Apple's Big Risk: Cannibalization

Erick is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Apple (NASDAQ: AAPL) is taking a calculated risk by releasing it's new iPad mini. This risk is encapsulated in Clayton Christensen's book "The Innovators's Dilemma." In the book Christensen explains that companies fear cannibalizing their products by releasing cheaper, smaller alternatives. The sales of the more expensive item are eaten away by the cheaper alternative and thus the company's margins are eroded but their revenues grow. The thing is that if you are not willing to release that cheaper alternative some rival will and then the rival will get to book those sales instead of you.

I am sure Apple's CEO, Tim Cook, has read the book. He even refers to this risk in the latest conference call and alludes to the fact that Apple is willing to cannibalize its own products rather than have a competitor come in and gain those revenues at Apple's expense. Apple's success in the past has in part been tied to this. As smartphones have replaced MP3 players, the iPhone supplanted the iPod.

Apple's management knows that the iPad Mini's margins will eat into profits, but the key is to make that up on volume and to prevent competitors from getting a toe hold. The intent is from keeping the consumer from switching from Apple's ecosystem to that of a competitor such as Google (NASDAQ: GOOG) or Amazon (NASDAQ: AMZN). Google with its Android operating system and Nexus tablets as well as Amazon with its Kindle Fire want consumers to choose their cheaper alternatives and then get sucked in to their ecosystems, thus buying content and upgrading to that flavor of device in the next upgrade cycle. Amazon's strategy is to sell the Fire device at a slight loss in order to entice people to consume the content from thier store. Just give away the razor and they will come back again and again to buy the razor blades. The same is true with the ecosystem being built by these 3 tech giants. 

Apple knows its ecosystem is particularly sticky with consumers. Once you have an iPhone you don't tend to switch over to Android since your apps will work on the iPad. Google and Amazon are going for the lower end of the market in order to undercut Apple. Apple is offering the iPad mini in order to round out its product line, but surprisingly they did not offer a device below the $250 or $200 price point.

Apple is a premium brand and by offering a premium product thy protect their brand and to a certain extent their margins. The real question oiver the next few months with the very important Christmas season coming up is whether consumers will keep choosing the premium brand or whether they will migrate into another ecosystem by choosing the cheaper alternative.

My view is that the iPad mini's price point will drop next year as the yields and prices improve on the components that seem to be in short supply. Apple has done this with the regular iPad and iPhone. As the new models come they discount the old models and thus gain new customers for that ecosystem that will drive profits for years to come. Just remember that Apple makes 30% from those app sales in the iTunes store.

Right now AAPL stock has taken a beating and is selling at very compelling valuations if growth can be sustained. There are a number of risks inherent in owning Apple, especially the risk of lagging behind on innovation. Apple tends to spend less on R&D than its rivals, but they do tend to get much more bang for the buck from that R&D budget. If you go into the culture of Apple it remains a culture of excellence and personal responsibility as demonstrated by Tim Cook's apology for the Map apps fiasco and his recent management shakeup.

My view is that given the current valuation and the potential for growth in the future especially if the economy improves, Apple remains a strong buy. Do your own research and if you disagree you may make some money shorting the stock.


Fool blogger Erick M. Santos, M.D., Ph.D. is way long AAPL, GOOG and AMZN. He owns a variety of iDevices including recently purchasing a brand new iPad mini and a new 13" MacBook Pro. The Motley Fool owns shares of Apple, Amazon.com, and Google. Motley Fool newsletter services recommend Apple, Amazon.com, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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