Oppenheimer's Prediction for Apple's Rivals? Pain

Posted by: Peter Burrows on July 21

As if the troubled world economy and consumer spending slowdown weren’t enough of a headache, it seems Apple’s rivals will now have a more aggressive Apple to contend with.

That was my take from the quarterly earnings call, during which chief financial officer Peter Oppenheimer said the company is targetting a gross margin of 30% for fiscal 2009. That’s significantly down from the 35% range in recent quarters. The slow economy and some solidifying of electronic parts prices may be part of the explanation, but Oppenheimer left little doubt that there’s a larger strategic change in the works. The goal: “not leaving an umbrella so big as to leave an opportunity for our competitors,” said Oppenheimer.

It’s a well-timed move, and a time-honored tactic by market leaders in tough times. If your competitors can’t afford to match you on price, why not accept a lower margin for a time and load up on market share (or force them to incur losses)? Apple is already giving rival PC makers, MP3 player makers and most recently cell-phone makers fits with its basic formula: create pricey and unique new products stuffed with technological innovations and design niceties, and then maintain market share by leveraging economies of scale and through “value engineering” to lower their cost. That way, Apple can lower its prices while maintaining margins. Take the iPod. Back in 2001, wags said the name stood for “idiots price our devices” because of the $399 pricetag. Now, Apple sells the shuffle for $49. And yet Apple continues to gain share, according to Oppenheimer.

Not everyone agrees that a major change is underway in Apple's business model. "Chances are it's not," says American Technology Shaw Wu. "At the end of the day, the difference between Apple and the other guys is that Apple has to fund its innovations. The risk is that lower margins could stifle that basic model: bringing innovative products to the market.”

Michael Dell isn't quaking in his boots, either. In an interview at our San Mateo bureau earlier today, he said he was not concerned that Apple would stray far from a strategy that has always been based more on premium, rather than bargain basement, pricing. "I just don't think that's how [Apple's] business works," he says.

But what if Apple is tweaking the way it works? In that case, Apple could put a meaningful dent in its rivals' profits. Think about what Dell himself did to the rest of the industry back in the 1990s. He had such vast operating efficiencies that he could sell Dell products at a lower gross margin than rivals and still make far more money than others. He used this advantage like a cat playing with a bird--charging more to raise margins when he wanted higher earnings, or bringing those margins down a tad when he wanted more share. This explains how Dell was for a time the only large PC maker making a profit. Everyone else sold at a loss just trying to protect their market share.

To be sure, Apple doesn't have that much power now. While Apple's share is growing far faster than the market, it is still a distant third in overall US share. PC rivals still have huge safe havens where Apple is a bit player, such as servers and corporate PCs. But Apple has got plenty of points of margin to play with in markets where it is strong. Apple had gross margins of 34.8% last quarter, compared to 18.4% for Dell, for example. If spending a few points of that advantage to hit lower price points spurs even faster growth, the company will end up with more absolute profits--even if each unit brings in less on its own. In other words, falling gross margins won't necessarily eat into Apple's big advantage on the bottom line. Apple's net margin last quarter was nearly 14%, compared to 4.9% for Dell.

So where to look for new, more aggressively priced products? They won't all be entirely new headline-grabbers. As Piper-Jaffrey's Gene Munster pointed out to me, Oppenheimer told analysts that upcoming "product transitions" might contribute to the lower margins. "He didn't say new products. He said product transitions," says Munster. He wonders if Apple will come out with an iMac and a MacBook for $999 (maybe lowering costs by using something other than aluminum for the exterior, given the rising price of that metal). Look for Apple to also fold even more features into higher-end models, without passing all of the extra cost on to consumers.

But I wonder if we'll see Apple go farther down market, as well. Here are some possibilities:

-- The iPod. Just a quarter ago, the low-end shuffle was supposed to be the weak link in the iPod product line. But Oppenheimer cited the product more than once during the call as a reason for Apple's record sales and profits, citing the hefty price cuts from a few months back. "We’re very happy with the elastictity we've seen, and think the tradeoff between volume and price was a good one.” If cutting the price from $79 to $49 was so successful, is an even cheaper offering--maybe called the iPod "Piqueno", as the folks at Saturday Night Live once suggested--in our future?

-- A lower-end notebook, or a "netbook" of some kind. That way, Apple could steal a march on what many see as a major growth opportunity for smaller, cheaper, more energy-efficient devices for people who are content using online apps (without the top-of-the-line chips and massive hard drives needed to run traditional programs). Apple clearly has the design and the software chops to be a leader here. And here's a thought: Apple's got low-power, high-performance processors designed by the crackerjack team at PA Semi, which it acquired earlier this year. One of my sources suggests Apple is tired of creating innovative products, only to watch rivals quickly get to work copying them. Apple could put up a huge added obstacle by using its own proprietary silicon. At one point in the earnings call, Apple chief operating officer Tim Cook said that "We are going to deliver some new products that our competitors are going to be unable to match.” My first thought was of those PA Semi chips.

Cheap iPhones -- If Apple is happy with the elasticity in the iPod market, it must be jumping for joy about the launch of the iPhone 3G. In just three days, it sold one million units. It took 74 days to sell the one millionth unit of the pricier first-gen iPhone, and two years to sell the one millionth iPod. And elasticity in the huge cellphone market translates into a very, very big number. Until now, Apple's public sales goal is to sell 10 million units this fiscal year. That's a measly 1% market share. With all the momentum around the $199 iPhone 3G, is there any doubt that Apple's engineers are looking at more affodable model to take a far bigger piece of the pie? As Cook said during the call, "Many people didn’t have a full view of what a phone could do until we introduced the iPhone. We think there will be a [long-term] shift where many more people will want a smart phone, rather than a voice phone.”

Clearly, investors hate what they heard from Oppenheimer. News of the margin forecast sent AAPL shares down around 10% in after-hours trading, and they have fallen another 4% today, to around $160. But so long as lower prices keep leading to increased sales, the news is worse for Apple's rivals than it is for the company itself.

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