Will iPad cannibalize Mac sales?

Clearly Apple is preparing for such a circumstance, or that's my interpretation of last night's fiscal 2010 second quarter earnings call. The question isn't if iPad will cannibalize Mac sales but when. If the cannibals are coming, they'll first strike during back-to-school buying season.

Apple CFO Peter Oppenheimer tipped off the company's thinking early in the conference call: "We expect gross margins to be about 36 percent down from 41.7 percent in the March quarter and reflecting approximately $36 million related to stock based compensation expense. We expect about 25 percent of the sequential gross margin decline to be driven by the first quarter of iPad sales." Whoa, one-quarter?

"As we said in January when we announced the iPad we have been very aggressive with pricing and are delivering tremendous value to customers," Oppenheimer asserted. "We think the market for the iPad will be large, and we want to capitalize on our first-mover advantage."

There are two intertwined issues related to Oppenheimer's statements: Mac cannibalization and margins. I'll start with margins. Whenever Apple launches a new product, the company absorbs additional upfront costs. Apple secrecy means that CEO Steve Jobs announces his "one more thing" product on Day X but availability is Weeks Y or Months Z later. Manufacturing ramps up in earnest after the product announcement, which is atypical of most industries. To get the product from Asia to Western retail, Apple typically absorbs higher upfront airfreight costs.

This dynamic is one reason why purchasers of new "one more thing" products pay more upfront. Their privilege of being among the first buyers helps to soften the blow Apple's cockeyed manufacturing and distribution system places on margins. This process is underway now in the United States, and Apple will repeat it in nine additional countries next month.

Margins Teardown

Based on various iPad teardowns, the tablet's base hardware cost ranges from $230 to $300. The teardown by iSuppli puts the $499 iPad product cost around $260 and $348.10 for the $699 model (both are WiFi; 3G models ship next week in the United States). By comparison, Apple makes oodles more on iPhone. Right after iPhone 3GS launched, iSuppli put component cost at around $179. While consumers pay $199 for the smartphone, carrier AT&T subsidizes what Apple charges, which is in the $500-$600 range (ASP is $600, according to Apple, which includes 32GB model). Additionally, falling component prices and economies of scale should put Apple's iPhone 3GS margins much higher today than June 2009.

Like iPhone and Mac products, Apple's base profit for iPad is pretty good. However, the aforementioned higher initial manufacturing and distribution costs sap profits by as much as half (based on my guesstimates). Assuming Oppenheimer is right about iPad demand, greater upfront sales volume would further sap margins, since Apple would pay more to get the product to market before achieving benefits from economies of scale. Higher sales volume would mean lower margins and a lowering of broder Apple margins.

During yesterday's Apple conference call, Sanford Bernstein analyst Toni Sacconaghi put startling perspective on Apple's falling margin guidance and iPad's contribution to it:

Let me just switch to one other topic if I may and Peter I think this is probably for you. Bear with me, I'm gonna, I'm gonna just plug through some numbers. You said gross margin is going to decline 600 basis points sequentially in the quarter that would be due to the iPad. So that is 150 basis point negative impact from the iPad.

If you assume the iPad is 10 points lower gross margin than the company average which is way, way lower than most, you know, third-party tear-down services which it would suggest it basically means for that contribution to be true for your guidance iPad would need to be 15 percent of your revenue or $2 billion. So either iPad is gonna be more than $2 billion in terms of revenue per your guidance for next quarter and have a gross margin that is less than 10 points less than the company average or the gross margins of the iPad are more than 10 points lower than the company average.

Apple COO Timothy Cook partly dodged, party answered the question, nearly repeating what Oppenheimer said earlier in the call:

I would point out that when we priced iPad we priced it very aggressively in order to deliver tremendous value to our customers. We think the market size for the iPad is very large, and we want to capitalize on our first mover advantage. So, as we have done in other products, although I am not forecasting it, you can see that we have a good track record of writing down the cost curves with value engineering and volume manufacturing or at least that's certainly been our experience with other products.

For iPad to reach 15 percent of revenue, Apple would have to ship 3.3 million units at an average selling price of $600 or 4 million at $500 ASP. The impact on margins would be colossal. But the margin pulldown could be just as strong if Apple shipped 1-2 million iPads, in process cannibalizing some Mac sales.

Wading the Price Gap

Until iPad, Apple computer selling prices were quite high, with the $999 white Macbook being entry point for most people to join the elite -- some might say elitist -- Mac club. In February, I reported that "Nine out of 10 premium PCs sold at retail is a Mac." Apple sells high and also reaps some of the highest margins in the tech industry. The Mac tablet changes the dynamic. Now, suddenly, the cheapest, functional Mac you can buy is $499, filling a hole between $399 and $999.

As I explained in a separate late-January post, "iPad fills a gaping hole in the Mac product line between the aforementioned $399 and $999." Various iPad models sell between $429 and $829.  "Apple now offers portable computers -- and that's how I classify iPhone, iPod touch and iPad along with Macs -- ranging from $99 to $2,499. From a pricing strategy perspective, iPad is a brilliant product, because it fills the gap between iPhone/iPod touch and Macbook without price cuts or risk to the Mac's premium brand status."

But there is risk to Mac sales, which would be greater during back-to-school buying season than any other time of year. Suddenly the cheapest Mac that schools can buy costs $499, too. Particularly for K-12 institutions, iPad could be a viable alternative to MacBook, particularly with budgets crimped by the lingering effects of recession on the tax base. Back-to-school buying season would also be the test of iPad's sales mettle, whether or not the product can succeed or will be doomed to ruin like the Power Mac G4 Cube. Low back-to-school iPad sales would perhaps be worse than many.

There are positive benefits to consider, as well -- schools that: might not buy any Apple product this year, otherwise would purchase Windows PCs or would swap out Macs for Windows computers; because of price. Now they could buy iPad. By whatever measure of increasing sales -- higher in general or cannibalizing Mac sales -- iPad would crimp Apple margins.

Yesterday, RBC Capital Markets analyst Mike Abramsky asked the obvious question: "Just wondering why you didn't see, or whether you expect any touch cannibalization from the iPad and what is your sense or do you think iPad is cannibalizing maybe competitive netbooks?"

Cook responded:

I can only tell you in the quarter we finished, Q2 that we finished in March. Although we announced the iPad in January there was nothing obvious in the iPod numbers or the Mac numbers to suggest cannibalization. There is an obvious difference announcing and people know it is coming and it is starting to sell. So that part of the equation we don't know yet. We will find out. We are thrilled with how the iPad is selling and the enormous response that we have received. We also announced new MacBook Pros that you probably saw last week and the whole line change. So we are also happy about how the Mac business is positioned and the level of product innovation in those notebooks. It is enormous. It is taking battery life up to 10 hours. That is absolutely amazing.

That's executive-speak for: "Yeah, we think so but aren't sure and so don't want to say for fear of causing a run on Apple shares." On the one hand, Cook lets be the possibility of cannibalization, while at the same time emphasizing newly upgraded MacBook Pros. The response is oh-so media-trained executive deflection. Media professionals teach executives at companies like Apple to deflect tough questions by ignoring them and shifting focus to strengths.

Of course, Apple executives expect at least some cannibalization of Macs by iPad. Apple's iPad pricing tells the story -- the aforementioned filling the pricing gap between $399 and $999. Then there is the guidance about margins declines to consider. Cannibalization is inevitable. The questions are: "When?" and "By how much?" Will there be a big surge of iPad orders during back-to-school season or will the lower pricing release pent-up sales among consumers pining for a Mac but unwilling or unable to spend $999? Or both?

[Editor's Note: I initially used quotes provided courtesy of Seeking Alpha but corrected them after re-listening to Apple's FY 2010 Q2 conference call.]

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