Thursday, November 8, 2012

iPad Mini promises big sales volumes yet a teeny, tiny profit

When I first wrote about the potential impact of the iPad mini on Apple’s profits, back in September before it was even announced, I enumerated the different factors that will negatively impact Apple’s profits: whether it serves  customer needs; its competitive positioning; and cannibalization of profits from other product lines. More importantly I then wrote that the iPad mini is about profits as opposed to market share. If it’s not going to be another billion dollar product line, Apple simply would not consider it because of the significant opportunity costs.

In contrast, most who wrote about the iPad mini, from stock analysts to bloggers, focused instead on market share. They made their case based on the apparent success of Kindle Fire and behemoths like Google entering the low-end market. To paraphrase what many opined, a smaller iPad would allow Apple to continue to grab market share as its competitors nip at its heels on the lower end. Funny—since when did Apple start worrying about market share over profit share?
Apple’s official announcement last week did two things. It quickly demolished the market share argument—at a $329 price point, Apple is obviously not targeting the lower end of the market. And it also reinforced the thesis that Apple plays a profit-share game; that is, it’s focused instead on soaking up any possible profits with a carefully designed pricing strategy. In short, the iPad mini is not competing on price, in fact it is not even competing for the same customers as other players in the 7-inch tablet market.
Unfortunately, and crucially, we cannot tell from Apple’s messaging which customers they are targeting or how they are positioning the mini. AllThingsD is positioning it as the iPad for those who find the current one too big and heavy. In my last article I wrote that Apple would try to position the mini as yet another device we all must haven in addition to the iPad and iPhone. That is clearly not the case though, as evidenced by their messaging. My best estimate then is that they uncovered a sizable market segment that values lightness and smallness in a tablet, but is not willing to give up the user experience they get from iOS by switching to any of the Android tablets.
How big is this segment? Will any of the current iPad customers see more value from lower-priced and smaller-sized iPad mini and switch?
Let’s run some numbers to find out.
As I did in the case of Pinterest revenue modeling, I am going to use statistical model to find the profit impact. What we will find is how likely each profit scenario is when considered against the input conditions. If you are a betting person you will see this as the odds of Apple making A specific profit (or loss) from iPad mini.
In simple terms:
Profit from the iPad mini = Margin on the iPad mini  X  Volume of the iPad mini
We determine the Volume of the iPad mini from four sources. There are those buying it as their first tablet, or as an addition to their current iPad. Then there are others who are trading down from an iPad, which is to say choosing the mini instead of an iPad. Finally there are those switching from Android tablets and then those who trade-up from an iPod Touch.
The trade-down from an iPad and trade-up from an iPod Touch have a negative impact on profit affecting these product lines:
Profit Cannibalization = Margin on the iPad X Trade-down from an iPad + Margin on the iPad Touch X Trade-up from an iPod Touch
We know for certain the margin on the iPad and iPod numbers (~42 percent). But for other variables we have to make an estimate to do the modeling. We begin with listing the different variables that feed into final result and their 90 percent confidence interval values. That is, we list all the different variables, and then state the low and high values that we are 90 percent confident about (we are 90 percent confident the real value is between low and high and there’s only a 10 percent chance the real value is outside this range).
iPad margins
Estimates for Trade-down volume come from marketing research conducted by, however that was likely based on the assumption that Apple would price their iPad around $199. Given the unexpectedly higher price point, I used a range of 10 to 30 percent, versus their average of 35 percent.
With these inputs I ran a Monte Carlo simulation to find the likelihood of different volume and profit scenarios. After running 1600-plus iterations, the results are stunning.
First the iPad mini volume numbers:
The results show that at the low end, come what may, Apple is all but guaranteed to sell 12 million iPad Minis per year. At the high end, Apple could sell as many as 58 million, but those chances are very very slim (1 percent). Considering all the possible scenarios, the expected value of volume is 40 million.
These are large numbers that frankly Google and Amazon could only wish for. But an interesting question is whether those big numbers automatically translate to big profits.
The results point to a high-risk game Apple is playing with the iPad mini. 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. On a per unit basis that translates to a $12.50 incremental profit. And note that the volume and profits are just expected value—the actual results could be worse because in a surprising 30 percent of the cases, Apple is losing money from iPad mini sales.
So despite an expected strong sales volume of 40 million units, Apple will realize at best just a teeny, tiny profit compared to iPad and iPhone lines. Such high volume is certainly nothing to be sneezed at (especially if you’re an Android tablet seller, with shelves full of stock), but the outcome of the game is not certain. Even with the assurance of expected of strong sales, the incremental profit from iPad mini appears too small to make any dent in Apple’s overall profit share. It leaves us to conclude that, strengthened by its string of successes, Apple chose this time to focus only on the bright side and unusually play a high-risk game.
Rags Srinivasan specializes in product strategy and strategic marketing and blogs atIterative Path. Follow his tweets @rags.

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