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It was rumored recently that Apple (NASDAQ:AAPL) would be introducing a lower cost iPhone in a bid to counter players such as Samsung, HTC, and Motorola (NASDAQ:GOOG). While Apple is the clear market-share leader in the USA, the rest of the world doesn't have the beautiful carrier subsidies that are available here. Further, the USA is generally a lot "richer" than many emerging markets, so a $199 iPhone with a 2-year contract (or $649 without one) isn't unheard of here, but just simply wouldn't work in areas where people aren't particularly affluent.

To continue strong smartphone growth, Apple is looking to expand beyond the US borders. How is it going to do that with phones that cost so much? The answer to this question is the simplest one: it won't try to.

A Cheap iPhone: Lower Margins, But Still Provides Growth

The major concern is that a cheaper iPhone will erode margins. While it is true that a cheaper iPhone will come at a lower ASP and perhaps a weaker gross margin profile than a legitimate high end iPhone, investors really need to keep an eye on two major factors when worrying about blended gross margins:

  • Do sales of the cheaper/lower margin product eat into sales of the higher end ones?
  • Can the cheaper devices be sold in large enough volumes to ensure an operating profit?

I believe the answer to both questions is "yes" and that investors need to stop worrying so much. Let me explain by way of two scenarios (the #'s are used for illustrative purposes):

Scenario #1: Apple Doesn't Go Low Cost

Apple sells 20 iPhone 5's at $650/device. Each phone carries a gross margin of 65%, for a gross profit of $8,450.

Scenario $2: Apple Produces Low Cost In Selected Markets

Apple sells 20 iPhone 5's at $650/device in developed markets. These devices carry 65% gross margin and give us the gross profit of $8,450.

In addition, Apple sells 100 iPhone 5C ('C' for "Cheap") for $199 at 40% gross margins in select emerging markets. This yields an additional $7960 in gross profits on $19900 of revenues.

The total gross margin profile obviously shrinks to ~50%, but assuming OpEx doesn't explode, and assuming that the 100 iPhone 5C users wouldn't have bought an iPhone 5 to begin with, this is pure upside for Apple.

What's The Big Deal?

It's hard to fathom this as negative for Apple unless the cheaper iPhones show up in the USA and start to take market share. However, even in the US, anybody looking for a cheaper iPhone can get a 1-2 generation old model for cheap/free with a contract. While it will be important to keep an eye on the mix of older generation versus newer generation devices in the developed markets, the point still stands that a "cheaper" emerging markets iPhone just isn't the problem that people make it out to be. Now, the two main problems that could arise are the following:

  • In the low end, Apple is competing with ruthless opponents that don't mind razor thin margins. If Apple can't get volumes where they need to be in order for these to be profitable (to offset SG&A + R&D costs), then this could actually negatively impact the bottom line.
  • In emerging markets, Apple does not hold the "prestige" that other brands may, especially as a non-trivial portion of Apple's cult-like popularity in the US is tied to the fact that it is an "American" company with a founder that people in the US came to adore

Conclusion: Stop Worrying!

Don't worry about a cheap iPhone targeted at buyers that couldn't afford an iPhone proper to begin with anyway. If Apple can sell these low cost devices in markets in which it has little to no penetration for psoitive operating margin, then this is pure upside. The total blended gross margin line will look weaker, but we really only care about top and bottom line growth. As long as these both go in the right direction, and as long as such an expansion is accretive to both of these, then this is an unequivocally good thing.

Source: Apple's Cheaper iPhone: Don't Panic!