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

Calculating Gross Margin for Apple's iPhone (4Q08)

APPLE INC (nasd:AAPL) According to my calculations, deferred revenue booked from Q4 iPhone sales carries a 55.5% gross margin. Gross margin on the deferred revenue (DR) booked from the first generation model averages about 29%. The average gross margin for total booked DR is 47.8%.

I derived this number from the “deferred expense under subscription accounting“ that Apple disclosed in its annual filing (10-K) in conjunction with the deferred revenue (under subscription accounting) also reported. I used some rather extensive math to come up with the 55.5% number which I discuss below.

Apple’s ”Non-GAAP“ figures it provided for Q4 implies that 3G iPhone GM was 47.8%. According to the 10-K, GM for iPhone deferred revenue not yet recognized in income is also 47.8%. Coincidence? Not likely. Since the deferred revenue carried on the balance sheet includes both the original and 3G models, that GM should differ from the GM implied by Q4 Non-GAAP numbers that solely comprise of 3G unit sales. We know that the GM on the 3G model is much higher than the first model.

So why is the GM according to Apple’s Non-GAAP figures the same as the GM derived from the 10-K? Apple included estimated future warranty expenses in the adjusted cost-of-goods sold (COGS), which inflates Non-GAAP COGS and understates GM. The amount of estimated expense is at Apple’s discretion. In my opinion, Apple overstated the Non-GAAP COGS adjustment for the sake of conservatism, but also to obscure the true iPhone GM. Normally, under GAAP accounting (subscription), Apple recognizes iPhone warranty expenses as incurred. However, Apple added its estimates for future warranty liability into the COGS adjustment, and I believe management was very conservative.

The gross margin on the iPhones sold in Q4 that will be recognized over the coming seven quarters is 55.5%. There will be some warranty expense incurred, yet I expect it to be relatively small. It’s likely that most of the warranty liability is incurred during the period sold. If a unit is defective, the problem usually surfaces shortly after it’s purchased.

I estimate the normalized gross margin is even higher, possibly north of 60%. Thus, iPhones sold in 1Q09 and beyond will carry higher GMs, assuming ASPs remain constant. iPhone GMs for Q4 were abnormally compressed due to elevated shipping costs, adapter recall, and other various expenses related to the global introduction of the new 3G model.

Gross Margin- Non-GAAP Reported Q4:
For the first time, Apple provided adjusted figures showing the actual iPhone sales/income earned in the quarter. Until Q4, Apple always gave the GAAP numbers that uses subscription accounting for iPhone sales. Instead of recognizing the actual revenue earned for the quarter, it is spread over 24 months and amortized on a straight-line basis. Using normal accounting methods, total revenue would have been 3.787B higher, or 11.682B. Cost of goods sold (COGS) increases 1.975B to 7.161B. Overall gross margins improve from 34.7% (GAAP) to 39.0%, which equates to a 47.8% GM for the iPhone adjustment ([revenue adjustment - COGS adjustment] / revenue adjustment).

However, the 47.8% figure is not the true iPhone GM. First, the adjustments include AppleTV sales, yet that amount is believed to be quite small relative to the iPhone, thus the effect is probably very minimal. Second, and most important, is that Apple included the estimated warranty costs for over its full life in the COGS adjustment.

iPhone Gross Margin- Deferred Revenue/Costs Reported in 10-K:
Without knowing the amount of deferred iPhone cost booked in a quarter, it’s impossible to calculate iPhone gross margins. Apple’s quarterly filings discloses the iPhone portion of deferred revenue which is reported was a liability on the balance sheet, but Apple never broke out the iPhone related deferred costs that is included in an asset account. The actual amount of iphone revenue earned in a quarter can be determined by adding the change in DR account (+) the amount of iPhone revenue recognized in income. To find the actual product costs, we need the change in deferred costs. In its annual filing, Apple disclosed the amount of iPhone related deferred cost on the books at the end of Q4, but we don’t know the Q3 number.

Using the DR & DC at year-end, an average GM (of all iPhone sales) can be found. At year-end, Apple had $5.78B in DR and $3.02B in DC on its books, which translates into a 47.8% gross margin for all the iPhone sales still be amortized. Since Apple gives the figures for current (less than 1yr) and long-term accounts, we can gain additional insight into iPhone margins. For the iPhone sales that will be recognized within a year, the average GM is 45.1%, and for the non-current portion, the GM is 51.9%.

The reason for the 7% difference is due to 3G sales, which carries a much higher margin than the original iPhone. Almost all the non-current DR & DC is related to the 3G, since iPhones sold in 4Q07 & 1Q08 have moved from the non-current to current bucket. Only a small portion of Q2 sales would be left in non-current, and Q3 sales were low, thus the figures classified as non-current are almost entirely associated with 3G sales. The actual percentage of 3G models can be estimated from the change in DR from Q/Q compared to the actual ending balance. Current DR increased 2.129B to 3.518B, which means 60.5% of current DR is from 3G. Long-term DR increased 1.63B to 2.62B, but the actual amount of 3G classified as non-current is higher because of the portion of legacy iPhone revenue recognized for the quarter. I estimate that 320M of DR was recognized in Q4. Roughly 86% of non-current DR is from 3G sales.

Actual 3G iPhone Gross Margin Calculation:
With the figures for (1) average GM for both current and long-term [45.1% / 51.9%], and (2) the percentage of units which are 3Gs for both classifications [61% / 86%], I solved for the “true” 3G iPhone gross margin by setting up 3 simultaneous equations. The goal is to find the GM number (for both the 3G units and the legacy units) that produces the same combined gross margin for all three classifications (current, non-current, total). As I mentioned above, I solved for the percentages or “weights” of each model represented in the amount of deferred revenue reported on Apple’s balance sheet. Using those weights, the solution I found was 3G gross margin of 55.1% and 29.2% GM for the original model units. When the 3G & legacy gross margins are multiplied by the percentage weights for all three classifications (Total, Current, Non-Current), the products equal the same gross margin extracted from Apple’s 10-K.

(1) Total deferred: 47.8(all)= .71(MGN[3G]) + .29(MGN[2.5G])
(2) Current Deferred: 45.1(all) = .61(MGN[3G]) + .39(MGN[2.5G])
(3) Non-Current Deferred: 51.9(all) = .86(MGN[3G]) + .14(MGN[2.5G])

Conclusion:
If my math is correct, the gross margin on the DR booked from 3G iPhones sold in Q4 (Sep 08) is 55.5%. This means over the next seven quarters, Q4 iPhone sales that will be recognized in current earnings contribute 55.5% GM. Yet, gross margins on units sold going forward will materially exceed the 55.5% generated on Q4 sales.

The rationale for thinking the normalized GM will be higher is due to excess product expense related to the roll-out. Shipping costs were abnormally inflated due to pressures created by supply shortages. The elevated expenses were due to more shipments of smaller lot sizes expedited at quicker delivery times. In short, distribution costs weren’t optimized, yet it’s better to spend a little more to make a sale, than to try to contain costs and forego a sale. For example, iPhones ordered through AT&T direct fulfillment were being delivered individually by FedEx. In addition, Apple stores were receiving smaller shipments but more frequently, on an as-needed basis, so that some stores don’t get too much stock leaving others short. Now that demand and supply factors are in balance, Apple is able to reduce distribution expense by shipping larger lot amounts, less regularly at non-expedited speeds.

Another item inflating product costs was the power adapter recall. Not only does this cause material costs to increase, shipping and packaging costs were likely unfavorably impacted as well.

Going forward, I foresee rising margins resulting from efficiency gains in distribution along with lower product costs resulting from falling component prices and scale benefits. Another item of note, the end of September Apple began selling unlocked iPhones online to Hong-Kong for roughly $685/$799 (free shipping). These prices are quite higher than what Apple receives on other iPhone sales. It’s possible that Apple can do decent volume through the Hong-Kong channel given the propensity for iPhones to find their way into grey markets, such as China, Thailand, Vietnam and others. It’s interesting that Apple decided to sell unlocked, open carrier iPhones only to Hong-Kong which makes one wonder if this is a direct response to the stubbornness of Chinese carriers.

Massive iPhone margins provide Apple with the ability to reduce selling price and still earn a generous profit. Apple has a key advantage over other mobile handset makers that don’t have nearly as high GMs. I expect Apple to eventually lower iPhone prices, but given the iPhone’s superior value proposition, a price cut shouldn’t be needed for some time. However, that doesn’t preclude Apple from doing so just to make competitors life difficult.

Apple could use the colossal iPhone margins to subsidize price reductions on other products if needed. Given the difficult economic environment, this is a very beneficial arrow for Apple to have in its quiver to draw upon.

Disclosure: Long AAPL