Saturday, April 21, 2012

Pricing Power Part I: Apple (AAPL) Demands a Premium


There are two forms of pricing power: the ability to raise prices and the ability to lower prices. The following is the first of a (two part? three part) series on pricing power as a competitive business advantage. 

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The ability to raise prices for your offerings, or demanding a premium over competitive products based on some perceived superiority of your offering, is an excellent indication that your business offers some form of competitive advantage. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must address some consumer want. 

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.

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I can't stop thinking about Apple (AAPL) as an example. It is the clear leader in consumer electronics. It has created beautiful products with elegant simplicity and the content ecosystem that gives users reason to keep on using. It is a beloved brand. Iconic even. So it is no surprise that Apple charges a tremendous premium for its products and does so unflinchingly.

Apple rolls out innovation after innovation. One can easily be lulled into believing that this string of successes portends a trend that will go far into the future, that each new cycle of the iPhone and iPad will demonstrate another "wow!" and send consumers running to Apple stores to secure their upgrade.

But what happens if Apple disappoints? Sustained innovation - staying at the lead of this pack - is very, VERY difficult. Expectations are incredibly high (Shleifer Effect anyone?). Competitors are emulating the technology and it would seem they're narrowing Apple's lead with each product cycle.

And the competitors are eager to charge a lower price. Think Amazon. Think about selling Kindle Fire at a loss. Think of Kindle Fire getting just a little bit closer to the iPad with each new generation. Think how Amazon offers an equivalent content ecosystem to keep users using...but often at a cheaper price. Think how difficult it will be to get price sensitive consumers to justify paying that premium as Kindle Fire gets better and better. 

Apple will just lower its price, you might argue. Or it will offer a scaled back set of devices to compete with Amazon. They have plenty of margin to give and still be plenty profitable. Right?

Perhaps. but what does Apple lose in the process? Certainly the high ground of being a premium-only device provider; one that refuses to sacrifice quality; one that seeks the sublime in its designs. That is the sacrosanct brand of Apple, that which Steve Jobs dedicated a life to creating.  Changing it would be a substantial change to the culture of the company.  Indeed, a big change to its image of itself.

Were it to accept lower margins for its products, it also presents a revised economic model to its investors. Can we imagine investors reacting well to a product line with lower margins that likely cannibalizes its much more profitable existing product line? That certainly changes the earnings profile of the business.  One might easily argue that such a move would create additional new unit sales for Apple, generating more revenue by bringing in the price sensitive buyers who want iPods and iPads and iPhones but cannot afford them today. Perhaps. That is a plausible scenario. But I suspect that Apple will have a hard time dumbing down its products enough to make them price competitive with Kindles. This just goes against the DNA passed down from Jobs. And if Amazon is willing to sell Kindles at break-even or lower...

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I suspect that Apple has painted itself into a corner. In no way is that comment meant to denigrate the company...its achievements are extraordinary; its products are remarkable. But from a competitive perspective and an investor perspective, I think it has a tough trail in front of it. I mean...

Customers have sky high expectations that each new release will make strides over the last. Apple must continue its track record of innovation (which is probably unmatched in the annals of consumer electronics) in perpetuity (or at the very least, only allow minor setbacks) to satisfy those high expectations.

This while carrying the banner of lead innovator, holding it high and proud for all the competition to see. This is hard! It's like holding the lead at the Tour de France. You cut into the wind for everyone behind you. They get the benefit of drafting. They can watch your every design move, tear apart each new release to learn how you did it, study your supply chain tactics...emulate your every move and pull closer to you with each cycle. 

That banner of innovation, and that grinding into the wind, gets harder and harder the longer you do it! The peloton drags you back in.

Finally, whether it comes from a lapse in innovation for a new product release or the decision to cut margins by moving downstream with a "value" product, earnings will suffer. And investors DO NOT suffer declining earnings happily. 

In light of how the market rewards Apples long string of record-breaking earnings - by giving it a multiple around 16 times its trailing results at a time when they should be at the height of their optimism - one must ask how investors react if these earnings slow down or shrink. (Actually, for the sake of the Shleifer Effect, it could present a good investing opportunity!)

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So Apple is my example of a firm able to raise prices and/or charge a big premium. At the outset I suggest that we must inquire whether the advantage(s) that gives the company the ability to charge a premium is defensible and enduring. We must understand this in assessing the strength of its competitive advantage. 

I believe Apple's is based on continuous superior innovation leading to excellent products and brand cachet. If the innovation slips, its reputation becomes scarred and competitors will step in on short notice to fill any breech. And innovation is hard. What Apple has done to date is extraordinary. But at some point do the pressures cause them to revert to a mean? At some point, do they tire and stumble? Perhaps not. But I wouldn't bet on it.


This post was originally published here on Adjacent Progression.