the availability of less expensive Windows machines. Consumers desiring Windows OS don’t purchase Macs to exclusively run Windows since it would be a waste of money. Consumers purchase Macs for the value-added benefits supplied.

The robust growth in Mac sales demonstrates that consumers are willing to pay more for Macs. Mac’s 70% share of the premium segment suggests that Macs are essentially the only computers for which consumers are willing to pay up. Windows PCs can’t compete in the premium segment against Apple. Premium Windows PCs can’t even compete against lower-priced Windows PCs. Since Macs run Windows (many say Windows runs best on Macs), PCs don’t provide any value-added benefits over Mac. Thus, to create value to the consumer, PC hardware firms cut prices to make their machines relatively attractive. Since the Mac offers Windows OS plus Mac OS, it provides additional benefits that command a premium price.

PC prices have come down a great deal, and continue to fall. However, Mac ASPs have been relatively flat since 2003 (~$1500). It should come as no surprise that Apple’s GM has risen from 26% to 35%, while Hewlett-Packard and Dell have seen their margins shrink. Where are these analysts getting the notion that cheap netbooks will pressure Mac sales when notebook prices have been relatively cheaper for years?

APPLE’S MAC SALES STRATEGY:
The two main reasons why consumers buy a Windows PC instead of a Mac are 1) Unaware of added benefits 2) Aware of added benefits, but assign little value preferring a low benefit package at cheapest price, i.e. price-sensitive. For many, they choose a Windows machine because it’s cheaper. Consumers would pay more if they believed the incremental value added exceeded the incremental cost. Many are unaware/unfamiliar of the incremental value the Mac provides, thus Apple’s primary goal is to inform consumers most likely to perceive added-value.

The primary challenge facing Mac growth is educating the market about Mac benefits. Due to Apple’s tiny market share, its growth potential is massive. At the start of the decade, Apple’s share was roughly 1%-2% and will likely reach 10% by decade-end. The major catalysts to share growth have been the iPod, iPhone, and Apple’s retail store strategy, which have increased Mac curiosity and awareness. For the past couple years, Apple has been reporting that more than 50% of retail Mac sales are to new Mac users. This is no surprise since Mac sales have outpaced the industry by a factory of three (3x).

Remember that Apple’s share of the computer market has been in the low single digits throughout time, only in the last several years did Mac sales takeoff. Therefore, most haven’t used or possibly seen a Mac in the wild. With little or no Mac experience, an individual would have difficultly to justifying the higher price. In addition, consumers don’t actively seek to acquire more information on products that are relatively more expensive. One has to spend more time and effort learning about a product that costs more and ultimately may not be suitable or worth the price. Therefore, expensive, less-known products experience greater difficulty in making the short-list of a consumers consideration set for a given purchase decision. Apple believes its Macintosh provides a superior computing experience. There is evidence supporting that claim as Apple earns the highest satisfaction ratings and gets the best reviews from industry pundits. So, it’s more about informing consumers that its product is the best than it is making its product the best.

Apple leverages the popularity of its iPod and iPhone to heighten attention for Mac. These gadgets arouse curiosity and interest about the Mac, as well as driving traffic to its stores where consumers can experience Macs first-hand.

MAC PRICING STRATEGY:
Since Macs are highly differentiated and offer features/benefits unique to its brand, Apple is afforded significant pricing power. Apple believes since it offers a premium product it should charge a premium price. Exploding demand for Macs seen in the past several years demonstrates that consumers justify paying a higher price (relative to PCs) for the extra value/benefits unique to Apple. Apple believes that there are many potential consumers that would share the same opinion if they were more knowledgeable about Macs.

Cutting prices does little to advance product knowledge for the uninformed consumer. Macs would still be pricier, and the consumer still wouldn’t know why. Thus, reducing Mac prices wouldn’t boost substantially boost demand. Many analysts miss this point. Amazon’s best selling notebooks are all within the $350 - $600 price range. If Apple cut the price on the $1299 MacBook to $1000 or even $800, it’s still more expensive than the more popular, cheaper notebooks. The $999 legacy white plastic MacBook has been less popular at Amazon than the $1299 new aluminum MacBook. There is a bifurcation in the computer market- 1) consumers seeking lowest price 2) consumers seeking value-added. The former are buying netbooks and the latter are buying Macs. If price were as significant an issue as analysts claim, then the $999 MacBook (actually $910) wouldn’t be ranked #15 behind the $1299 MacBook ranked #7.

I believe it’s not the size of the price differential versus the amount of added benefits that is in question. To clarify, it’s not that consumers don’t believe that the higher price of Macs aren’t justified by their unique features, it’s that consumers aren’t aware or don’t care for Mac features. Those who are price-sensitive and seek bare-bones machines are a waste of Apple’s time to pursue.

Apple would have offered larger discounts (as analysts were predicting) on Macs for its Black Friday sale if it thought lower prices would materially affect demand. Unit sales wouldn’t increase very much, but dollar revenue would decline (lower ASPs) when customers are willing to pay the higher prices.

Apple still has an abundance of potential consumers willing to pay premium prices for a computer that Apple has not yet penetrated. It is these consumers that Apple is chasing, the mid to high income demographic, which are less price-sensitive and receptive to a product that offers value-added benefits. Generally, these consumers understand that “one has to pay more to get more,” and that if a product is cheap, “then it’s cheap for a reason.” In addition, sometimes saving some bucks might result in owning a product that is unsatisfactory, or possibly worthless. In these circumstances, one often is forced to make another purchase since the original product was a dud. Thus spending the extra cash, on the margin, makes the most economical sense. In essence, by spending more, one may be actually be paying less considering the long-term costs and product life.

On the 4Q08 conference call (from Seeking Alpha), Steve Jobs remarked: “There are some customers which we choose not to serve. We don’t know how to make a $500 computer that’s not a piece of junk, and our DNA will not let us ship that. But we can continue to deliver greater and greater value to those customers that we choose to serve and there’s a lot of them. And we’ve seen great success by focusing on certain segments of the market and not trying to be everything to everybody. So I think you can expect us to stick with that winning strategy and continuing to try to add more and more value to those products in those customer bases we choose to serve.”

APPLE’S CHALLENGES:
The economic turmoil presents a significant challenge for Apple. As I mentioned previously, it’s not consumers that normally would buy a Mac trading down as some analysts suggest. Consumers either want the added benefits Macs provide, or they desire the basic functionality of Windows OS PCs. If one wants a Mac, then there are no other alternatives; Macs can’t be substituted by Windows PCs opposed to the substitutability of cheaper Windows PCs for more expensive Windows PCs.

The recession won’t cause cheap Windows PCs to take sales away from Macs, instead it will slow the rate that Macs take share from PCs. The higher-end consumer that Apple targets is less sensitive to the economic cycle, yet not immune. Consumers are less receptive to learning about/trying out unfamiliar products, as their mood to spend is subdued. During periods of rising asset prices, the wealth effect reduces the threshold for capturing a consumer’s attention and subsequently closing a sale.

I eventually expect Apple to address the popularity of the netbook segment by introducing a computing device in a tablet form. I imagine it will be something similar to the iPod Touch, yet with more power and viewing area. It will offer the same functions that consumers look for in a netbook, yet the form factor will be different.

CONCLUSION:
The popularity of low-priced PCs stems from the lack of added value for pricier Windows computers, rather than the inability/unwillingness to spend more for a computer. Lower prices are driven by the intense competition among Windows PC manufacturers whereby the primary differentiating factor is price opposed to other value-added benefits. The fact that Mac demand growth (which sell at higher entry price points) has been much higher than the industry indicates that Macs don’t compete on price, but rather features/benefits.

It’s incorrect to assert that Mac sales growth is vulnerable to netbooks or cheap PCs. The real challenge facing Apple in this rough economy is attracting new users and enticing current users to upgrade/replace. New models, the expansion of the retail store footprint, the halo effect from iPod/iPhone, and positive word of mouth are the primary driver in sustaining Apple’s Mac sales.


Disclosure: Long AAPL

18 comments:

Anonymous said...

THIS HAS BEEN A BASIC PHILOSOPHY AT APPLE FROM THE BEGINNING.... WHEN THEY STRAYED FROM IT DURING THE JOBS ABSENCE THEY ALMOST LOST THEIR FOOTING.

APPLE IS WORKING VERY HARD NOW ON THE VALUE PROPOSITION BY WORKING ON PROPRIETARY CHIPS AND SNOW LEOPARD ENHANCEMENTS TO FURTHER DIFFERENTIATE PC AND MAC.

MORE AND MORE INVESTMENT AND STOCK PURCHASES ARE JUST AHEAD.... THE AGE OF APPLE WILL BE DEFINED IN THE NEXT UP LEG STARTING IN LATE 2009....

Jim said...

ditto Anonymous
Moreover the latest moves of allowing Mr Jobs to disappear from center stage will remove the Jobs reality distortion field, baring the true nature of the differences between PC-Mac.
Additional purchases of companies like the chip manufacturer last year, purchasing the graphics company this year and using the 27+ billion in cash to stablise Apple through this recession/depression.
It is all about the OS, and its integration with web-phone-entertainment.

Anonymous said...

Completely agree!

Anonymous said...

I completely agree with all of the statements that have been made. I would like to say that I have owned and used Apple products for years. To name a few, Home built Apple I, Apple II, Apple II+, Apple IIc, Apple IIe, Apple IIgs, Macintosh 128, Macintosh 512, Macintosh Plus, Macintosh SE, Macintosh SE/30, Macintosh IIx, Macintosh Quadra 800, Macintosh LCIII, A few of the Performa line, Workgroup Server 6100/60 and 66, Powermac G3 (Beige Tower and Desktop as well as Blue and White models, eMac, Bondi Blue iMac, and Powermac G4 Sawtooth, Quicksilver 2002, Powermac G5 and now a Mac pro. I strayed from the fold for a short time building my own PC systems to save money. I learned the hard way that this was a mistake for me because I enjoy the added value and performance that Apple provides. When I was given the G4 Sawtooth, which was a 400 MHz machine and it performed equally with my 2,000 MHz AMD Athlon XP, I made the switch back. I will never stray from the fold again.

Anonymous said...

Great analysis, Mr Muller. Makes perfect sense. I have changed 4 laptops in about 4 years. Dell, Gateway, HP, Sony.. all the same junk. They either broke down or I wasn't happy with it. Now I finally got a new Macbook and I consider it cheap for $1299. The monent I saw it I know I wanted it. Built quality is amazing, much different from other plastic PCs. It's very simple -- what you pay is what you get and hopefully more people will see a true value in Apple products.

Anonymous said...

Great analysis, Mr Muller. Makes perfect sense. I have changed 4 laptops in about 4 years. Dell, Gateway, HP, Sony.. all the same junk. They either broke down or I wasn't happy with it. Now I finally got a new Macbook and I consider it cheap for $1299. The monent I saw it I know I wanted it. Built quality is amazing, much different from other plastic PCs. It's very simple -- what you pay is what you get and hopefully more people will see a true value in Apple products.

Marco said...

The consumer is an interesting character. It is right to call consumers as such because they consume then they throw it away. It's the way of the world and a current paradigm. Apple are still firm believers of the old paradigm. You purchase things that will last more than the equivalent technology. When colour TVs were just appearing in the market my parents purchased a fairly expensive then Sanyo TV in 1976. The technology is very old and there were no remote controls. Tuning was done manually. The TV still works and has never had a technician look at it for any problems. On the contrary my brother in law purchased a 60" DLT rear projection Samsung TV in 2006. In 2008 the TV has broken down twice and just this week it has gone in for repairs. There's a 68cm Panasonic CRT TV replacing it for the moment. The point is that Apple will make every effort to create technology that is user friendly and long lasting. It is value for money. Something that the current technology consumer does not see and will not try to discover, being blinded by the $ factor. It's hard to swim against the current but not impossible. A stroke at a time.

Anonymous said...

Excellent commentary. Very well said. Thank you

Cranny said...

As usual, Turley's analysis is excellent and well thought out. I also agree that I doubt the decreased profit would have been offset by sufficient sales increases driven by new lower prices.

However, I would like to note that there are users like me where the price is impacting my decision to buy. I'm a potential switcher. The true Mac guys will never waver, but the pace of switching from PCs to Mac is probably slowing right now. I think I'm ready to be a Mac guy for the first time, but cost is an issue as I consider the jump. I did the same thing 24 months ago, and bought another Dell. I'll be in the market again soon, but I wonder if I'm ready to pull the trigger. Honenstly, I bet I'll continue with the torture of the PC because I'm cheap and the cost differential will stop me again.

Dave Barnes said...

@Cranny,

You are NOT the customer that Steve Jobs is seeking.

Steve wants (and continues to get) customers who say: "I want the Apple experience. Here is my credit card."

Don said...

Apple also has started doing something that the others have not done; provide an ever increasing number of quality tutorials that help insure both new and long time owners that they can easily use the power of their Mac's to do things themselves that PC folks can only dream of!

I call this Apple Magic; when you see users scroll with just their fingers, put together a movie and post it on Mobile Me, sort & tweak photos like a pro in Aperture 2 or just stare into their 24" iMac "personal drive-in movie screen", then you'll realize that Mac users are "one with their Mac" and for them, PC's are now just part of history...

_|\|_ said...

IBM clones -can- run OSX, you simply have to copy the OSX DVD to your computer, apply a patch to the DVD file, burn the DVD, pop it into your IBM clone and go.
"Many consumers desire a computer capable of performing basic tasks, such as email, internet, etc. Netbook CPUs are low-powered, and are not suitable for heavier usage, such as graphic intense games or spreadsheets containing complex formulas." Spreadsheets containing complex formulas? Those would have to be some ridiculously complex formulas to overwhelm a 1ghz CPU...

Anonymous said...

very interesting look on this, what do you personally use mac or pc? FinanceTrail

Vishesh Narayen said...

Good, comprehensive analysis. However, I felt your writing was a bit verbose and as a result your insights (which were actually quite powerful) got lost in the mix.

$ Mad Money Renato $ said...

nice blog, can we exchange links?

http://www.madmoneyfund.blogspot.com/

Anonymous said...

great post, keep it up. i also feel that I think financial institutions are in trouble. with the markets frozen, these P2P lending sites are stealing market share, by eliminating the middle man. Plus the returns seem unreal, great article on it at

www.crashmarketstocks.com

Sujan Patricia said...

Rumors of an Apple tablet – essentially a large iPhone or iPod touch, may launch in September 2009. But is it just a bigger iPhone or a totally new package, I don't know!

Rome Traveller said...

I am a huge fan of Apple products and I think their products are far superior.
Here's to the success of Apple. The tablet is great.

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