Marginal Opinions on Apple

Missing the point
Ever since Apple (Nasdaq: AAPL  ) introduced its new Mac Mini and iPod Shuffle -- only a couple of days ago, even though to some it might seem like years -- the financial press has been aflutter with reports that the rollouts would cause trouble with margins.

I find this concern peculiar, given that, over the past year, most of the analysts have ignored the three-year downward trend in gross margins while at the same time screaming, "Buy!"

A quick definition for the head-scratchers out there: Gross margin is the percentage of sales that you have left after accounting for what it cost you to build a product.

Getting back to business, this margin erosion was brought about by the rise of the iPod. Simply put, Apple makes more money per computer than it does per iPod, on a percentage basis as well as on an absolute one, because iPods sell for much less than computers. Since Apple's computers are priced at a premium, a shift in the mix of CPUs versus iPods would naturally bring about a decline in gross margins, and maybe even net margins, depending on how much it costs to sell these things -- something we see in the filings as "selling, general, and administrative" expenses, or SG&A.

But then, this is the way things used to be. As I pointed out in my commentary on Cupertino's Q1, Apple's net margins soared as the huge revenue increases leveraged big profit gains relative to fixed -- or relatively fixed -- SG&A costs. More interestingly, Apple's gross margins increased as well. Since product expenses aren't broken down by product, we don't know how much of this gross margin increase was due to the comeback of computers, which increased 26%, and how much comes from better gross margins on the music player.

I'm going to go out on a limb and guess that, as Apple geared up to deliver 4.6 million players in a single quarter, its costs per unit just might have shrunk. And I'm going to go one better: I'm betting that the margins on the new, low-priced Mac Mini and iPod Shuffle do not come with a big dose of bad margins that others are predicting. I'm speculating here, but stick with me.

Eyeless iPod
Anyone else wondering how Apple could afford to undercut similar, mass-market, flash-based music players by some 30% in its iPod Shuffle pricing? You think they're taking a wallop on these just to increase sales? C'mon! Mamma Jobs didn't raise no dummies.

To me, the answer is crystal clear: It's the screen, baby. Take away the display, take away the fancier OS chips necessary to run a visual user interface (UI), take away the extra manufacturing steps and buttons it would take to run that UI, and I'll just bet you take away a lot of cost.

But if everyone else has a screen, how do you compete? Easy: You order them to "fuhgeddaboudit" at a gala Macworld unveiling. You tell them screens are for squares, Daddy-O. You say, "We're different from that." You compensate for your austerity plan by naming the thing "Shuffle" and by convincing the masses out there that they don't need no stinkin' screen. You've got plenty of consumer capital to spend because the iPod is a megahit and the press adores you. Bingo -- you turn a problem into a feature. Very clever.

Whatever your opinion of the merits of the approach -- and I think the lack of screen might come back to bite Jobs in the tuckus -- Apple may have kept gross margins at a much better rate than the Street expects. I say the margins here are fine, and even if they're not, they probably won't sell enough of these -- in dollar terms -- to upset the Apple cart anyway. And if they bring people into the store, well, we'll talk about that below.

Headless Mini-Me
The mainstream press is raving about this $500 computer that doesn't actually cost $500. Meanwhile, some market-watchers are rumbling about the cost that this budget machine might bring to bear on Apple. Once again, I find those concerns flawed. First of all, I think margins on the Mini are not so bad. Here's why: Dell (Nasdaq: DELL  ) can sell a similar-level computer for $50 less in addition to giving you the speakers, monitor, mouse, keyboard, and a bowl of soup. If Dell can do that, Apple can do fine on the Mac Mini alone.

So, the Mac Mini comes with nothing. No keyboard, no mouse, no speakers, no screen. The theory out there, again promulgated by Mr. Jobs himself, is that PC users will buy this as a second computer and hook it up to the old spare parts they've got kicking around.

I don't believe that for a moment. First of all, PC users don't have old USB mice and keyboards hanging around because, until recently, the vast majority of PCs took serial input devices. They may have monitors stuffed away, but I doubt that many people want to put a giant, ugly, old, dusty CRT next to their stylish little mini-Macs. Some will. Most won't. And I'll bet you your Apple shares that Steve and Co. know this too.

What does this mean? Buyers interested in the Mini are likely to spend much more than just $500 for the bare-bones box. As I have mentioned, the cheapest minikit you can put together at Apple's online store costs $800, and it features a big, ugly CRT display. Add improved memory, an Airport, and other features, and you're very quickly pushing $1,000. At this point, I'm betting that the margins are very, very good. Also at that point, anyone who balks at dropping that much for the Mini will probably be thinking, "hmmm, that iMac over there is only $1,200," and the buying up begins. That's where margins are even better.

See how this works? It's like $5 cases of Coca-Cola (NYSE: KO  ) just inside the door of Wal-Mart (NYSE: WMT  ) . If the Mini's $500 promise can just get people in the door at the Apple store, they'll probably walk out with something pricier. To be clear, I don't see this machine converting the price-conscious PC consumer, because anyone can do the math to figure out that the Mini doesn't actually compete. If it's not a $450 Dell, it could be a $600 system from Hewlett-Packard (NYSE: HPQ  ) shoveled out by the pallet-full at my local Sam's club.

But the Mini might take a few of those skeptical consumers who are straddling the fence and push them into Apple's side of the pasture. It might just persuade Mac users who still slave over aging G3s to get themselves to the store. And, given Apple's tiny market share, nominal increases can have heavy fallout -- of the good kind -- on the bottom line.

For related Foolishness:

Seth Jayson is now the most Mac-daddy dandy on his commute. He's got an iPod Shuffle going into one ear and an iPod U2 blasting in the other, but he has no position in any firm mentioned here. View his stock holdings and Fool profile here. Fool rules arehere.


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