Apple's iPod Business

There are many things which are very much common all over the world . I Pod is one of them. Slowing iPod sales growth has been one of the chief concerns among Apple Inc. (AAPL) investors because the iPod has historically been a major contributor to Apple’s overall revenue growth. The concern stems from the belief that the PMP market is becoming saturated.

The sale of iPod is also very high all over the world. With 175 million iPod units sold, finding new customers is becoming more difficult. However, the iPod is becoming less of a revenue contributor, hence Apple is less dependent on the iPod for its sales growth. Andy Zaky, a highly accurate AAPL analyst addressed the iPod’s shrinking importance with regards to Apple’s corporate revenues. In addition, If Apple reported iPhone sales as part of the iPod segment, this wouldn’t be much of a concern, because the iPhone would have reaccelerated sales growth in the iPod segment. I recently discussed that scenario. Yet, Apple reports the iPhone separately. Therefore, this analysis focuses on the traditional iPod product line and its growth outlook.

If we go in the history then we can find many facts behind it . Historically, Apple has used price reductions to fuel unit volume. The demand elasticity allowed the increase in unit sales to outweigh the decrease in ASP, resulting in higher dollar revenue. In a more saturated environment, demand becomes less elastic. Unit growth has been slowing: 6% [FY08] vs. 35% [FY07], but iPod dollar revenue grew 10% in FY08 compared to 8% in FY07. Apple was able to increase iPod ASP to $167 [FY08] from $161 [FY07] with the introduction of the Touch.

Look at PMP market . Even as the PMP market has neared saturation, Apple has reformulated its iPod product line which will motivate upgrades to iPod models carrying higher ASPs. Therefore, Apple’s current iPod product line strategy focuses on appealing to non-PMP users, as well as motivating current users to upgrade to higher ASP models. Apple has also positioned the iPod product line so that it’s practical for a user to own multiple iPod models to serve different purposes.

iPod Sales- In percentages

iPods were the primary growth engine for FY05 and FY06, responsible for roughly 58% of Apple’s total revenue growth for both years. In FY07, iPod segment generated only 14% of overall sales growth. As a percentage of total revenue, iPod accounted for 33% [FY05], 40% [FY06], 35% [FY07] and 28% [FY08].

The iPod is becoming less significant for revenue growth due to the success of the Mac and iPhone segments. Apple’s revenue grew 35% in FY08 and 24% in FY07, yet the iPod was the slowest growing segment both years. In the last quarter [4Q08], iPod sales were only 21% of total revenue, and less than 15% not using iPhone subscription accounting. Thus, concerns about flagging iPod sales detrimentally impacting Apple’s overall business are stretched since the iPod is becoming less of a contributor. On a non-GAAP basis, the largest revenue contributing segments are the iPhone and Mac, which are the also the fastest growers.

Historically, Apple has introduced new iPod models at high prices then gradually lowered prices. Unit volume accelerates at lower price points, but the decrease in ASP results in less dollar sales growth. The reverse is true when Apple introduces models at high ASPs, which offsets the effect of lower unit volume on dollar revenue. In a saturated market, demand elasticity evaporates as unit volume is not responsive to lower prices. The focus shifts to motivating current users to upgrade to new-featured models at higher price points.

A common belief is that Apple has sold so many iPods, that there isn’t anyone left that doesn’t already own one. In a sense, that’s almost literally true. Those that would enjoy such a device likely have already bought one. Figuratively speaking, the low hanging fruit has been picked. Therefore, Apple needs to keep introducing new models with advanced features that will entice user upgrades and appeal to new consumers lying beyond the PMP market. Apple has accomplished this with the Touch.

iPod’s first two years on sale, ASPs averaged around $350. Then in Q404 (September) Apple cut iPod prices $100 and demand increased considerably. In Q205, Apple priced the “Mini” iPod model at $199 along with launching the shuffle. This resulted in ASP dropping to $191 in Q2 from $264 in Q1. Unit sales exploded even exceeding the previous period which was a holiday quarter. ASP trended down over the next couple quarters until Q106 when the video iPod was released. ASP rose to $207. ASPs gradually fell over the subsequent 8 quarters, sustaining unit volume growth.

In FY07, unit sales growth was 31%, but revenue growth was only 8%. In 1Q08, Apple introduced the Touch model which carried a significantly higher ASP. This resulted in FY08 iPod revenue growth of 10% on top of 6.2% unit growth. That’s right, iPod revenue growth was higher in FY08 compared to FY07. Thus, even though unit volume has slowed materially, dollar revenue growth has actually increased. I think that point is often missed from investors and the media primarily focusing on unit sales.

iPod unit sales only grew 5% YOY for 1Q08, but dollar sales increased by 17% due to a higher average selling price [ASP]. After 8 consecutive quarters of declining ASP, the Touch reversed that trend as ASP rose to $181/unit in 1Q08. You would have to go back 6 quarters to find a higher ASP. We have seen a decline in ASP since Q1 mainly due to the price cut for iPod Shuffles, which management stated has had a very positive effect on volume.

In the September quarter [Q4], ASP fell to $150, primarily due to the back-to-school promotion. I surmise that ASP might have been $20-$25 higher otherwise. Going forward, I expect the recent trend of declining ASPs to reverse. ASPs will rise due to the sales mix skewing towards the Touch model. The July opening of iTunes App store, along with the September’s introduction of the 2nd generation Touch model at reduced prices, will substantially boost demand.