The pending release of the mid-priced iPhone 5C has led to concerns about Apple's (NASDAQ:AAPL) premium brand, the direction of its gross margins, and the potential cannibalization of higher-end products. I argue that by properly constructing a "rate fence," Apple can minimize these negatives while making the 5C a large, material contributor to the bottom line.
In addition, there has been little press coverage of the likely impact of the 5C on Apple's competitors - this, despite the fact that the pricing on the 5C sits squarely in the breadbasket of most of HTC and BlackBerry's (NASDAQ:BBRY) latest offerings. Nokia (NYSE:NOK) and Samsung will also be affected but not as greatly.
Will the iPhone 5C Hurt or Help Apple?
As the phonosphere eagerly awaits the release of the Apple's iPhone 5C (with some half-joking that the C stands for "cheap"), there has arisen two distinct worries for Apple with respect to this pending release. Some are worried that by going lowbrow (well, actually at a price of $400 it is more middlebrow), Apple risks damaging its brand. Others worry that customers who would otherwise have bought the more expensive model (5S) might downgrade to the cheaper one. Economists refer to this as "cannibalization." Here are two examples from fairly recent history:
In 2001, Ford's management decided to take the Ford Modeno and slap a Jaguar grill on it and sell it as a Jaguar X-Type. Though the company sold a good number of "Modenos," management was surprised when upper-crust buyers stopped buying as many high-end Jaguars. (These high-end buyers did not switch and buy the cheaper Jaguars. Instead, they stopped buying Jaguars, altogether.) Clearly the move was not a good long-term one for the Jaguar brand.
Ford Modeno; Source: hdwpapers.com
Notice the resemblance? This is clearly an example of a brand that was damaged by the poorly-thought-out introduction of a lower end product. Now consider this second example:
Mini Cooper; Source: TreeHugger.com
In 2000, after divesting the Rover Group, BMW ended up owning Mini Cooper. Was BMW's brand name damaged by its ownership of Mini? Did people who were previously buying BMW's suddenly start buying cheaper Minis instead?
So what was the difference in these two scenarios? I argue that management and marketing made all the difference.
Getting back to our cell phone world, the question then becomes:
Which of the two scenarios will more resemble the iPhone 5C launch?
Well, I do not think the iPhone 5C is much like either of these scenarios. The 5C is not like the Mini analogy because Apple is not establishing an entirely new brand for this lower grade of product. The scenario is also not like the Ford analogy because Apple is building its new 5C from scratch.
Instead, in keeping with our automotive analogy, the introduction of the iPhone 5C is much more akin to when Porsche introduced the "low-priced" Boxster. For a mere $50,000, it was suddenly possible for the middle class to stretch a bit and be driving a Porsche. Porsche introduced the Boxster because it realized that the market size of this segment was six times larger than that for the more expensive 911. They successfully kept 911 buyers from going "downstream" by limiting the horsepower on the Boxster engines to be below 400. (I think they still do this). In addition, there was more than one buyer who walked in expecting to buy a Boxster and walked out with a 911. (Having to tell the wife afterwards is never easy.)
Getting back to Apple, we do not know the details of the 5C yet, only what has been widely reported in the media - there will be many colors, pricing will be $300-$400 off-contract, etc. But the key to whether this becomes a net positive or negative for Apple will depend mostly on how effectively management is able to build what economists call a "rate fence" to keep the 5C from cannibalizing its kin or destroying its brand.
A rate fence is the mechanism by which the two groups of consumers are kept separate so that the higher end group does not end up purchasing the lower end product. Of course, Apple will reduce the feature set as its main differentiator between the two models. But by providing more colors, it may appeal more to younger, less affluent purchasers. In brief, we do not yet know all the different ways Apple will try to keep its cache in the new model while keeping its higher end customers from shifting down.
Will it succeed? Is it even possible? I do not know what will happen, of course, but to answer this question, I am asking myself whether Apple is good at marketing or bad? Certainly we can argue about whether Apple has lost its ability to innovate recently in the post-Jobs era, but the overall success or failure of the 5C does not depend on innovation, it depends on management's marketing ability. They must create an environment for which they keep the two sets of consumers (high and medium/lower end) with its respectively differing price elasticities separate. If it can succeed in doing this while making the lower end model attractive to the majority of its target audience, it should be cause for celebration on Apple's income statement. And the impact should be felt almost immediately.
Samsung is proof that is possible to sell phones in all different pricing segments. Does anyone believe that Galaxy S4 sales are significantly impacted by the availability of lower end models? Some of you may suggest that Apple's brand is different from Samsung's because the former only sells high-end products. But my counterpoint is that before the Boxster came along, Porsche only sold high end automobiles. The key is how well it builds that rate fence. Thus, my investment thesis is predicated on the strength of Apple's marketing which so far has been nothing but stellar.
While most of the press has been focused on whether the iPhone 5C will be good or bad for Apple, there has been relatively little discussion on how it is likely to affect Apple's competitors, namely Samsung, HTC, BlackBerry (BBRT) and Nokia. Here are my conclusions after looking at the various platforms these competitors offer:
Local Brands Likely Unaffected: Most in-country, local smartphone brands make Android clones positioned at $150 and below. We do not expect they will be materially impacted by the $400 iPhone 5C.
HTC One and Done: A lot of the company's products (One, 8X, ThunderBolt, etc.) are squarely aimed at the same price points of the 5C. As such, I believe HTC will be the most affected by the 5C's release. Given that the company is already teetering, one has to wonder if this will end up being the death blow to its cell phone aspirations.
BlackBerry: No doubt looking over their shoulder, management sees the 5C coming. I have to wonder if this was, at least, in part of what caused the company to shop itself now instead of waiting longer. (But BGR suggests that it had more to do with weak sales of its most recent offerings.) Overall, the pricing on most new BlackBerry models is similar to that expected for the 5C. Conversely, if I was thinking of buying the entire company, I would wait to see how the 5C plays out before making my offer. If BlackBerry does not get sold soon, there is going to be more trouble ahead.
Samsung: We expect the company to lose some mid-tier market share as a result of this iPhone 5C release. This is somewhat counterbalanced by the possibility that the lower priced iPhone could potentially finish off HTC and also accelerate BlackBerry's sale - both of which would help consolidate the mid-tiers of the smartphone industry. Thus, the effect on Samsung is mixed.
Nokia: The pricing of the 5C runs up against the company's Lumia 92X product line. But its recently released Lumia 1020 (with the 41 MP camera) is unlikely be severely impacted. Likewise, the lower priced Lumias (sub $200) are also most likely unaffected. Thus, the 5C might bifurcate Nokia's sales by reducing the middle tier revenues (they were headed in this direction already given how long in the tooth the Lumia 92X series already is). Similar to Samsung, the additional pressure that the 5C causes to BlackBerry and HTC may be to Nokia's benefit.
Wall Street's Gross Margin Concerns
Every portfolio manager on the Street has been trained like a Pavlovian dog to see a decline in gross margins as a sign of increasing competition, even if overall profit dollars are on the rise. No doubt this is one major factor that has recently depressed Apple's stock price. The Street recognizes that the blended margins, once the iPhone 5C is released, must come down for Apple. I'm not arguing otherwise.
But there are some benefits also. Certainly some of the lower tier customers will end up stretching to buy the high end phone - if not initially then perhaps later in their economic life cycle. More importantly, the 5C opens a new market segment for Apple which volume-wise must be larger than the current high-end market.
Most investors are worried that the soon-to-be released budget iPhone from Apple will hurt the company. I contend that even based on good (not great) marketing execution on Apple's part will make this a big net positive for the company. Meanwhile, it looks as though the pricing of this product is coincident with much of where HTC and BlackBerry are currently positioned.
With HTC we expect heavy additional pressure at a minimum. With respect to BlackBerry, the pending release of this phone probably accelerates their desire to be sold. For Windows Phone, we expect the pricing of the 5C to taper demand for Nokia's 92X series of phones but not to have a significant effect on the higher end Lumia 1020 (and its upcoming variants) as well as lower end Lumia 52X and 62X phones.
Disclosure: I am long AAPL, NOK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.