Will Low Cost iPhones Actually Lower Apple Margins?

| About: Apple Inc. (AAPL)

The standard response by the media and traders is that a low cost iPhone and signing up of China Mobile (NYSE:CHL) as a customer will send Apple (NASDAQ:AAPL) margins cratering. Even the Options Action crew on CNBC Friday night immediately returned to the same old theory that a lower cost phone automatically means lower margins. Even if the phones create lower margins, it isn't necessarily bad if it helps garner market share for the iOS and traffic for the app store and iTunes.

Investors without kids or ones that missed what happened in the PC race in the early days probably don't realize or remember that the lack of a low cost option kept many consumers out of the crucial Apple ecosystem. Another concern should be these consumers going to the Android operating system due to the lower cost that may never return to the iOS once snarled in that platform.

So besides the benefits of more consumers in the ecosystem and 'trapping' young and lower income consumers into the operating system, a couple of analysts actually think the demand will lead to higher gross margins and profits. Remember the old debate is whether selling 100 products at a $5 profit is better than selling 1,000 products at a $1 profit. That might be a drastic example that isn't practicable in this scenario, but the company getting the $1 profit ends up with double the money and 10x the customers.

Huge China Mobile Potential

The speculation surrounding the potential signing up of China Mobile as a customer hit highs after hours as news broke that Foxconn was told to add the world's largest carrier to the list to receive the iPhone 5c. The wireless provider is seen as the top target of Apple considering the company has an estimated 180 million 3G customers. According to a report by ISI analyst Brian Marshall, the 3G subscribers should jump to nearly 250 million by the end of next year. In essence, China Mobile would have a larger potential user base than AT&T (NYSE:T) and Verizon (NYSE:VZ) combined. The below table details the analysis by ISI:

Another key point is that China Mobile has over 750 million total subscribers providing a significant source of future customers. The great debate though has been that the company is requesting better pricing from Apple and the question remains whether that is what led to the development of a lower cost phone that could still generate solid profits or if it actually means that Apple is finally going to give in on margins in order to regain share in China.

Worth noting is that Apple saw a dramatic 14% decline in China revenue during the last quarter. In total, ISI sees the potential for over 5 million iPhones sold by China Mobile during Q413 and for the total to reach 12.5 million by Q414 or nearly 40 million total for calendar year 2014. Even if lower margins had to be swallowed, it could be worth it to capture that many users.

Gross Margins To Rise?

Back in June, Morgan Stanley went so far as to suggest that a low-cost iPhone could actually lead to higher margins. The basis of the theory by analyst Katy Huberty is that the margins on iPhones are higher than the margins on Apple's other products thereby producing a slightly higher gross margin. The higher gross margin combined with more revenue would generate a gross profit that could be significantly higher. See the table below:

Whether this research is accurate or not will depend on the details released on either September 10th or 11th. The investor needs to realize that while an estimated price of $399 will erode the average selling price of an iPhone, the lower costs of producing it will still allow for huge margins.

Stock Poised For Another Run

With the typical market theory of selling a stock based on the release of a major product, the average investor probably expects a selloff next week. This time around though, Apple has traded flat to down for the better part of a month heading into the product release. With the potential for huge gains from a China Mobile deal, the below chart doesn't suggest the stock is heading lower anytime soon:

Chart - 18 Months


Whether ISI is correct about the China demand or Morgan Stanley is correct about the gross margins increasing, the Apple story is not nearly as clear-cut as the Options Action crew or any other media outlet makes it out to be. The typical analyst or investor greatly mixes up the importance of average selling price, gross margin, and gross profit. While Apple is clearly heading towards a low-cost phone with a lower average selling price, the story on the gross margins and profits has not been told yet. As these analysts have pointed out, the possibility exists that Apple will surprise the market with higher margins and profits. If that is the case, the stock is heading back to the all-time highs.

Disclosure: I am long AAPL. 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.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.