iPhone SE Is Apple's $30 Billion Bet On 4-Inch Screens

| About: Apple Inc. (AAPL)

Instead of representing a seismic shift in iPhone strategy, the iPhone SE is a byproduct of Apple's (NASDAQ:AAPL) current screen size differentiation strategy. Apple has given the iPhone SE a very specific mission: succeed the iPhone 5s and entice a portion of the 240 million iPhone users still using a small screen iPhone to upgrade to newer hardware. Apple is placing a $30 billion bet that a 4-inch iPhone with a four-year old design, updated with newer components, will help accelerate the iPhone upgrade cycle. The iPhone SE is a "special" opportunistic bet set within Apple's existing strategy to expand the iPhone line.

Background

The best way to understand why Apple introduced the iPhone SE is to look at the iPhone business over the past few years. In September 2014, the iPhone 6 and 6 Plus not only kicked off Apple's entry into multiple screen size iPhone development (4.7-inch and 5.5-inch screens), but also began a global sales bonanza as pent-up demand for larger iPhones, combined with the iPhone rollout at China Mobile (NYSE:CHL), resulted in strong 37% year-over-year growth in iPhone sales for FY2015.

However, in recent months, a few negative developments began to appear in the iPhone business. While Apple was still bringing new customers into the iOS ecosystem at a steady clip, the rate at which existing iPhone users were upgrading to newer iPhones was beginning to slow. Specifically, 3.5-inch and 4-inch iPhone users were showing hesitation toward getting larger screens. While the reasons for this hesitation vary with some preferring smaller screens and others simply being content with their current small iPhone, Apple had a growing dilemma on its hands: how to get these users to upgrade to newer iPhones. The motivation isn't just found with hardware profits, but also with services revenue since roughly 40% of the iPhone user base is using an iPhone that does not support Apple Pay in retail stores.

To make matters worse, Apple stopped selling its low-cost iPhone 5c (an OK seller) this past September, which meant the iPhone 5s was Apple's last remaining 4-inch screen iPhone. With the device getting long in the tooth and its third anniversary quickly approaching, Apple would need to make tough choices regarding not just the iPhone 5s, but also its broader 4-inch screen strategy. It was time for Apple to place a few bets.

The Keynote

Apple VP Greg Joswiak had one objective when announcing the iPhone SE: explain to the press why Apple is selling a new 4-inch iPhone when the trend had been toward larger screen iPhones. Obviously, he couldn't say that Apple needed a way to get existing 3.5-inch and 4-inch iPhone users to upgrade, so instead he framed the narrative that small screens were still popular among iPhone users in addition to serving as an iOS entry point for new users. Specifically, Joswiak pointed out that 13 percent of iPhones sold in 2015 (more than 30 million units) were 4-inch iPhones. Since Apple sells more than 200 million iPhones per year, even a small sales percentage like 10-15 percent is a significant number of iPhones.

After saying that people (current iPhone users) asked and pleaded with Apple to keep a small 4-inch iPhone in the lineup, Joswiak spent the rest of his time on stage explaining that Apple was going to do just that. Instead of facing the prospect of the 4-inch iPhone form factor possibly becoming extinct in a few months, Apple would take an iPhone 5s and future proof it by adding some of the latest technology to the same "beloved aluminum design" familiar to hundreds of millions of customers.

Slide after slide, Joswiak ran with the message that the iPhone SE was better than the iPhone 5s. Specifically, Joswiak focused on the features that would matter most to existing iPhone 5s users thinking of upgrading, discussing how the SE was faster than the 5s, had better battery life, included better cameras, and of course, supported Apple Pay.

The message couldn't be clearer. Apple is positioning the iPhone SE as a "special edition" model targeting the 240 million existing iPhone users still on smaller screens. If the SE ends up also appealing to feature phone users or Android users in emerging markets, then the model will have done even better than expected, but this is not Apple's primary target.

Within just five minutes, Joswiak was able to explain the iPhone SE. The presentation's brevity was due to the device being an iPhone 5s with some 6s internals. The iPhone SE isn't quite an iPhone 6s in smaller form factor as it contains the same screen and home button as the 5s resulting in no 3D Touch or second-generation Touch ID. Meanwhile, the front-facing camera is the same one included in the iPhone 6 and 6 Plus. Instead, Apple picked a component set that would not only appeal to existing iPhone users, but also be able to last for an extended period of time in an iPhone line that would see updated components in six months with new flagship iPhones.

Price

From Apple's perspective, having 30 million people buy a 4-inch iPhone in 2015 suggested that smaller iPhones still had a future. However, a key question remained. How much of this small iPhone demand was due to the iPhone 5s (and 5c) having a small screen or low price? During the first nine months of 2015, Apple sold the iPhone 5c for $450 while the iPhone 5s went for $549, followed by a $101 price reduction this past September. The fact that a greater percentage of smaller rather than larger iPhone sales went to first-time iPhone users didn't do much to answer the fundamental question concerning screen size versus low price.

Apple was very deliberate in choosing the iPhone SE's $399 price. The device is not priced as a cheap iPhone 6s, but as an iPhone 5s successor. This means that in a world where a year-old 4.7-inch iPhone retails for $549, a 4-inch iPhone with a four-year old design needs to be priced aggressively to appeal to existing small iPhone owners.

Pricing a new iPhone at $399 is a significant change for Apple because for the first time, a consumer could own the latest iPhone technology at a 40% discount from the traditional $649. However, instead of this change being a transformational shift in Apple pricing strategy, the move is actually based on Apple's screen size differentiation strategy kicked off in 2014 with the iPhone Plus. Apple has been positioning screen size as a way to determine an iPhone's price. The iPhone SE is the first 4-inch model to go through this differentiation strategy. As seen in Exhibit 1, the iPhone SE is positioned within the iPhone line as Apple's less expensive 4-inch iPhone 5s successor. Come September, the iPhone SE will have year-old technology and be in line with year-old $549 4.7-inch and $649 5.5-inch models.

Exhibit 1: The iPhone SE's Place Within the iPhone Line (September 2016)

Similar to how an iPhone Plus is priced at a premium to the flagship 4.7-inch model, a 4-inch model would be priced at a discount to the flagship iPhone model. The iPhone SE's borrowed iPhone 5s design allowed Apple to hit this $399 price without destroying profit margins. In addition, the iPhone SE is still priced at a premium internationally, similar to other iPhone models, suggesting Apple is not looking at the iPhone SE as its "cheap iPhone" emerging markets Trojan Horse. Instead, the iPhone SE is a special edition 4-inch model geared toward existing iPhone users that crave small iPhones.

The $30 Billion Bet

Apple is making a significant bet with the iPhone SE as billions of dollars in revenue are put at stake by discontinuing the iPhone 5s and positioning the iPhone SE as its only small iPhone.

Over the next two years, Apple thinks it will be able to use an updated iPhone 5s to entice a certain percentage of the 240 million iPhone users still using small iPhones to upgrade. From a sales perspective, if the iPhone SE can continue to grab the same sales share as the iPhone 5c and 5s in 2015, then the device will bring in $7 billion of revenue in FY2016 (two quarters remain), as shown in Exhibit 2.

However, with the iPhone SE displaying qualities characteristic of a model that will stay around in the lineup for a while, Apple's bet could escalate to $30 billion of revenue over the span of the next two years. Of course, it is conceivable that at $399, the iPhone SE will sell even better than Apple expects and represent as much as 25% of iPhone sales, which would contribute nearly $40 billion of revenue to Apple's top line over the next two years. On top of it all, much of this revenue would be related to iPhone sales that may not have occurred if it wasn't for a new 4-inch model.

Exhibit 2: Potential iPhone SE Unit Sales and Revenue (FY2016 and FY2017)

If the iPhone SE sells well at $399, then Apple will gain confidence with future 4-inch screen pricing strategy, especially for a completely new 4-inch screen iPhone (likely priced at $499). This pricing strategy would largely be based off of Apple's ongoing screen size differentiation strategy in which larger iPhones are sold for more while smaller iPhones are sold for less.

A poor performing iPhone SE at $399 will provide even greater insight to Apple. If the iPhone SE doesn't sell well, then Apple knows consumers likely prefer a completely revised iPhone and not just an older iPhone with newer components. The fact that 240 million are still using small iPhones despite being able to upgrade to newer, larger models suggests there is some level of demand for a small iPhone, even if it represents only 10%-15% of the iPhone user base (translates to an eventual 50 to 100 million users).

Apple's iPhone Strategy

Apple employs a business strategy of selling a select number of iPhone models at significant volumes and premium prices in order to maximize profit. Beginning at the high-end, Apple squeezes as much profit out of the smartphone market as possible, gradually working down market, grabbing whatever profit is available at each subsequently lower price tier. The end result is that Apple holds 90 percent smartphone profit share but 15 percent sales share.

Historically, $649 was the lowest price at which Apple was willing to sell the latest iPhone technology. Meanwhile, older iPhone models with dated technology were offered at $450 and $549. However, these prices were for an iPhone line that lacked screen size diversification. As the iPhone line matures and Apple embraces multiple screen sizes, larger iPhones are priced at a premium while Apple is pricing newer, smaller iPhones at a discount. This dynamic is now taking place with the iPhone SE.

Heading into last week's keynote, expectations were for the iPhone SE to be priced at $399 or $449, so its $399 price is not so much a shock, but rather a sign that Apple is confident it can manufacture the device quite efficiently. Given its four-year old "beloved" design and the fact that all of its components are already being produced at scale and will be included in nearly 200 million iPhone 6s and 6s Plus units sold in FY16, Apple is able to sell the iPhone SE at $399 and still retain respectable profit margins.

Apple is essentially utilizing screen size differentiation as the next step in its long-standing iPhone strategy of maximizing profit by moving downmarket. At $399, Apple would be pushing consumers in the $199-$299 price range to move up and purchase the iPhone SE. This moving up process results in value creation within the smartphone market as consumers are willing to spend more on an iPhone - a byproduct of Apple's existing strategy.

While the iPhone SE is fundamentally different than the iPhone 5c, both devices share a few characteristics. Instead of each representing a fundamental shift in iPhone strategy, the 5c and SE are targeted Apple bets aimed at addressing friction points within the iPhone business. The iPhone 5c served as a way to sell iPhone 5 technology in a less expensive shell and also differentiate the more expensive iPhone 5s. With the iPhone SE, Apple is answering the dilemma posed with aging iPhone 5s and iPhone users still showing interest in a 4-inch screen. There is no question that the iPhone SE is a different kind of iPhone, but being different does not automatically suggest a fundamental shift in strategy.

The iPhone SE's Future

It's too early to determine the iPhone SE's future. Since the "special edition" nomenclature denotes the device's goal of bringing in iPhone upgraders, the iPhone SE's popularity may ultimately play a factor in how long Apple keeps the SE on the market and at what price. It would seem likely that the iPhone SE will continue to be sold beyond September when Apple introduces new iPhones. There is no indication that Apple will begin selling another 4-inch iPhone at that time. This would serve as another piece of evidence that the iPhone SE is not a shift in iPhone strategy, but rather a targeted bet. If Apple continues to sell the iPhone SE well into 2017, it is not unfathomable that we would eventually see a $50 or $100 price drop as the device would then be based on a five-year-old design and year-and-a-half old technology.

Given the iPhone's increased role in people's lives, there will likely be demand for iPhones with a compact design meant to be used differently than larger iPhones. The iPhone SE is essentially Apple's first step with smaller screens set within its screen size differentiation strategy. Eventually, this strategy will create a space for Apple to introduce new smaller iPhones alongside larger siblings. These smaller iPhones would then retain the iPhone SE's low price relative to larger models.