That Product Transition

Friday, 7 September 2007

During Apple’s most recent quarterly earnings conference call on July 25, CFO Peter Oppenheimer was asked why Apple’s guidance for the current quarter (Q4 2007) was just 65 cents per share, significantly lower than the 92 cents per share they booked in Q3.

As noted by Forbes’s Brian Caulfield, Oppenheimer gave an intriguing answer:

Oppenheimer gave three reasons for the shift, two prosaic, and one very tantalizing. Apple’s back-to-school product promotions will cost the company. Prices are rising for key parts, such as the flash memory that powers the iPhone and many of Apple’s music players. Finally, Oppenheimer said, there will be a “product transition I can’t get into.”

When I linked to this, I wrote:

Here’s how I’m interpreting this. I think what he’s saying is that Apple is going to replace an older product which currently has high margins with a new product that, at least at first, will have significantly lower margins. Imagine, say, new iPods that sell at the same prices as current models but which cost more to produce. Or maybe it means they’re going to switch to the subscription-based accounting for more products?

Hate to say “I told you so,”¹ but this, I think, is exactly what happened this week.

Apple’s current quarter covers July, August, and September. They’ve had two product introductions since the conference call: the iMac/iLife/iWork event a month ago, and the iPod/iPhone/iTunes event this week.

None of last month’s product announcements would lead to a decline in earnings. If anything, profits from iMacs, iLife, and iWork are going to be higher than last quarter, not lower.

So what did Apple announce on Wednesday this week that would lead to a decline in earnings? With regard to profit margins:

• Certainly not the Shuffle, which neither changed technically nor dropped in price.
• Not iTunes. If anything, this week’s announcements of the iTunes Wi-Fi Music Store and ringtone sales will increase earnings, not decrease.
• Probably not the iPod Nanos or Classics. The new Nanos sport a significantly improved display — bigger, brighter, and with a 204 ppi density. The Classics sport much higher-capacity hard drives. Both are very nice updates from last year’s models, but neither seems so significant as to bring about a 30 percent decline in earnings.

That leaves the iPod Touch and the price-dropped $399 iPhone. Margins, I suspect, may well be lower on these products than on the other iPods and most Apple products. The $299 8 GB Touch is priced just $100 higher than the $199 8 GB Nano. Given Apple’s usual margin of around 30 percent, the Touch would have to cost just $70 more to produce than the Nano. The far larger (and multi-touch-capable) display, faster processor, and Wi-Fi strike me as costing more than $70.

With regard to the iPhone price cut, it’s certainly possible that at $399 Apple is now earning its usual 30-percent-ish margin, and that the $599 debut price was indeed extraordinarily profitable. But it’s also possible that it was at $599 that Apple was booking its usual margin, and that at $399, it’s now selling iPhones for a far-lower-than-usual margin in order to build market share.

Either way, though, and regardless if it was planned all along, I don’t think the iPhone price cut is the “product transition” Oppenheimer alluded to.

The most likely explanation for Apple’s supposed² earnings drop this quarter is that Apple is moving additional products to subscription-based accounting. Apple announced back in April that they would account for iPhone earnings over a 24-month period, so as to be able to provide additional features via future software updates without charging for them. (Remember the $2 charge for the 802.11n AirPort enabler?) This means that no matter how much profit the iPhone generated at $599 or does now at $399, only a fraction was going to be booked this quarter, price drop or not.

It seems almost certain (to me at least) that the iPod Touch will be accounted for by subscription, too. If you thought there were glaringly empty spots for additional icons on the iPhone home screen, take a look at the iPod Touch’s. The iPod Touch and iPhone are clearly sibling products running variants of the exact same system software; I expect future software updates to appear simultaneously for both products.

And perhaps Apple is switching to subscription-based accounting for the entire new iPod line-up. If so, it means that for the current quarter, they’ll book less than 1/24th of the profit for all new iPods sold this month; the remaining profit will be spread over the next 23 months.