Why Apple Won't Build A Cheap iPhone... And Why It Should

| About: Apple Inc. (AAPL)


A recent article by Benedict Evans pointed out that a “cheap” iPhone costing about $300 (unlocked) would address a large new market for Apple.

Apple hasn't priced its current low-cost iPhones (the 5c and 4s) at the $300 price point because doing so would reduce Apple's gross profit on these phones.

Despite this, Apple should field a ~$300 iPhone in order to increase market share and drive growth of the iOS ecosystem.

When the Apple (NASDAQ:AAPL) iPhone 5c came out last year, I was, like many, surprised at how expensive it was. It didn't seem to address the need for a low cost iPhone. Even today, the unlocked 16 GB version at $549 is only $100 less than the unlocked 16 GB 5s.

Unanswered Question

Last week, Benedict Evans shared some thoughts on the subject in his "Note On Cheap iPhones," which stimulated my own thinking on the subject. Evans presented some estimates of how many iPhones could be sold and the revenue and gross profit that would be generated at various price points. Depending on the exact price point, Evans concluded that a low-cost iPhone in the $200-300 range would increase iPhone revenue by about 15% and gross profit by about 7%.

At the end of the article, Evans leaves the reader wondering why Apple doesn't produce a $300 (unlocked) iPhone, so I thought I would pick up where he left off and try to answer this question.

Part of the answer is the one that Apple executives have stated so often, that they just want to build the best possible product. I don't minimize this as a motivation - an obsession with quality is very much a part of Apple's corporate DNA. Apple has tended to remain focused on designing a single flagship iPhone and only older models, or the 5c, which was based on the older iPhone 5, are sold as low-cost alternatives to the current flagship.

Concern with providing an outstanding user experience also keeps Apple from selling really inexpensive hardware that would run iOS sluggishly or be unable to support major iOS features such as Siri. All the iPhones Apple currently sells not only run iOS 7 well, but will be able to run iOS 8 when it arrives this Fall.

So the need to maintain compatibility with current and future iOS versions probably limits the range of hardware Apple can offer, and the iPhone 4s probably represents the lowest performing hardware that Apple would be willing to offer.

But this doesn't explain why the 5c and 4s are priced so high. The iPhone 5c is based on the 5, which was estimated by IHS/iSupply to have a manufacturing cost of $207. The best information on the gross margin of iPhone came from court documents filed by Apple in 2012 for its patent suit against Samsung (OTC:SSNLF). According to Reuters, iPhone gross margins were between 49% and 58%. Assuming an iPhone ASP of about $600 (the average ASP for the last 6 quarters was $594) means that Apple had a cost of sales of $240-300 per phone.

It's not clear what contributes to the higher cost of sales, but there's probably packaging and shipping costs, retail costs, and some cost of OS and app maintenance and support that may be part of it as well. Over time, manufacturing costs could come down, so let's assume that the lowest cost of sales for an Apple phone of acceptable quality is about $200.

Demand and Profitability

So Apple could sell a cheap iPhone for $250 with a 20% gross margin, right? Well, they could, but it would probably have the effect of lowering Apple's iPhone gross profits overall. This has nothing to do with cannibalization of sales of higher cost iPhones, which could make matters even worse. The lower profits that Apple would make selling a $250 iPhone 4s are based on the behavior of economic demand functions, which specify the demand in units sold vs. the price charged.

Evans provides some data points for a low-cost iPhone demand function in his article. It's not clear where he got the data, but it appears to be representative. Demand functions can take various forms. As can be seen in the chart below, Evans data is almost, but not quite, linear.

I also include a linear fit and a polynomial curve fit. The red line is a classic case where demand is exactly inversely proportional to price. The demand functions can be used to calculate how total gross profit varies with the price set for a product, given some constant cost of sales. In the chart below I plot the gross profit from a hypothetical cheap iPhone costing $200 to produce and sell.

As can be seen from the chart, none of the assumed demand curves suggests that cutting margin to the bone is the way to maximize profit. The increased unit sales don't compensate for the lower gross margin. The gross profit for the curve fit peaks at about $380, very close to the current unlocked selling price for the iPhone 4s of $450.

These calculations are meant to be illustrative of general principles, as I don't know what the exact demand function would be for a cheap iPhone. Probably the linear case and the inversely proportional case bracket the true demand curve. Evans' data appears to be a good approximation to the true demand curve by being an intermediate case.

My point here is that Apple's pricing of its current "low-cost" iPhones is based on maximizing the profit from those sales. Moving to lower price points would almost certainly result in lower overall gross profit on sales of the 5c and 4s, although unit volumes would be higher.

The Right Thing

In the past, I've argued that Apple should lower its margins on iPhone (and it's other products) as a way to spur sales and increase market share. This probably had some knowledgeable readers shaking their heads at my apparent naiveté. Didn't I realize that this would diminish Apple's tremendous profitability?

Actually, I did. I assumed that Apple would need to forego some profit in order to gain market share. In the long run, I believe that's the best way to accelerate the growth of the Apple ecosystem on which so many depend. Although it's very difficult to prove, I also believe that it's the best way to maximize profitability in the long run.

Maximizing profit is a near-term, somewhat myopic approach to management, but one sees it time and again. Much of it is driven by stock based compensation, which incentivizes managers to take the short-term view. When Apple's margins declined last year, the stock was severely punished.

It's very difficult for any company management to swim against the current of market opinion, but Cook has shown a willingness to do so. At Apple's annual shareholder meeting in February, Cook was widely reported as saying "If you want me to do things only for ROI reasons, you should get out of this stock."

Cook was saying that doing what's right is more important than profit. I agree, and if one truly believes that iOS is a superior operating system (and I do), then isn't putting it in the hands of as many people as possible the right thing to do?

Ironically, lower margins, if accompanied by significantly higher market share, would be more beneficial for Apple's share price than any capital return program, since it would convince investors that Apple is a growth company again.

Although much attention will be given to Apple's newest iPhone 6 flagships when they debut in September, a more important indicator for investors will be what Apple decides to do at the lower price points. Probably the 4s will be retired, and the 5s will become the new lower cost iPhone. Or perhaps Apple will put the guts of the 5s into a new 5c.

However Apple approaches the low cost iPhone, Apple badly needs a $300 (unlocked) iPhone. Evans is right that a $300 iPhone would address a significant new market for Apple. It just won't increase profits.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.