A Blogger’s Advice to Apple for its Cash Pile – Cut Prices

Apple’s cash pile brings out activist investor who took large positions in Apple and bloggers with their own suggestions to Apple for the cash.

The activist investor is Carl Icahn and his recommendation for the cash is to buyback shares at $525.  His motives are clear. It is in his right to keep asking for buybacks so he can cash in on short term stock price jump.

But the implication is that Mr. Icahn and those who believe in him will only get that huge return if about a third of Apple’s shareholders think it won’t work. Either that or they would just like to help Mr. Icahn add a few more bucks to his pile.

But there is enough evidence to show that price jump from stock buybacks are short lived and pointless.  If the intention is to return cash to investors they can do so as one time dividends. Cash buybacks are actions of a company that has run out of creative ideas to invest in its future.

Since this advice is driven by profit motives this is both sane and pardonable.

The recommendation from the blogger is – “Give away media or storage. Or just cut prices“. He does make other absurd recommendations but those don’t rise up to this level. This advice is so bad it is not even wrong.

Let us see once again what he is saying – one solution to too much cash is free add-ons and  lower prices. In what convoluted  business logic can this recommendation be labelled anything but absurd? In the blogger’s mind the answer is clear because of  these reasons:

Missing out on streaming video

Why has Apple let Netflix Inc.NFLX +4.24% and Amazon.com Inc. AMZN +1.27% run away with the market for streaming video?

Strategy is about making choices. Does Apple have to play in every market? What does “run away” here mean? Amazon has not turned profit as an enterprise in past few quarters and if they were to breakdown the line of business numbers streaming video will look really bad. Netflix seems to be able to grow revenue only with subscriber growth with no foreseeable way to grow revenue per customer.

Given these we should call into question the definition of streaming video market. It should not be measured in number of subscribers but revenue and profits to be made. If Apple believes it cannot get its fair share of value created in streaming video market why should it play there?

I can go even further and argue that if diversification is what is being suggested then the business need not do its own diversification, investors can with their money.

Free this and Free that

Why, after I’ve already spent hundreds on an iPhone and a cellular plan, does Apple ask me to pay even more for enough cloud storage to back up all my photos? Wouldn’t it be fantastic if your Apple device came with a year of access to exclusive streaming movies, or 50 GB of space on the cloud (which Samsungalready does, or any number of other goodies (like the free productivity apps it is now giving away)?

I will let you in on a secret – you do not have to give anymore value than what customer is willing to pay for. You do not have to beat customer expectations by a mile, just a foot would do.   The goal of a business is to create paying customers – they do that by creating value for customers and getting their fair share of this value created.

Sure it would be fantastic to get 50GB space, so would it be to get free money.  What kind of logic is this? If Samsung does this and if customers find this value more compelling than Apple’s products they sure can switch.

The productivity Apps are not free because Apple cannot stack up the cash, they are free because Apple is likely practicing different kind of price discrimination to get even more profit than software license fee.

Add-ons and price cuts to gain market share

I know what you’re thinking: These plans would eat into Apple’s margins, and investors hate when that happens. True, but they would drive sales and improve Apple’s market share, which would be a boon to Apple’s future earnings, especially if you believe that its low smartphone market share leaves it vulnerable to Google.

Another way for Apple to boost market share would be to just cut prices, as Slate’s Matt Yglesias has suggested.

Really? Investors like margins? Investors understand anything? What about Netflix and Amazon the blogger just quoted? But the point rich in absurdity is the need to gain market share.

It is easy for anyone to compute market share – compute market size which is sum of all revenue made and find a business’ share of that total. There are metrics like HHI index and  Relative Market Share that makes focus on market share legit and business savvy.

But these proponents fail to understand the simple concept that you do not have to sell to every person who wants your product. Your strategy is to decide which segments to go after and how to maximize your profit.  Should LVMH go after everyone who wants a purse?

So why does the blogger think Apple should gain market share? To gain share to make more money from them later? Aren’t they already making more money from the share they have than any other competitor? Let him compare revenue of just iPhone line with total revenue of Amazon.

I do not know what Apple should do with its cash. But to say cut your cash pile by cutting prices to gain market share is nothing but a pile of rubbish.

Quote

Quote of the Century On Running a Business

This is from a column in The Wall Street Journal,

Another way for Apple to boost market share would be to just cut prices, as Slate’s Matt Yglesias has suggested. This would effectively return Apple’s cash to its customers rather than shareholders. But shareholders ought to rejoice at that prospect. In the long run, it’s better for Apple to curry favor with customers over investors. See all that cash? It comes from customers.

I think the absurdity of the quote speaks for itself without need for any embellishment.

Also from the same article, a quote of the century finalist

these plans would eat into Apple’s margins, and investors hate when that happens. True, but they would drive sales and improve Apple’s market share, which would be a boon to Apple’s future earnings, especially if you believe that its low smartphone market share leaves it vulnerable to Google.

The most beautiful price fence

Fence a3

Fences are never beautiful. May be the picket fences are. But when designed to keep two sides from moving easily from one side to the other they are not usually described as beautiful. Price fences are as bad as say a fence between two countries. But they do serve the same purpose – to keep the two sides apart. Here is how a research article from 2009 defines price fencing,

market segments should be kept separate to prevent demand spillover from high priced segments to low priced segments and the associated revenue loss. Tools to restrict customer migration across segments are referred to as ‘fences’

 Price fences are key components of segmentation and revenue management. They are designed such that those who can afford and willing to pay higher prices are not tempted by the lower priced versions.

Let us take an extreme example from the early days of railroad transportation. Railroads are a high fixed cost business and the marginal cost of adding one more passenger was practically zero. They could have set the ticket price really low to fill every seat but that would be not capturing value from those willing to pay higher prices.

So they offered classes of service – small number of super premium first class service, moderately priced second class service and really low priced third class service. To prevent those who can afford second class service from being tempted by the low price of the third class service railroad operators removed roofs from the third class cars.

That price fence was not beautiful.

But here is some really beautiful price fence – comes from your favorite brand that excels in product design, Apple.

mbp-price-fence-2

It is three different price points with right mix of features so carefully selected to let those who can and willing to pay higher prices from choosing the cheaper version. You may not see how impervious the fence is as you admire the beauty of the MacBook Pro. Let us dig deeper.

Between the $1,299 and $1,499 versions the differences are only in the RAM and flash capacity. Say you like the $1,299 version but just need more flash capacity. They are designed such that those with higher willingness to pay will choose the $1,499 version and pay the $200 extra.

You want the lowest priced version and try to customize your MBP with higher flash capacity. But guess what? There is no option available to increase just the flash capacity of your MBP. You can increase your RAM from 4GB to 8GB (the same level as the two versions on the right) for $100 more but cannot do that for flash  capacity. It is not hard for you to see that if RAM difference is priced at $100 the disk difference should also be priced and offered at $100.

Do not think this is a technical challenge. It is not, and it is offered as an option for another MacBook Pro – the non Retina version.

flash-upgradeThe MacBook Pro without Retina ships with hard-drive (the spinning platters kind) and if you want to customize it with SSD you would pay $200 more for 128GB and $400 more for $256GB. That is they want those customers to pay $200 for the same 128GB to 256GB upgrade.  So offering  just flash upgrade for Retina version  (for $100 as we saw above) would pose challenge to that $200 extra they charge for non-retina MacBook Pro version.

To state in simple terms, Apple’s price fences are not some isolated chain links but an integrated system of impenetrable walls that are passable only if you are willing to pay the same price where ever you decide to cross the fence.

They want $200 additional price  and they make sure they do it with price fences.

And go ahead and try to tell me that is not the most beautiful price fence you have seen.

 

The iPad Mini Retina Pricing Brilliance

ImageLast Tuesday Apple announced a refresh of their iPad, iPad mini and MacBook lines. You likely read about every piece of detail about the event, what the Apple executives wore, the nano-meter differences of the device dimensions, etc., from every major news outlet and blog.

I want to talk to you about the design of their iPad mini pricing – not the parts about how they all end in 9 or the font size they use but how this one company so effectively puts to work basic principles of pricing that are decades old.

Let us start with the objective.

Pricing for Profit Maximization – When Amazon announced Kindle Fire Mr. Bezos wrote,

“There are two kinds of companies: those that work hard to charge customers more, and those that work hard to charge customers less.”

It is understandable who he was referring to and why. But it is not difficult for you to see that no company in a free market with customer choices can work hard to charge more. Customers do not have to stand in line three days before product release to pay more, they have choice.

There there is the media frenzy. There are two types of bloggers- a tiny tiny fraction that  understands customer segmentation and a vast majority that doesn’t. For a while the latter group has been either clamoring for or predicting Apple’s move into low end of the price spectrum with cheaper iPhones, cheaper tablets and cheaper laptops. Their ill-conceived notion stems from their focus on market share as a metric vs.  a company’s profit.

A business’ goal is not to capture market share but create value for segments of customers, deliver it a price that reflects that value and maximizes its profit and of course produce it at the lowest possible cost.

Apple continues to understand this value creation (perceived or real) and designs pricing to maximize its profit over meaningless market-share numbers. Apple does not have to put an iPhone or iPad mini in everyone’s hand, after all that is the shotgun approach to marketing.

When people focus on individual details of pricing this overall objective and segmentation strategy is lost on them. It is important to get your objective right and them make sure every action, every detail and every product design feature works to further this objective.

Now let us look at iPad mini pricing through the lens of this objective.

ipad-mini-retinaiPad mini vs. iPad Retina – In the recent product launch Apple announced iPad Mini Retina for $399 while dropping the price of iPad mini to $299. When Apple first launched iPad mini they chose not to have Retina display on it and priced it at $329. Those who didn’t and still don’t understand the first point I made above were furious and upset. First they were surprised at the price tag compared to Kindle Fire. Second they expressed outrage at the lack of Retina display.

The first point needs no further discussion. The second point can be explained by failure to grasp customer value and willingness to pay. You do not have to beat customer expectations by a mile if an inch will do. You do not start by packing a product with features then try to monetize it.  You design and deliver the Maximally Viable Product not a bundle of features.

If you are a regular reader of this blog you know I have written about my doubts about the profit impact of iPad mini. You likely also read my mea culpa on using a more pessimistic model to estimate iPad mini sales. In all likelihood they could sell about  10-12 million iPad minis per quarter.

Now the Retina part.

Why now?  And why the $30 price drop in regular iPad mini?

What the $329 mini did was help expose the demand for smaller tablet and also the latent need for Retina display among those who prefer a smaller tablet.   Even if 20% of these are willing to get Retina that is $140 million in additional profit (per quarter).

If you are asking why I did not subtract the cost of Retina display, that was deliberate based on my discussion of MacBook Air Retina discussion here. There is little or no marginal cost impact from the display.

But the $30 price drop on regular iPad mini means $240 in lost profit from the rest of 80% of iPad minis.   If there were no changes in total demand, the upgrade percentage Apple needs to break-even is just 30% – that is 30% of current iPad mini customers select themselves to $399 ipad mini Retina.

The way to look at this how Apple most likely approached this – better understanding of demand curves and segmenation.

  1. The 10-12 million units sold point to existence of larger demand at lower price point-  as long as this price point will further the profit objective stated above. (Don’t lose sight of that for market share – it is not about capturing market share in mini tablet space)
  2. There exists a sub-segment that values Retina display that they are willing to pay premium for it. There likely also exist another sub-segment that stood on the sidelines not buying iPad mini because of the lack of Retina.

As you combine these two factors even if the market expands to total of 15 million units with 80-20% split between iPad mini and iPad mini Retina and 50% gross margin on mini and 62% gross margin in retina (assuming same COGS as mini) —  (15 million number is not far fetched from the scenario analysis I did a while back)

  • Lost profit from $30 price drop is 15 X 80% X 30  = $360 million
  • Profit from expanding demand for mini is  5 X 80% X $299 X 50% = $598 million
  • Already in the black – incremental profit exceeds lost profit by $238 million
  • Incremental profit from retina – 15 X 20% X70 = $210 million
  • Possible total profit of $448 million, just in one quarter

That is about half a billion in profit from just one product line – while the other kind of company refuses to make any profit from its $17 billion in sales across all product lines.

All this because Apple has defined its objective right and everything it does is about meeting that objective.

What kind of pricing does your company practice?

 

The Tale of Apple ASPs

Yesterday Apple announced its Q3 FY-2013 earnings. The product line unit numbers and revenues reveal something rest of the earnings statement do not.

Here are those numbers,

apple-q3-13

ASP is the Average Selling Price. You can compute that by dividing revenue by units sold. While average usually hides details a change in average is interesting. Because change in ASP points to change in product mix they are selling or change in prices. When a business has products that cover the entire price spectrum, ASP shifts are something to pay attention to.

For example a larger drop in ASP  with only minor drop in unit numbers will point to people not seeing value in their premium products and are happy with the low-end products. Good enough beats better. Since premium products bring more gross profit – you don’t think it costs Apple  $200 or even $100 (at 50% gross margin) to go from 128GB MBA to 256MBA do you?

With that background let us look at iPhone, Mac and iPad ASPs.

First iPhone ASP.

iphone-asp-q3-13

iPhone ASP held stead till last quarter (Q2-FY12). But since then it took a drop. The reason it held stead in the past quarter was iPhone 5. But after all those seeking new and great buy their iPhone 5, the market is left with only the price conscious customers and they are buying iPhone 4 or iPhone 4S leading to this drop in Q3. Another factor for slowing iPhone 5 sales is some of those who want new and great are waiting for imminent iPhone 5S.

Next the Mac ASP. Previously Apple used to break down desktop and portables. Unfortunately we do not have that data anymore. So the ASP comparisons do not tell full story.

mac-q3-13

Last year I wrote in GigaOm how the new Retina display would help Apple increase ASP. That is happening. More people prefer the SSD and Retina components in their MacBook Pros. It is also likely more 15″ models than 13″ are selling as the former offers more value than the 13″ models.

But the slight drop in last quarter could be explained by the MacBook Air refresh and those waiting for MacBook Pro refresh. The new MacBook Air pack lot more value for the price and the absence of Retina display is not a concern as you can see in that linked article.

Finally iPad ASP. Apple said customers use other tablets as expensive paperweights. But its tablet ASPs are dropping like paperweight.

ipad-asp-q3-13

I wrote (in GigaOm) before how keeping the iPad2 and introducing iPad mini will affect ASP and profits. You can see those models are not that far off from what we are seeing now. iPad minis are definitely more popular. But I believe there is another factor at play here – fewer customers are willing to pay high price premium for 32GB and 64GB versions of iPad. Most realize they do not need that much storage or rely on Cloud storage that obviates need for $100 SSD upgrade on their iPads.

There are rumors about Apple testing bigger tablets. As they realize they cannot price discriminate just based on commodity SSD capacity they are opting for other product dimensions as a way to up the ASP.

Bottom line, iPhone is relatively safe. With iPhone 5S the ASP will stay steady or improve. MacBook series ASPs are a worry, as people have more options to add external flash drives Apple will find hard to justify the price premium on those. iPads are a definite concern, watch for significant product changes in this area.

 

Apple’s MVP – Maximally Valued Product

In the startup parlance MVP refers to Minimal Viable Product.

 “The minimum viable product is that version of a new product which allows a team to collect the maximum amount of validated learning about customers with the least effort.

In this explanation there is no mention of  which customers and what is customer value.  It is inward focused definition. Since it does not talk about customers or value it does not talk about pricing. Some variations of the explanations have included pricing component to MVP.

However measuring customer value or charging for the value delivered is not the primary concern in defining or building a Minimum Viable Product.

I would like to take this concept and flip it on its head and show you what Apple builds.

When Apple builds its products it is packed with only those features that are valued by its customers and it can charge for it. It may look the opposite when you consider the fact that they were the first to introduce all inclusive iMac and MacBooks. But had they thought they would not have been able to extract a price premium for those included features they would not have included them, I will come to that in a minute.

Sure they could have built product versions that lacked some of those features and competed with other low-end products. As Steve Jobs would have said, “if we knew how to make it inexpensive without making the product crap, we would have done it”.  Apple chose to go after those higher willingness to pay customers and added product features that extracted more value in the form of higher prices than the cost to add those features.

See  below how they extracted value from flash drive capacity and 3G in iPad.

Apple Pricing

Why the price difference is not the same?

Why the price difference is not the same?

On the flip side see what they chose not to add.

Even when you pay $829 for iPad you will not get ear-phones with it while you get them with measly $49 iPod.

You can ask all you want for a Retina display MacBook Air but until they figure out a way to extract price premium for it you won’t see one.

What Apple is doing is starting with the customer segment they want to target (they don’t have to get the iMac in billions homes) understand what these customers value and willing to pay a premium for, and deliver them just that at a premium price.

As opposed to a Minimum Viable Product, Apple builds and delivers Maximally Valued Product. Here is my academic sounding definition for it

A Maximally Valued Product for a given customer segment is the product version that adds most value to the customers while enabling marketer to extract their share of the value as price premium.

Note the segment specificity, value creation and value capture aspects of the definition unlike the definition of Minimum Viable Product.

The Maximally Valued Product packs features for sure but these are the features customers value and willing to pay for. It also lacks many features, sure customers may value them but if that does not flow into better prices, why bother?

Which MVP do you build?