Apple (AAPL) is entering a new era with a change of its smartphone strategy. While it previously had no problems growing sales by "just" releasing a new high-end model each year, consumers have become increasingly interested in cheaper smartphone models, which has resulted in sales of the high-end iPhone being somewhat stagnant. The consumer trend isn't unexpected as the industry has reached a stage where the low-end smartphones are "good enough," and only those with extra money to spare are willing to purchase the most expensive smartphones.
Therefore, Apple has decided to launch a new cheap model, iPhone C, which is expected to be launched September 10th. The iPhone C is expected to be priced around $400-500, which I would classify as a mid-range phone. So the iPhone C won't be cheap enough to obtain high sales figures in emerging markets. Instead, that role will likely be fulfilled by the old iPhone 4s which is expected to be priced in the $300-$400 range.
Previously, Apple sold the most recently released iPhone at $650, the 1-year old model at $550, and the 2-year old model at $450. Thus, it seems that Apple is taking a small step towards offering cheaper models while attempting to maintain its brand as a high-quality producer.
But the question is, how well will the strategy work? Can Apple expect to increase its iPhone earnings over the next twelve months? Before I attempt to answer that question, I'll begin the analysis with a brief review of the historical sales.
Cheaper iPhones are becoming increasingly popular
If one studies Apple's earnings reports, you are likely to conclude two things; 1) the ASP (average selling price) of the iPhone is declining, and 2) sales figures are still growing, but at a much slower pace than previously.
The decline in the ASP can be caused by a few factors, such as;
- Changes in geographical mix (it may be cheaper in certain countries)
- A stronger dollar
- Older models becoming increasingly popular
For simplicity, I will ignore the first two factors, and instead assume that the entire decline in ASP is caused by increased sales of older models. Given that assumption, I have estimated sales of old iPhones relative to sales of the new high-end iPhones (below graph). As can be seen, many consumers seem to be satisfied with older models and in the most recent quarter, the iPhone 4s and iPhone 4 outsold the iPhone 5.
Given the trend of cheaper smartphones becoming increasingly popular, it seems quite logical that Apple is reacting to the trend by offering a wider range of cheaper models with a new price strategy.
How will the strategy impact earnings?
In order to forecast earnings of the iPhone business segment, we need to make two estimations;
- Gross profit per smartphone sales for the old iPhone, the high-end iPhone and the iPhone C.
- Sales forecast for the next year for all of the three models.
According to iSuppli, the BOM for the iPhone 5 is roughly $200. However, those numbers ignores costs related to software, IP, accessories & packaging. Taking those costs into account, I estimate that the average BOM per iPhone is $292 (note; I spent a lot of time studying historical earnings in order to come up with that estimation).
Assuming Apple sells mostly 16GB iPhones, the average ASP for the high-end iPhone is likely be around $675, which is equal to a gross margin of 57%.
For the iPhone C, I assume an ASP of $450 and unit cost of $260, which gives a gross margin of 42%. For the old iPhone I assume an ASP of $325 and unit cost of $210 which corresponds to a gross margin of 35%.
To forecast sales of iPhones over the next year, I assume that Apple's market share will decline from 16.6% (TTM) to 16.3% (1-year forward). This is mainly due to the fact that the expected $325 price tag of the iPhone 4s isn't competitive with many of the Android models in emerging markets, and it also takes into account that the majority of Apple's sales comes from developed markets where sales are expected to grow at a lower rate than in emerging markets.
Despite the decline in market share, I still estimate that sales will increase as the global market size is expected to increase from 857M to 1065M (1-year forward).
In the graph below, you can see my sales forecast for each model. I believe the iPhone C and high-end iPhone will make a big splash when they are released, but as time progresses I expect the "old model" to cannibalize sales.
Given these assumptions, iPhone earnings will decrease over the next year. Q4 2013 (which corresponds to Apple's fiscal Q1 2014) will be pretty good as sales of the very profitable high-end iPhone are high. However, with the expected popularity of the "old iPhone" in Q2, there will be a significant downward pressure on margins, which will result in lower earnings.
Despite the fact that I expect iPhone earnings to decrease, the new price strategy is in my opinion still the correct decision. Earnings will likely decline regardless of which strategy Apple uses as the smartphone industry is becoming less profitable for high-end producers.
The alternative of an even larger loss in market share (which would arise if Apple didn't offer a sub $400 iPhone) would probably have resulted in even lower earnings.