Mac Mini, iPod Shuffle Could Hurt Apple Profits

SAN FRANCISCO – Apple Computer Inc.'s (AAPL) blow-out quarterly results had investors cheering on Thursday, but Apple's profitability could weaken as the Mac and iPod maker goes after lower-priced consumer markets that it has shunned in its nearly 30 years of existence, analysts said.

At the annual Macworld show this week, Apple's co-founder and Chief Executive Steve Jobs (search) unveiled the Mac mini (search), starting at $499 and its cheapest Mac ever, and the iPod Shuffle (search), which starts at $99.

The products, which are less profitable than Apple's overall corporate average — the Shuffle's margin is less than 20 percent compared with an overall 28.5 percent in the most recent quarter — are a departure from Jobs' long-time characterization of Apple as the BMW of the computer industry that can command a premium on its products.

"There's definitely some risk of margin erosion but my sense is it's pretty manageable from Apple's perspective," said analyst Roger Kay of market research firm IDC. "But if these low-cost unit start taking over the rest of their products, they're going to have to look at ways of lowering costs."

Not only do the new products carry lower gross margins, but Apple's costs are also higher than that of other personal computer makers. Apple's selling, general and administrative expenses and its research and development spending accounted for 17 percent of revenue in the most recent quarter. For Dell Inc., the same percentage in its most recent quarter was 10 percent.

But even if Apple hits a grand slam with the mini and the iPod Shuffle and drags down Apple overall gross margin — the percentage of revenue left after subtracting production costs — it could be a good problem to have, one analyst said.

"If they sold enough to have a meaningful impact on gross margin in one quarter, I think we'd call that a happy problem," said Darcy Travlos, an analyst with Caris & Co. "That means Apple is increasing market share and bringing more people into the Apple family."

After the market close on Wednesday, Cupertino, California-based Apple reported fiscal first-quarter profits that nearly quintupled as revenue rose 74 percent from a year ago. It sold 4.58 million iPods, up from 2 million in the prior quarter, and shipped more than 1 million Macintosh computers (search), the highest number in more than four years.

Shares rose as much as 13 percent on Thursday, and in late trading the stock was up $5.95, or 9 percent, at $71.41. In 2004, Apple shares more than tripled.

Apple's gross margin in the first quarter was 28.5 percent, up from 26.7 percent a year earlier, and was well ahead of most analysts' forecasts. Moreover, the average selling price of its iMac computer, the most popular in the quarter, actually rose from a year earlier, and this in an industry where prices almost always contract over time.

Chief Financial Officer Peter Oppenheimer said the widening gross margin was due to the high revenue, which allowed it to amortize more of its fixed production costs, declining component costs and a mix of products that was skewed to higher-priced ones.

And even if gross margin contracts in the current quarter, which is likely, any reduction is more likely due to the seasonally slower quarter, which follows the holiday-sales-fueled previous quarter, Travlos said.

"That's a function of seasonality, not lower-priced products," Travlos said, adding that the cheaper products will likely prove effective in enticing consumers to buy Apple peripherals for the Mac mini and even more expensive PCs.

"Interest in the Mac mini will bring people into Apple stores and they'll see the whole range of Apple products," she said. "There's opportunity for upselling."

Kay agreed, noting his belief that Apple is using the lower-cost products to get more customers into its stores in the hopes of selling more expensive gear.

But there is a downside to offering a Mac whose price is at the sweet spot of Windows computers and a digital music player that undercuts its rivals in cost.

"You don't want to sell so many that you dilute your margins substantially."