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The Low Cost iPhone: Apple Plays Offense And Defense

This article is more than 10 years old.

For the past several years, Apple has been extraordinarily successful selling very high-margin iPhones in substantial quantities. In return, it has rung up billions in profits. And yet as the company approaches another new spate of product launches, profit growth has turned negative, worldwide iPhone share is in decline and the company's market valuation implies a belief that its best days are long gone. None of this is in question. The issue for Apple is what to do about it. It has some of the world's most loyal customers, extraordinary assets with which to grow its franchise and a cash reserve that is effectively unlimited. What it needs to do now is buy itself a future.

The Wall St. perspective

I argued yesterday that CEO Tim Cook needs to ignore Carl Icahn's plan to buy back more of the company's stock. A report from Bloomberg more or less vindicates my argument: Buybacks don't work. They rarely raise the share price as much as hoped and they certainly don't signal to anyone that the company is heading in the right direction. "What’s more important to the stock is delivering products that are going to return the company to earnings growth," Walter Piecyk, an analyst with BTIG, told Adam Satariano of Bloomberg

All you really need is to look at Apple's performance since it announced its own buyback. Shares traded at $406 when the company added $50 billion to its repurchase fund on April 23. While they traded up to $460 afterwards, by July 27, Apple stock touched a low of $394. Since then, it has mostly gone straight up, reaching $500 thanks in part to Icahn, but also in anticipation of those new products, beginning with the Sept. 10 launch of two new iPhone models. Where's the proof of the effect of the buyback? You're either forced to argue (1) it's working even better than planned and therefore it's just psychological anyway because shares are up by more than the buyback mathematically should affect them (2) it failed miserably to prevent the free fall in July or (3) it isn't actually evident in the share price.

What we do know though, is that it hasn't changed Wall Street's long-running belief that Apple can't keep making lots of money; that its peers are worth more. Wait, you say: Apple is the most valuable company of them all. Yes, but we are talking relative worth as a multiple of earnings. Consider that even at Apple's peak above $700 per share it traded for just 16 times earnings, which is roughly what the average company trades for on the S&P today. Today, its P/E is just over 12. That's half the multiple of Google and nearly exactly the same as Microsoft. Analysts forecast Apple to grow earnings twice as fast as Microsoft over the next 5 years and almost exactly as much as Google, yet the company trades like the former. Go figure.

Slaying the sacred cows

Whether you believe the company should be run for the benefit of the shareholders or you simply love Apple products and want to see the company thrive, you can't be pleased by that status quo. So perhaps it's time for Apple to adopt one of its old slogans and start to "Think Different." On the one hand, there is perpetual panic at Apple over declining profit margins on its products. On the other hand, there is constant worry over market share, which was down to 14% in smartphones globally in the second quarter, according to Gartner. "It is risky for Apple to introduce a new lower-priced model,” commented Gartner analyst Anshul Gupta in a statement about the rumored new cheaper iPhone. "[T]he potential for cannibalization will be much greater than what is seen today with the iPhone 4."

Here's what's risky: A 14% global market share is risky. Blackberry market share was 20% in 2010. It's below 5% now on its way to zero. While iPhone remains strong in the U.S. and a number of markets where high-end phones are subsidized by carriers, 14% is the kind of thing that can disappear in a hurry. When Apple introduces the lower-priced iPhone, allegedly called the 5c, next month, you'll hear people decry Apple joining the "race to the bottom" no matter how it's priced. Ignore them. What you want to hear is the absolute lowest price possible because it's quite honestly a race for survival in the mobile-phone arena.

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Apple sells to fewer than half the carriers worldwide in part because it hasn't had acceptably priced offerings for them. (A deal with China Mobile, the world's largest carrier with 740 million subscribers, seems at last close at hand). The company isn't going to start satisfying everyone with one new phone model, but in the prepaid market and in countries where consumers are asked to pay full price for phones, every dollar matters. If the iPhone 5C is sold at $450 like an iPhone 4 is currently, it suggests Apple will defend only the high end and likely become further marginalized. If, on the other hand, the price comes in at $299, Apple opens up an opportunity to sell twice as many phones as it does today -- or more.

This matters to developers, for whom iOS has been the starting point of choice even as Android has surpassed it in absolute user base. Thoughtful discussion of the topic has been going on among Benedict Evans, Rene Ritchie and Steve Cheney, among others. If the topic interests you, click through for more. But suffice it to say, iOS' place atop the developer pyramid isn't a birthright and isn't a permanent guarantee. And without it, more of the best apps will wind up on Android first which will make the iPhone less compelling, especially if it seeks to defend only the high end of the market. This is not a tenable position, which is why Apple is moving now.

Others have pointed out that Apple should have moved downmarket sooner and the criticism is valid, if pointless. But the current order of the day is how far down the company moves with respect to price, and it's here Tim Cook should be taking calls -- not from Icahn, but rather from smart folks like Evans.

There seems to be some confusion about what's realistic on pricing, so let's clarify: Apple sells an iPod Touch without a rear camera and cellular radio for $229. Those parts wholesale for less than $50. Given that the iPod Touch doubtless meets the company's margin goals (it was added to the lineup at $70 below the then cheapest model just a few months ago), a $299 iPhone would carry a similar gross margin percentage. But it's not purposeful to think of margin in this way; it's useful to think of total margin dollars. If we assume the $299 phone would carry a 35% margin or more than $100 worth of gross margin, we could see that lowering the price to $249 would require Apple to sell twice as many to break even just on phone sales.

The company, however, doesn't make money only on phones. It also makes money when people buy apps, music and movies and even to a small extent from advertising sold inside of some apps. While buyers of a lower-price phone might make less use of the App Store, it's also reasonable to view them as potential long-term customers not just of iPhones but also of iPads and Macs, too. If they instead buy Android phones, Apple won't be making money from them.

There is no doubt that pricing the phone at, say, $399 makes more per phone, but it's hard to fathom how the total profit is higher than at $299 if we take crude estimations of $100 and $200 in gross margin, respectively. At $399, the iPhone 5C would still be premium priced in most of the world and it would likely still be a tough sell with many carriers who have thus far not struck a deal with Apple to carry the iPhone. It also would lose all the above-mentioned gateway benefits. Much smaller volumes times somewhat more dollars will yield a better percentage, but almost certainly less money.

Spend more to sell more

Cook has discussed his desire to push up the portion of iPhones sold directly by Apple through its own retail stores, but the low-cost iPhone will make that even harder to achieve. Unless, of course, Apple opens a great deal more stores. Despite some nonsensical handwringing that Apple's store sales are down a bit per square foot this year (with no new products since last year's iPad Mini, this should surprise no one), the retail effort is the envy of everyone. So why not expand it further? Although smaller format stores were tried a number of years ago in the U.S. and eventually abandoned, they make more sense than ever with an increasingly mobile-focused Apple that sells mostly iPhones and iPads.

And the existing stores are a competitive weapon, with their top-notch tech support and evangelical sales staff. Since showing John Browett the door 10 months ago, though, Cook hasn't hired a new head of retail. So an initiative like smaller, mobile-focused stores -- even if someone wanted to surface it -- couldn't currently happen. Given that Apple's physical presence acts as sales and marketing while also producing at record levels, it's a missed opportunity that the company could easily afford to experiment with growing more aggressively, especially outside the U.S.

Cook has been accused of lacking boldness, but he's already shown a willingness to break with Steve Jobs, introducing a smaller tablet Jobs openly mocked as a terrible idea. Had Apple not produced the iPad Mini, its tablet leadership would have evaporated. But one product isn't enough and while Cook was decisive on firing Browett, not replacing him hasn't inspired confidence. Apple isn't fully exploiting retail, but that's not the only thing it isn't fully exploiting.

The low-cost phone is a good step in further establishing Cook's leadership. He talked of not leaving a pricing "umbrella" under which competitors could fit, but clearly there is one with iPhone. We'll see how much rain he chooses to bring down soon enough. Still, even with more retail outlets, this market-share push is likely to be purely profitable from the beginning. It therefore doesn't begin to spend down Apple's cash or really push the envelope. More on that as I continue this series tomorrow on the weekend.

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