## Motley Fool Predicting Blowout Profit From iPad mini – But if you check their math

A blogger for Motley Fool is predicting  a blowout quarter for Apple. He writes,

You can put me in that group.

Millions of consumers agree. By my math, the Mini probably brought in \$2.2 billion in operating profit in fiscal Q1,

These are big claims. Note that he is predicting \$2.2 billion profit from just one product line and that too operating profit not gross margin. Just as a refresher, gross margin is revenue less Cost of Goods Sold (COGS) for that product line. Operating profit is after R&D, sales & marketing and other operational expenses.

In the last quarter Apple made \$11B in operating profit, so Motley Fool is predicting 20% increase over last quarter just due to iPad mini.

What is the basis for this? Well we know this blogger bought one and hence he believes millions did so as well. But after that we do not know how he did his math to show \$2.2B as operating profit.

Well I did some math as well, about three months ago, and published my math, model and assumptions. In my last article in GigaOm I wrote (these are numbers for full year, not just Q1),

At the low end they could possibly lose \$1.7 billion and at the high end they could make \$2.5 billion in profit. But the chances of both these scenarios are just 1 percent. And so realistically, considering all possible scenarios, the expected value of profit is half a billion dollars—and that is gross profit, not including marketing and other costs associated with iPad mini.

From my more rigorous statistical modeling I predicted the best case scenario is \$2.5 billion gross margin for the entire year and the chances of that happening are just 1%. So for Q1 numbers let us assume even distribution and divide my numbers by 4. That gives \$125 million as expected profit and \$625 million as 1% possibility.

How can Motley Fool predict such large numbers?

The first difference is I did statistical modeling that considered all possible scenarios and not just the best case scenario. If Motley Fool assumed,

“I bought it, so millions would buy”

Of course it would yield \$2.2B but that fails to say how likely is such a scenario. Only in statistical modeling we can not only state an outcome but also state how likely is that scenario. (You heard of Nate Silver?)

Second difference is I took into account the negative effect of iPad mini on other product lines. That is iPad mini is not all additive, there is cannibalization. Using customer research data I included that effect (accounting for the uncertainty in the cannibalization rate) in computing net profit from iPad mini.

Finally I am not sure if Motley Food did any math at all. They say Apple would sell 20 million total iPad units (mini and maxi?). Since last quarter Apple sold 15.4 million iPads last quarter that would mean 4.6 million iPad mini (and by their assumption there was no cannibalization). So \$2.2B in operating profit from mere 4.6 million units.

That is each unit contributed  \$478 in operating profit. Really? Far more than the likely ASP of iPad mini and more than gross profit from iPad line. What kind of investment analysis or math is that? I hear this site gives investment advice, I wonder.

Lastly, I do stand by my model. Just wait a week more and plug in the numbers from Apple’s earnings report into this model and find out.

Note: Some have pointed out in GigaOm comments section that I used too conservative a number for iPad per unit profit and that iSuppli had a different (higher) margin prediction. My mean was 32% with sigma of 4.6% while iSuppli says the numbers are 42%. Even if I adjusted my mean to use iSuppli numbers, my predicted BEST CASE (2% chance) gross profit will utmost go to \$0.8B per quarter and not  \$2.2B Motley Fool predicts.

## You can’t let your past cannibalize your future – Note on iPhone 5 Sales

You most likely know by now that Apple is cutting back its demand for iPhone 5 components. Analysts who did the supply chain check attributed to the slowing iPhone 5 sales. And among the many reasons they quote the one that stands out (and probable) is

The less-expensive iPhone 4 and 4S is eating into iPhone 5 sales. With a two-year contract, the iPhone 4 is free and the iPhone 4S is \$99, and they might be popular enough among consumers that not everyone is opting for the iPhone 5, which costs \$199 with a two-year contract in the U.S.

The number to watch out for in Apple’s earnings report is the average selling price (ASP) of iPhone line. We have seen similar drops before when Apple decided to keep its \$399 iPad 2 product. Now it appears it is iPhone’s turn.  (By the way, you can learn a lot from earnings reports.)

This is basic second degree price discrimination – when offered multiple versions at different price points, customers self-select themselves to the version that offers them the most consumer surplus. But to execute effectively on the multi-version strategy the business must raise appropriate version fences such that those who have higher wherewithal to pay and prefer the higher priced version are not tempted by the lower priced version and switch down.

In case of iPhone 4 and iPhone 4S, these are extremely very well done products that offer lot more value especially when combined with the lower prices they are being offered at. And these older (yet superb) models are cannibalizing iPhone 5 sales.

Most people say, “it is better your products cannibalize your own than others doing it to you”. While no cannibalization is good, that statement would make sense if newer higher profit generating models replace your older models before your competitor does that to you. You can’t however let your past cannibalize your future. It also says something about your future product pipeline.

I also don’t believe we have seen the end of iPhone downturn. Here is what I wrote in GigaOm about effect of iPad mini (before it was released)

iPhone: The crown jewel. It is harder for most to see how a smaller tablet could threaten the iPhone. Consider this in the context of total cost of ownership of an iPhone over two years: At \$100 per month for mobile service fees and at \$199 for the device, it costs \$2,500. Mobile service providers are moving towards just one bundle of voice and data at \$100 per month. If there were a \$299 4G iPad Mini, some may consider a regular phone for occasional talking and the iPad Mini with \$40 data fee as an iPhone replacement.

Is Apple, a company that is unusually excellent (here, here and here )in multi-version pricing strategy, starting to stumble?

## Apple Playing High Risk Game with iPad mini – Monte Carlo Analysis

It appears iPad mini (or whatever branding Apple comes up with for their 7″ tablet) is real. Apple did announce an event for October 23rd which is highly likely the iPad mini event.

I have written about the profit impact of the iPad mini and so did many others. (See my longer piece at GigaOm.)
Many take the approach

1. Apple will sell 10s of millions of iPad mini before Holidays
2. iPad mini is a market share game
3. There will be cannibalization but it is better to self-cannibalize
4. There will be so much new volume from lower price point of iPad mini that Apple will capture marker share
5. iPod Touch is a different product category and it will not be impacted by iPad Mini

My question has been centered around whether or not the new device will deliver incremental (net new). No one has done some real analysis to show what the impact is. Even my article stopped short of exact numbers. Articles by others (of course) are even worse, they expect us to believe on faith that Apple will do well with iPad mini.

Now there is some real answer, based on more rigorous analysis than just claims that self-cannibalization is better.

My analysis, using statistical modeling, shows Apple may end up selling 22-52 million iPad minis but is placing a high risk bet when it comes to profit. Let us start from the beginning.

As I did before for Pinterest revenue model I chose to do Monte Carlo analysis to find impact on Apple’s profits from iPad mini. This is a reliable tool to use when there are many variables and there is uncertainty in the result. It also helps to state the result as a probability distribution instead of absolute statements we see from some of the analysts.

The model starts with listing the different variables that feed into final result and their 90% confidence interval values. That is we list all the different variables and state the low and high values that we are 90% confident about (we are 90% confident the real value is between low and high and only 10% chance the real value is outside this range).

I am going to assume contribution margin from iPad is \$225 (given its 40%-50% margin numbers stated by iSuppli and others). All volume numbers are for the full year. The trade-down numbers and the “steal” numbers come from a recent market research on iPad mini preference. Steal here means how many of current nook/Kindle/nexus customers will switch to iPad mini. New sales is the number of new customers entering the market because of iPad mini. Current iPad volume numbers are based on Apple’s past four earnings reports.

It is easy to see that

Net new profit = Profit from iPad mini  – Lost profit from Trade-down

Note that I ignored the effect on other products both iPod Touch and iPhone.

Running the model for 1600 iterations yields some stunning results.

First the total iPad mini volume numbers. These are huge. It is almost certain that Apple will sell at least 14 million units per year. There is 95% probability that they will sell somewhere between 22 million and 52 million iPad mini.  And considering all possible scenarios the expected volume is 35 million units. These kind of numbers blow out the ramp up curves we have seen with any of the electronics products.

Such numbers will bring smile to those who chase market share and will delight analysts who recommend chasing market shares. But what does that do to Apple’s profit?

Here is the big surprise. Despite huge volumes, profit estimates show Apple is playing a high risk game with iPad mini.

First there is a 47% chance Apple will lose money (not including fixed costs, just the marginal costs, so the real impact can be worse).

At its worst, there is 1% chance that Apple could see \$2.2B drop in its gross profit. It does not get much better, there is 15% chance Apple could see \$1 B drop in its profit.

At the other end there is only 1% chance they could make \$2.3B additional profit and only 13% chance they could see \$1B additional profit.

Considering all possible scenarios, the expected net new profit from iPad mini is just \$97 million a year.

That is not a big enough considering other R&D and marketing expenses (fixed costs).

There you have it. Apple will likely sell 34 million units in the first year but runs the risk of seeing no impact or worse significant impact on its profit.

Analysts betting on Apple stocks, thinking iPad mini will a few dollars to their EPS, take note. iPad mini is a high risk game for Apple despite assured high volumes.

## Is \$99 the right price for the new Kindle?

If Pigou were alive and happened to look at Amazon’s new kindle pricing today, he would turn to the person beside him and say, “That my friend is second degree price discrimination, offering multiple versions and letting customer self-select themselves to the one they are willing to pay”.

Amazon introduced a new version of Kindle at \$114 that is \$25 cheaper than regular Kindle. It is the same Kindle with no difference in hardware. The \$114 version shows Ads.

It is not far reaching to say there exist some customers who will buy the Kindle at lower prices. Introducing the “crippled” Ad supported \$114 version enables Amazon to capture these customers without sacrificing profits from those who would rather pay \$139 for Ad-free Kindle.

This to me is great versioning and given Amazon’s history of effective pricing it is highly likely they measured the demand distribution and the expected incremental profit before setting the price at \$114 (more on this later).

There are predictable reactions in the social media from tech bloggers that Amazon got it wrong on pricing. The right price, they state, is \$99

Imagine a Kindle for \$99. There would be a frenzy. Amazon would sell so many of them.

A lower priced version will bring in new customers, but it will also cause many of the full price customers to trade down, leading to profit cannibalization. This is because customers look at a product as a package of benefits and price. They are willing to trade one for another.

If the price is right even a product with fewer benefits will deliver higher consumer surplus than a better product at a higher price.

Key to effective versioning is designing product benefits (features) and setting prices in such way that those who have high willingness to pay are not tempted by the lower priced version and buy it instead of the higher priced version.

If the lower priced version is priced too low or gave away too much benefits it will end up attracting those who would have bought the higher priced version.

At \$99, even those who prefer the \$139 version but not the Ad-supported \$114 version may move down, adversely affecting profits.

\$99 is the price only if that price yields better incremental profit than \$114 price not because of its beauty or the notion, “psychological importance of losing that third digit cannot be downplayed”.

Update: corrected math, thanks to careful eyes of Saurabh Mathur. The conclusion that \$99 is worse is even more strengthened.

For those who are mathematically inclined, let us try to build a simple model.

Let us say lifetime value of Kindle customer from book purchases and Ads is \$50.

Let us say the marginal cost of Kindle is \$89 (so the contribution margin on \$99 price is \$10 and \$114 price is \$24)

Let N1 be the number of new customers who will buy Kindle at \$114 and  n1 be the number of people who will trade down from \$139 version.

Let N2 be the number of new customers who will buy Kindle at \$99 and  n2  be the number of people who will trade down from \$139 version.

For \$114 version to be profitable, Amazon has to attract one new customer for every  customer who trade down from \$139. (Amazon loses \$25 times n1 and gains \$24 times N1, hence N1 >  n1)

For \$99 version to be profitable, Amazon has to attract one new customer for every 4 customers who trade down from . (amazon loses \$40 times  n2 and gains \$10 times N2)

The ratio of new to lost customers quadruples when price drops to \$99.

In addition, it is fair to say n2 is far greater than n1  because of the very reason \$99 is attractive and gives away too much.

Is \$99 still the killer price point?

Note: See my own past sins on Kindle pricing here.