Is Apple's iPhone 5C/5S Strategy All Wrong?

| About: Apple Inc. (AAPL)

In recent days, several Seeking Alpha authors and sell-side analysts ("analysts" for both from this point on) blasted Apple's (NASDAQ:AAPL) decision to not set the unsubsidized price of the iPhone 5C at a lower price-point. The price, ~$735 in China, did not seem to fulfill the analysts' models and forecasts and therefore to them, Apple's complex strategy appears fundamentally wrong. The question I will address below is as follows: What was Apple thinking setting such a price point for the 5C, and are these analysts right?

Here's why the analysts are concerned. Their bottom-up models assume they are correctly projecting the ramp-up of future demand at various price inflections. By using product and geographic segmentation, the analysts project the average price of the product sold in any given quarter and multiply their average price estimates by the projected volume to get their revenue estimates over certain future periods. The fear is that an expensive iPhone 5C in a huge geographic market like China will forego much of that expected volume in a heavily contested market during those next few periods.

Others don't even bother doing any analysis. They simply use the now popular argument that goes something like this: Apple is losing the operating system battle and therefore Apple is losing the smartphone war!

First, are these analysts right about China?

I will start by saying that Apple does not need to duke it out with the discount smartphone makers just like Mercedes does not need to create a competitive strategy to fend off Hyundai (OTC:HYMLF). Yes, Hyundai will likely take an extremely marginal market share from Mercedes with its top end models, but not enough for the German luxury automaker to lose tens of thousands of dollars per vehicle in order to price lower and compete head on with the Korean automakers.

What many of the analysts fail to understand is the demographic structures of different segments, especially the Chinese market, and how brand perception plays into Apple's and the population's decision-making.

First of all, the Chinese market is extremely fragmented and with 1.15 billion subscribers (out of a 1.35 billion population), the Chinese market is also quite enormous. According to mobile research, only about 22% of those subscribers were on 3G/4G networks by April 2013. That means that the Chinese smartphone market is still in its early stages of development and there is room in that market for many players and in different product tiers (I will define them as low-end, middle-range, and premium tiers).

When Apple launched two phones with different price points, its strategic decisions were focused on the following four major themes, in my opinion:

1. Brand preservation

2. Margins

3. Cannibalization

4. Competition

Brand Preservation

During its launch of the iPhone 5C/5S, Apple, as the number one global brand according to Forbes magazine, had to be extremely careful not to damage its premium brand. The damage could have come through a creation of a price point for the 5C that would have been on the extreme opposite end of its traditional premium iPhone price point, or on the lower-end of the smartphone market. It made a strategic decision to avoid that. In other words, it does not want to compete on price with the discount phone makers, just like Coca-Cola (NYSE:KO) does not want to compete on price with cola-drink made by your local grocer. Sure, cola-drink might almost have the same taste, but that has not put Coke out of business just yet. There are plenty of BMWs still parked outside my house alongside many Toyotas (NYSE:TM). And of course, even if cheap China-made Nike (NYSE:NKE) knockoffs look identical to the real Nikes, that will not stop the mainstream from buying authentic Nike products. These top-brand companies spend billions of dollars protecting and growing their premium brands for which they charge a premium, and the brand appeal plays a critical role in the purchasing decisions of emerging market consumers.

Of course, my frustration multiplies when authors compare Apple to Blackberry (NASDAQ:BBRY), Nokia (NYSE:NOK), and even Huawei. No, these companies never had the same level of brand appeal as the number one global premium brand Apple, and they were always in entirely different tiers of the smartphone market. Additionally, as I've mentioned in previous articles, Apple's ecosystem is still much preferred to the Android, even by Samsung's own executives. And although some believe that Google's (NASDAQ:GOOG) Android ecosystem is quite robust, Chinese consumers, of course, do not get the same Android ecosystem as Americans, so the decision to turn to Apple becomes just a little bit easier. As the Economist explains, "the Chinese government requires handsets to run a neutered version of the Android operating system, without Google's app store, mail service, maps, and other features."

In terms of the 5S and the 5C offerings, my view is that the correct way to consider the twin iPhones would be to see the 5S as a premium phone and the 5C as a middle-range phone that directly competes with Samsung's (OTC:SSNLF) top phones at the moment (the Galaxy S4, for example).

Margins

A more obvious reason why Apple created a higher-than-expected 5C price point is to preserve its profit margins. So for analysts to simply lower volume estimates and the price-target and call it a day, as many sell-side analysts seemed to have done, is extremely irresponsible and thoughtless in my opinion. Surely, they have given consideration to China's extremely dynamic and evolving smartphone market. Just adjusting volume down given a certain higher-than-expected price point is quite useless. Surely they understand that the China smartphone market is still developing and Apple is still commanding the premium end of the China market, and by now injecting the 5C into the middle-range market they're competing in a different range head on. Surely they understand that several strategic China Mobile (NYSE:CHL) decisions could transform the Apple volume in entirely different ways. Those premium prices would then contribute to extremely fruitful operating margins that would be entirely foregone with a lower-priced 5C. Of course, rational analysts should also adjust for risks, in case these forecasts don't bear fruit, but to just make assumptions on average price and linear-growth is absolutely the wrong way to look at the China market. It's exactly why many Apple analysts have consistently gotten Apple's price target wrong.

Cannibalization

Sure, if I am a millionaire living in China, the decision between buying a higher-priced 5S and a plastic 5C is simple. I will go with the 5S. But if I am a middle-class citizen living in China, as many of the Chinese are, deciding between the two phones becomes slightly more challenging with a price range that is strategically supported by Apple. Now imagine if Apple priced the 5C at lower margins in the $300-$500s as some of the analysts wanted. That would have priced its phones in the range of many discount low-end and middle range phones in China. Yes, that middle class citizen now has a slightly less difficult decision to make. He or she will surely take the 5C, because it's the same premium brand at give-away prices, but then Apple is leaving a lot of money on the table.

While it's true that a lower-priced phone would have produced a higher top-line number in the near term, it would not have been the best longer-term strategy for Apple. Here is why. Lowering the price and margins would cater to a much larger portion of the Chinese population from an affordability perspective, but injecting a low-priced phone without much precision and consideration for Apple's margins would have destroyed the premium brand appeal Apple has worked so hard to create. In the longer term, Apple would not have been able to hang on to its premium pricing strategy for the 5S and margin erosion would have been more severe over time. So while a lower priced phone would have been great if Tim Cook was in the business of making sell-side analysts happy with aggressive revenue pricing in the near term, it would have been a terrible strategic longer-term decision for Apple and its long-term investors.

Competition

"But Apple is losing to competitors," some say. No, it is not. At least not in its "premium" smartphone range. Sure, Samsung, which operates in the middle-range tier, grew its total smartphone market share with its successful Galaxy S3 distribution, but the company does not appear to have had the same level of success with its Galaxy S4 phone and that spells trouble for the middle-range phone maker. It's also excellent news for Apple, a company that could easily reach into Samsung's market share with its 5C middle-range offering.

Now about that operating system argument. Many authors like to use the argument that says the following: Because Android commands 80% of the world's operating systems, that means that Apple is losing the smartphone battle. This, of course, is an extremely warped and incorrect argument and anyone trying to make a decision about Apple should surely steer clear of it. Here's why.

Let me present my view with an example (and this is only an example, not actual) using 7 phone makers that started off using their own operating systems.

Click to enlarge

After a certain point, Apple continued using its own operating system while the six others converted to Android over time. During the first year, Apple dominated with a 45% OS market share. After year 2, however, it appears as if Apple is quickly losing market share, but in reality, its hardware shipment growth actually appears extremely healthy at +20%. Notice Phone maker E, which actually had heavy (+42%) shipment growth in year 2, looks like it's getting beaten up because of this warped Android OS market share view. I would love to buy a stock of a company that is increasing demand in its product by +42%, but the "Android is winning market share" people would tell you to steer clear of that stock using their argument.

This has now become a popular argument among pundits and Apple haters - but it's obviously a view that has very little to do with a smartphone maker's top line, bottom line, or its profitability. It's just a very easy and silly way to attack Apple that actually means nothing for its sales or profits. The fact that Apple still dominates with more than half of all smartphone profits does not mean much to these pundits and authors, even though this is the statistic that is actually relevant to Apple's stock price.

Conclusion

At the end of the day, Apple is here to stay and with its piles of cash, cheap debt, proven products+additional products in its pipeline and healthy dividends, it is priced attractively at this point. Apple's smartphone strategy is one of the most robust and impressive strategies I have ever seen. Sure, its stock price has been volatile, but that has more to do with the analysts' and pundits' volatile projections than with Apple's actual business model.

I've mentioned in a previous article that I truly do believe that this is only the beginning. Apple could use its ecosystem to transform the way we do so many things.

That also means that as the smartphone market begins to plateau, Apple will roll out new products to create additional growth for its ecosystem. That view is well supported by Tim Cook's discussions with analysts.

Because Apple controls its iOS and its hardware, one way in which Apple could roll out additional products is to strategically attack Google's Android relationship with Samsung in such a way that a copycat product would be impossible to produce. That's a topic for next time, but if anyone has any such ideas, I would be happy to hear them in the comments below.

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: This article represents my views only and not the views of any company that I am affiliated with. This article is intended for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation, or endorsement to buy or sell any security or private fund.