Apple: Is a Low Cost iPhone in the Works?

Apple Inc (AAPL). For some time, many have speculated about an arrival of a $99 iPhone. Some analysts expect a low-cost model with scaled back features, such as 2.5G instead of 3G, no GPS, and possibly a smaller form factor. While I believe a lower iPhone price point is possible, I don’t expect Apple to go backwards by removing features that reduce device functionality to achieve a lower-cost offering. The price of the handset is much less significant than the lifetime cost of the required $30/month data plan. Therefore, crippling device functionality to lower handset price makes no sense when the primary cost component is the data plan.

I believe if Apple were to pursue reducing the price of the iPhone to the consumer, it should first explore offering alternative pricing that doesn’t necessarily lower selling price and margins. Offering cheaper data plans that coincide with less usage would allow consumers to be able to pay according to usage, rather than being required to pay for unlimited when their usage is actually quite limited. Carriers would apply less subsidy and charge more for the handset, yet consumers would still save over the life of the contract. Carriers would still benefit from increased demand even though ARPU may not be quite as high. Carriers could capture the iPod touch demand that arises from those who wish to avoid the required data plan.

Low-Cost Model With Less Features- Unlikely:
While unit demand increased dramatically from previous price reductions, ($599 - $399, $399 - $199), I don’t expect unit demand to be nearly as responsive to a $100 price reduction, from $199 to $99. At this price level, demand elasticity begins to evaporate, as consumers are less responsive to further price cuts. At $199, the iPhone is competitively priced, as opposed to when it was priced out of the market at $599. The bulk of the pick-up in demand from cutting handset price has already been realized.

Reducing hardware cost is another challenge. Eliminating or scaling back certain features through cheaper or fewer components won’t significantly impact build costs. The obvious modifications that many have cited are removing GPS, 3G baseband, and installing less flash memory for media storage. These actions would likely only lower component cost by $15-$20. Additional cost reductions could be brought about with a smaller form factor, however the savings wouldn’t be great enough to offset the burdens it would create on the software development side.

Perhaps the most crucial aspect is it’s the cost of the service plan, not handset, that is the most costly. The iPhone requires signing a 2-year contract for the $30/month smartphone data plan. Over the life of the agreement, this amounts to $720. For those who currently have a $15/month data plan for a non-smartphone device, the incremental difference over 24 months is $360. However, AT&T (T) offers a bundled unlimited text & data plan for non-smartphone devices for $30/month, instead of $35/month ($15 data + $20 text), which raises the monthly price difference to $20, or $480 over 2 year contract for those affected customers. AT&T subscribers who use a smartphone other than the iPhone wouldn’t pay more since the price of the data plan is the same as the iPhone.


Lowering the iPhone handset price by $100 accomplishes little in the sense of affordability due to the $720 24-month cost of the required data plan. I frequently track online discussion forums (such as AT&T iPhone support) as an informal survey tool. The amount of discussion regarding the iPhone handset price pales in comparison to the required data plan. People tend not to have any problem with the $199 price, but are very vocal about the recurring $30/month for the data plan. In fact, there have been a couple of individuals who weren’t adverse to pay $399 since they weren’t eligible for an upgrade, but were inquiring if there were a way to circumvent the data plan requirement. There is little evidence suggesting a $100 price drop will have a profound impact due to the large number of consumers who find the data plan requirement inhibitory.

Reducing the data plan fee, or eliminating the requirement altogether, would have the most substantial impact on demand. The problem with this alternative is that Apple receives a ~$400 subsidy based on the higher ARPU generated by the data plan. Therefore, if the iPhone ARPU were to decrease from reducing the price of the data plan, then the iPhone subsidy would decrease as well.

Assuming that hardware costs can be reduced by $50, and the subsidy falls to $200 from $400, gross margin would decline to 33% from 58%. In order for earnings to increase, unit volume would have to rise by a factor of 3.5x.

Assuming a more generous subsidy of $250, perhaps with required $10/month plan, gross margin would only fall to $43%, but volume would have to increase more than 2.3x.

A scenario where a $20/month data plan produces a $300 subsidy, gross margin would only drop 800 bps to 50%, and volume would only have to rise 75% to be cash flow neutral. However, consumers still face an incremental $480 increase from the data plan, which will limit the impact on demand.

Even if the economics of reducing hardware and service costs were to make sense, there are other issues. Crippling device functionality takes away from the user experience, which is the primary focus of Apple products. Substituting 2.5G would significantly worsen web browsing and video streaming.

The tests I have been conducting show iPhone 3G data speeds are currently 7-8x faster than 2.5G. In the months following the 3G iPhone release, speeds were only 2-3x faster than EDGE. Obviously, AT&T has made substantial progress in improving its network, which significantly enhances the iPhone user experience. With many competing devices beginning to offer 3G, a slower iPhone might damage consumer perception and lessen its appeal. The iPhone is designed for heavy internet usage, thus a much slower connection would dramatically lessen the iPhone experience. This move would probably only save $5-$10 in hardware costs.

Removing GPS would only save ~$5 in component costs as iSuppli lists the price of the GPS radio at $3.60, and the impact on user experience would be considerable. Many apps are designed around the user’s current location, which requires GPS to obtain an accurate position. The integration of location services with other iPhone features is a major factor that differentiates the iPhone from other devices. Therefore, without any real cost benefit, offering a model without GPS makes no sense.

Altering the form-factor is another alternative for reducing costs. A smaller device could reduce hardware costs to a degree, yet it would require a relatively large size reduction to meaningfully affect hardware cost. This would pose several challenges. Apps are developed for a specific display size, thus duplicate versions may be required to accommodate different displays. The challenge may be further exacerbated due to input commands being handled by the multi-touch display. Therefore, modification may be needed not just for output, but input as well. In addition, a smaller viewing area would reduce the user experience, and a smaller area for input commands may cause navigation to suffer. To achieve meaningful savings, the handset size would have to be reduced to a point at which the user experience would highly suffer.

I don’t believe there should be any change to the iPhone hardware since potential cost savings are rather insignificant. The only exception would be offering 2.5G models in markets where 3G is unavailable as long as it were accompanied by a cheaper data plan. This might help spur demand in non-3G markets where consumers must pay $30 for 3G service and aren’t even able to take advantage of the faster speed.

Possible Alternatives:
The best course of action would be to offer multiple data plan choices, and adjust the handset price accordingly by applying less subsidy. The consumer would have to pay more on the front-end, yet would save money over the 24 month agreement. A cheaper data plan results in less handset subsidy which would be absorbed by the consumer. Thus, it wouldn’t affect the economics of the iPhone with respect to Apple, yet it would provide flexibility for consumers. If a particular individual plans to use very little data, then he/ she could select a cheaper plan with less data usage included. They would pay more for the handset, but would still save money over 2 years from the cheaper monthly cost of the data plan. The savings will come at the expense of AT&T, yet it’s not a real expense, rather the opportunity cost of not receiving $30/month for the unlimited data plan. However, this could be offset (or overcome) with sufficient increase in demand.

A scenario with a $10/month data plan would raise the handset price to $349, a $150 increase, but reduce lifetime service fees by $480. Including the price increase of the device, net savings over 24 months is $330. A second scenario with a $20/month plan for heavier data usage would increase the iPhone price $100, to $299, but lower service fees $240 over 2 years, resulting in net decrease of $140. If an individual pays the extra $100 for the cheaper $20/month plan, and later decides he / she needs the unlimited data plan, the carrier could offer a $25/month instead of $30/month since $100 was collected on the front-end. If one wanted to switch to a smaller data plan, then the handset discount could be recovered from lowering the monthly fee by less than the full amount.

There is one scenario of a low-cost model that I do think is a possibility. Bernstein Research’s Toni Sacconaghi has broached the idea of an “iPod phone” which makes a lot of sense. The premise is that music is moving onto many basic mobile phones which may pose a threat to iPod sales. The concept of a converged device means that users won’t prefer to carry both a phone and an iPod. For those who don’t want an advanced phone with internet capability, such as the iPhone, but want a media player combined with a basic mobile handset, an “iPod phone” would be a suitable match.

Essentially, an iPod classic or nano could be married with a basic mobile device that wouldn’t require a data plan. Possibly, it may offer some “widgets” such as stocks and weather, but not email or internet browsing. The sole purpose would to counter iPod defection from those using their mobile phones more and more as a music player. I don’t foresee such a device anytime soon, however it remains a viable possibility down the road.

I do believe a $99 iPhone is inevitable. However, it wouldn’t be a “low cost” model, rather Apple could offer the current iPhone model for $99 in light of an introduction of new advanced models. I expect new iPhone models to arrive this summer, which will have faster processors, and advanced graphics chips that will allow multiple apps to run simultaneously and video capability. There has been an unsubstantiated rumor that AT&T might buy back iPhones since current 3G owners would be ineligible for a subsidy on a new iPhone model if one were to come this summer. These phones could be sold for $99 or less. AT&T has been running deals for $99 on refurbished iPhones.

Apple’s iPhone Vision:
Management has stated it doesn’t intend on making an iPhone for everybody. Apple says it isn’t interested in selling the most units, but rather is committed to being the leader in the market segment it prefers to serve. Comments from Apple contradict many pundits and analysts that claim the firm is limiting the iPhone’s potential by addressing such a small portion of the overall mobile handset market.

However, Apple is a company that demonstrates patience. Steve Jobs once said rather than crossing a river to get to someplace else, Apple waits for the other side of the river to come to it. The smartphone market is growing considerably, thus there isn’t much reason to stoop down into the basic handset market that will be contracting.

Disclosure: Long AAPL

Comments

[Zoltan L. K...:]

It is funny to hear about the same old speculations trying to become a self-fulfilling prophecy. Well Apple as a company doesn't have an external remote control for product development. Anyway, it is not about selling cheap products to people who only buy them because of the low price. The one thing I am not worried about is Apple's capability to invent really great products and value to customers.

Mar 06 01:59 AM

[jmmx:]

szia Zoltan

Mar 06 03:42 AM

[jmmx:]

A device may have FEWER features NOT "less features"

oi vey!

Mar 06 03:43 AM

[Turley Muller:]

ha, I know. I caught that too.

Fewer pertains to quantities that can be counted. Less for indeterminate items such as "less time" but "fewer minutes."

I really should have stated less functionality, since a cheaper device could have more features but still be inferior and less functional depending on what the features actually are.

Good catch.


On Mar 06 03:43 AM jmmx wrote:

> A device may have FEWER features NOT "less features"
>
> oi vey!
>

Mar 06 04:35 AM

[rd4sndk:]

Turley... I believe Apples approach to lower cost is not in the mechanical systems or the feature rich components but rather in its core electronics--the mpu. Apple wants to lower power consumption and cost for the iphone and it needs to lower cost for the ipod--particularly the touch. Some and including yourself have over looked the cost involved with the cpu core for both the ipod and iphone.

CPU core

Apple can lower its BOM with its own mpu and given the volumes its not hard to ring up billions in savings. It's been estimated that the current Samsung processor used in the ipod and iphone cost upwards of $20. This processor was not designed to interface with other feature components and perhaps carry another dollar amount in glue logic and discrete components (both passive and active). I can see at least a $20 cost savings in components and another $3 savings in PCB realistate per iphone and a similar amount for the touch. Its not a stretch to forecast apple selling 50 million iphones and ipods-touches this year. With a cost savings of $20 plus per device Apple reaps a $1Billions in component cost alone-- not to mention labor and handling cost.

Elimination External DRAM

Its possible now to eliminate external DRAM with eDRAM patented by IBM. Since non of the current smartphones uses more than several 100's of Megabytes of DRAM its possible to include 256 MB or 128MB of eDRAM. Although this wil drive up the size of the cpu chip and cost there's a greater savings in inventory, PCB realistate, total component and glue logic cost.

Law of large numbers

Many have concluded correctly that $5 cost savings in removing a feature is not worth the lost in functionality. However, when that $5 is saved without lost of functionality and is multiplied by 10's of millions of devices, it becomes a profit center for Apple. That $5 cost savings on 100 million devices becomes a $1Billion in gross margin expansion.

If my premises is correct that Apple will save a $1Billion a year in component cost, an interesting question is what would be the most productive use of that cost savings? My answer is drive innovation by buying a controlling interest in Sprint/Nextel inwhich they could then offer the iphone with reduced service plans say $10/month and thereby completely alter the mobile lanscape in America over night. Apple's iphone volume will escalate north of 100 million annually as aforedability will extend down to the low cost consumer.

Apple having controlling interest in a carrier will drive innovation products in movie down loads, music down loads, ebooks, navigation, education, texting ect.

At todays current prices, Sprint/Nextel would only require about $5billion for a 50% stake in the company. However, for much less, Apple could get access to the network with just the capabilities it wants to revolutionize things.

Mar 06 08:58 AM

[mollytjm:]

an iTouch w/phone for gamers would probably sell well. And Amazon just made a Kindle app available, free, for iTouch and iPhone. So an iTouch, with phone, would work for certain people who don't care about surfing the web or emailing but would like only one device to carry around. Dropping the iTouch price might be a good choice.
Good article, as usual and i guess in this context, 'less' isn't more:)

Mar 06 09:32 AM

[dvd:]

Great piece, agree 100%... read recently of wireless carrier "innovation". What a joke. First carrier to offer limited or pay-as-you-go data plan will see marked gains esp. if they support the best of breed smartphone (iPhone, maybe Palm Pre).

Mar 06 09:35 AM

[Turley Muller:]

Excellent points. I guess what I was getting at is that the cost savings if passed on to the consumer in terms of cheaper hardware wouldn't make much difference- to the consumer. Of course, savings for Apple, even $5 adds up quick with volume.

The key is power consumption, I think Snow Leopard and PA Semi design is working towards higher-performance, less power consuming chips.

Apple could take extra-margin an essentially reverse subsidize the service plans by paying AT&T on behalf of the customer, or essentially accept less subsidy.

The Sprint idea is interesting. I agree Apple is needs a strong footing, I think that was the premise of the AT&T exclusivity to give Apple more control with the carrier.



On Mar 06 08:58 AM rd4sndk wrote:

> Turley... I believe Apples approach to lower cost is not in the mechanical
> systems or the feature rich components but rather in its core electronics--the
> mpu. Apple wants to lower power consumption and cost for the iphone
> and it needs to lower cost for the ipod--particularly the touch.
> Some and including yourself have over looked the cost involved with
> the cpu core for both the ipod and iphone.
>
> CPU core
>
> Apple can lower its BOM with its own mpu and given the volumes its
> not hard to ring up billions in savings. It's been estimated that
> the current Samsung processor used in the ipod and iphone cost upwards
> of $20. This processor was not designed to interface with other
> feature components and perhaps carry another dollar amount in glue
> logic and discrete components (both passive and active). I can
> see at least a $20 cost savings in components and another $3 savings
> in PCB realistate per iphone and a similar amount for the touch.
> Its not a stretch to forecast apple selling 50 million iphones and
> ipods-touches this year. With a cost savings of $20 plus per device
> Apple reaps a $1Billions in component cost alone-- not to mention
> labor and handling cost.
>
> Elimination External DRAM
>
> Its possible now to eliminate external DRAM with eDRAM patented by
> IBM. Since non of the current smartphones uses more than several
> 100's of Megabytes of DRAM its possible to include 256 MB or 128MB
> of eDRAM. Although this wil drive up the size of the cpu chip and
> cost there's a greater savings in inventory, PCB realistate, total
> component and glue logic cost.
>
> Law of large numbers
>
> Many have concluded correctly that $5 cost savings in removing a
> feature is not worth the lost in functionality. However, when that
> $5 is saved without lost of functionality and is multiplied by 10's
> of millions of devices, it becomes a profit center for Apple. That
> $5 cost savings on 100 million devices becomes a $1Billion in gross
> margin expansion.
>
> If my premises is correct that Apple will save a $1Billion a year
> in component cost, an interesting question is what would be the most
> productive use of that cost savings? My answer is drive innovation
> by buying a controlling interest in Sprint/Nextel inwhich they could
> then offer the iphone with reduced service plans say $10/month and
> thereby completely alter the mobile lanscape in America over night.
> Apple's iphone volume will escalate north of 100 million annually
> as aforedability will extend down to the low cost consumer.
>
> Apple having controlling interest in a carrier will drive innovation
> products in movie down loads, music down loads, ebooks, navigation,
> education, texting ect.
>
> At todays current prices, Sprint/Nextel would only require about
> $5billion for a 50% stake in the company. However, for much less,
> Apple could get access to the network with just the capabilities
> it wants to revolutionize things.
>

Mar 06 10:09 AM

[jmmx:]

The last thing Apple wants is to run a wireless network, or even own one. It is way far away from its core expertise.

IMHO

Mar 07 01:04 AM