Why Apple’s margins are eroding as it tries to maintain share

In March, I wrote you about my concerns about Apple’s ability to maintain growth expectations without margin slippage. My view was then and still is today that Apple faces a choice of maintaining either margins or growth in both handsets and tablets because Android, Google’s mobile platform, has finally caught up to and, in some cases, surpassed iOS, Apple’s mobile platform.

Here’s what I wrote then:

Here is my basic thesis from on Apple. Apple is a monster company, the largest cap company in the world. And this is for good reason as Apple is executing perfectly on its strategy and throwing off so much cash that it now has over $100 billion that it could invest or distribute. The fact that Apple has finally done what I have been encouraging it to do for a while, provide a dividend, is a sign that the company has realised that it doesn’t have investment opportunities for this cash pile. That doesn’t have to be a problem though as long as it continues to execute on its business model.

That is where the problem is. Apple has very good margins due to its premium pricing. However, Apple is now faced with a choice of whether to go downmarket to protect share and network effects and suffer margin erosion as Android has now taken over as the top dog in the mobile space. The iPad fills a premium niche that was partially filled by the iPhone/iPod as a mobile computing device. So it has more than offset the share erosion in iPhones because of this. Still, it’s more than a worry. It is what’s coming this year I believe.

Now, we did see some margin erosion and an earnings miss earlier this year. Apple’s shares had stumbled briefly earlier in the year, but this miss, as I have predicted, was not a big factor for Apple and it has gone from strength to strength on market cap. The dilemma between market share and margin is still there and will eventually trip Apple up and shares will be hit.

Yesterday, comScore released some data on share from the previous quarter, showing that Android was increasing share but that Apple was increasing share more as users fled Microsoft’s and Research in Motion’s platforms. Together iOS and Android comprise over 85% of the market for device mobile computing platforms and I expect that number to remain high. The division between Android and iOS is the issue because, along with patent lawsuits to protect its turf, Apple has been moving down market to thwart the Android threat. First, Apple has begun to offer cut rate older phones as a part of its line-up. It continues to produce these phones even after the new iPhones hit market. Apple then tiers pricing down to where the iPhone 4 is now available for free for a two-year contract after the carrier subsidy. Ostensibly, the margins here hold up because the cost of production is much lower after Apple has already ramped up production for these units. But there is the cannibalization issue.

Then there’s the coming iPad mini, which is Apple’s effort to thwart Android’s move into the tablet space where Apple is fantastically dominant.  The iPad mini is expected to be unveiled next month helping Apple boost sales in the holiday selling season. The price point has been rumored to start as low as $199, matching Google’s Nexus 7, though $299 is a more reasonable guess that I have also heard. Either way, the problem here is not just the cannibalization of iPad sales as with the cut rate iPhones, but also the margins. The iPad mini is a new product. So the production volumes do not afford Apple a competitive advantage in terms of economies of scale. Apple will definitely eat margin.

So there are three issues here.

First, there is the overarching question of margins and growth. I believe it is an either or proposition. And apparently, so does Apple because they have seen the huge share growth at Android and have decided to offer lower end product to prevent market share erosion. This dilemma will continue to plague Apple given its favorable high growth and high margin position. This fantastic combination was always destined to attract competition and now it has.

Second, given Apple’s decision to go for share, you have to wonder about margins. Not only are the product prices lower, but they are also in a market that competes with device manufacturers that are used to much lower margins. It’s a bit like BMW offering a cut rate car to compete with the Honda Civic. Such a move would kill BMW’s margins. BMW doesn’t have to do this because there are no automobile network effects from having high market share. There are in Apple’s world.

Third, given that Apple is forced into this move, you have to wonder about cannibalization. How many customers who would have bought an iPad will now buy an iPad mini? How many customers who will buy an iPhone 4 for free without a contract would have bought an iPhone 5 for $199 or $299? We can’t know. But this has to be a worry for Apple as it moves down market.

All in all, the cost will be margin loss that translates into slowing earnings growth and missed expectations. This quarter and perhaps next, the iPhone 5 launch will mask these issues because the product mix will skew toward Apple’s highest margin product. But next year this year’s margin erosion will continue and the shares will come under pressure.