iPhone SE, Not iPhone 7, Is The Key To Apple's Future

| About: Apple Inc. (AAPL)

Summary

The iPhone SE is Apple's acknowledgement that it now faces a real problem in its most important product line.

The iPhone 6 was a decision by Apple to emphasize screen size over battery life. The iPhone SE goes in precisely the opposite direction.

Apple has made other changes long sought by customers. The iPhone SE is basically the antithesis of the iPhone 6 line. If neither can restore sales, sales will inevitably decline.

The extent of these changes means that even if iPhone SE works, Apple may have a hard time determining why and which features were most important.

Nevertheless, a successful iPhone SE will offer Apple important guidance about what changes to make in its iPhone 7 line this fall to restore iPhone growth.

Introduction

As the iPhone SE enters its second week of trial by fire on the market, reports are mixed as to whether it's performing above or below expectations. That game, long beloved of Apple (NASDAQ:AAPL) fans, is particularly difficult to play in this case since not only do we not know sales figures, which is par for the course - when it comes to the SE, we don't even really know what expectations were at Cupertino since it is the first iPhone produced outside its normal upgrade cycle and the first iPhone to produce a smaller screen than its predecessor. It's a game some may be quitting anyway, or at least sitting out for a round. One of the major themes of SE media coverage has been the argument advanced by many that it doesn't really matter how it performs since it's a budget product. Apple's real test, the argument goes, will be to create a true "wow" product in September.

I cannot offer any new clarity about sales performance, but I can say that this last is completely wrong. The fact that iPhone SE is so different from other iPhones is precisely why it's so important.

Cruise Control

One of the many famous quotes of Steve Jobs was "people don't know what they want until you show it to them." That has been Apple's guiding creed for almost every product it's built since Jobs returned to the CEO chair, and it still lives on after his death. And mostly, the company has actually made it work pretty well, considering it's basically a license to ignore the customers who keep it in business.

Lately, though, the company has perhaps been bumping up against the limits of this approach. Apple Watch has not proven to be the next big thing, Apple TV is still a work in progress, and iPad sales are down almost 40%. With the iPod more or less a part of history now, Apple relies more than ever on one product to drive growth and maintain its dividend: iPhone.

The iPhone has long been the workhorse of Apple, accounting for 66% of total revenue. And because it has been such a reliable profit machine, it has essentially been on autopilot for years. This is not a shot at CEO Tim Cook, whom so many seem to love to belittle as being "not Steve Jobs." In my opinion, Cook has done an admirable job trying to fill some almost impossibly big shoes after his old boss died. The iPhone was on autopilot long before Jobs died. Ever since the iPhone 3GS was announced in 2009, the schedule has been the same: internals are upgraded every year, hardware and design are upgraded every two years. Pricing dates back even further. The base model price always is $649, and it's always knocked down by $450 if you buy on a two-year contract. Older models are available for $99 or even free, but their older internals mean they are hardly bargains. Every model must be more thin than the previous one, and screen size only ever goes one direction: up.

Unfortunately, lately the iPhone has hit some roadblocks as well, though fortunately nothing like the iPad. Still, growth in unit sales did come to almost a complete halt last quarter (up less than 0.5% YoY) and projections are for the first ever YoY decline since the product was launched in the current quarter.

Go Big Or Go Long?

It isn't that Apple hasn't been making advancements. It's that the advancements it makes always seem to come in the same areas, with little apparent fresh thinking about where improvements should focus. The iPhone's camera, screen size, graphics power and computing power are all light years ahead of the original model. Meanwhile base storage has only been upgraded once (from 8GB to 16GB) and battery life has scarcely moved at all. In fact some reports have current battery life actually down from the original iPhone 2G that Jobs launched in 2007.

There were warning signs that a course correction might be needed. But they were not in the sorts of places Apple usually paid attention to. In 2014, as Apple designers were hard at work preparing what would become the iPhone 6 and 6 Plus, multiple surveys of iPhone customers all showed the same thing. The good news: iPhone customer satisfaction was top of the charts, as usual. But every phone has some weakness, and hands down, the biggest complaint of iPhone users was that the battery still couldn't hold up under a full day's full use. Longer battery life and bigger screens were the two most desired improvements for the next design. But battery life was outpacing screen size by better than 2:1.

Of course, as we all know Apple made the decision to expand the screens of both models while battery life was still middling. Radios get more efficient with time, like most technology, so 3G time actually rose to match LTE time. But the latter did not improve at all and neither did standby time. Video playback, perhaps a better measure of Apple's own battery life improvements since it is entirely an internal process, rose 10%. This is in a phone where CPU rose 25% and graphics rose 50%, and the screen got a lot bigger.

The most puzzling thing was that when Phil Schiller, Apple's marketing chief and regular iPhone dazzler at events, described the engineering of the phone's new A8 chip, he declared it had become 50% more energy efficient over the previous model. The reason the improvements were so much smaller than that was that like every iPhone, the 6 had also been made thinner. Had it even just kept the thickness of the 5S, battery life could have been much greater, but thinness has been an obsession at Apple for a while, and it was not prepared to sacrifice it just to give customers what they only thought they wanted.

At first it seemed to work, as usual, as everyone who had only bought one of Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) Android smartphones only because iPhone's screen was too small stampeded onto the platform. But underneath this flood of defectors was a worrying trend, as upgrades from existing customers slowed and a maturing market meant fewer people were shopping for their first smartphone. In Apple's last earnings call in January, Cook made a somewhat worrying admission: even now, 60% of the iPhone customers who already had an iPhone when the new iPhone 6 came out have still not upgraded. With two full holiday seasons having passed since then, it is now clear a large portion of Apple's customers do not want what the "6" platform is offering.

In response, Apple has decided to shake things up.

Break With The Past

In many ways, the iPhone SE is Apple's first "customer-designed" iPhone. Obviously I don't mean that literally, but the contrast between the way Tim Cook and Greg Joswiak introduced iPhone SE and the way Steve Jobs and even previous Tim Cook intros have gone was remarkable. Jobs would often discuss why Apple's own decisions were better than its competitors and take customers step by step through why they should want what Apple had already decided to offer. Cook generally stuck to that model. But last week Greg Joswiak, in the first iPhone introduction since Jobs' death not led by Schiller, started off by telling the crowd that customers had "asked us, some even pleaded with us, to please keep the four-inch products in our lineup." When Joswiak was done, Cook came back up to reiterate that "many, many customers have asked for this." Apple is apparently a little less confident these days that it knows what the customer wants better than it does.

The break with the past went well beyond the rhetorical. For the first time, Apple will launch a non-flagship product with flagship-level internals. Joswiak made a point of emphasis that the new SE has the same graphics and computing power as the 6S, and the camera also is 6S level. Apple Pay is included as well. Aside from a slightly older Touch sensor, the SE basically is the 6S, just in a smaller shell.

These changes also all point to one other big change. By taking a thicker body with a smaller screen like the 5S model and pairing it with power-sipping internals that were made for the 6S, Apple has produced a device with a substantial leap in battery life.

And perhaps the most surprising thing was price. After charging $550 for a plastic iPhone with old chips just two years ago, Apple cut the price of an aluminum iPhone with cutting-edge internals to just $400.

See What Sticks

Apple's decision to break with precedent in so many ways is both alarming and reassuring. It is reassuring because Apple is clearly not in denial about the problem. With iPhone sales flattening and customers avoiding its newest products, the company is open to considering even ideas that were previously anathema at Cupertino, like cutting prices and upgrading older models that might compete with newer products.

What is alarming, however, is that Apple seems to be admitting that it is also a little stumped. A lot of outside experts are throwing different theories out about why iPhone sales are declining. They cost too much. No, they are too big. No, they focus on the wrong things and ignore what customers really care about, like battery life. No, the decline is all a mirage and everything's fine. Apple's behavior would seem to indicate it doesn't believe that last one, but it can't seem to pick between the others. The one other explanation, that Apple doesn't want to believe, is that the end of the two-year upgrade cycle in the American market has permanently lengthened replacement cycles and sales are never going back to where they were. Apple can only hope that isn't true.

So it's decided to take every common complaint about Apple's iPhones and address them all at once in one model. It is a little hard not to contrast this new, semi-panicked reaction with the confidence with which Steve Jobs would tell customers what they wanted, and the near-magical aura that came to surround him and his company when he turned out to be right almost every time.

A First Step

The bad news of this "fire everything" approach is that even if it works, Apple will still not know why it worked. If iPhone SE sales do come in strong, were they strong because of the form factor, the price cut, or the internal upgrades? All three? Two of the three? Which two? Would a $550 iPhone SE have done just as well, or close enough to make it more profitable? How about a slightly thicker $400 iPhone 5S, without the internal upgrades but with the battery life?

On the other hand, if Apple offers lower prices on a better product in the size that customers want, and they still won't buy like they were two years ago, then AAPL will take two conclusions away from that. One, Jobs was right: listening to customers is pointless. Two, and more relevant to Apple investors, there will no longer be any getting around it: its profit engine has stalled, replacement cycles are lengthening, and iPhone sales are probably going to continue to decline.

That, however, is the worst-case scenario. Ideally, the iPhone SE would rev sales up. That would confirm that demand for iPhone remains strong as ever and there is still some growth left in the platform. Of course, it would also mean that there was something about the iPhone 6 that was turning off customers, which would be embarrassing for the company that prides itself on making devices customers love. But at least it would know it, and still have enough time left to incorporate some of SE's lessons into the upcoming iPhone 7 design.

Conclusion

The iPhone SE is critically important to Apple, precisely because it is everything the iPhone 6 is not. It's as close to two opposite approaches as you are likely to find under a single company's roof. With over half of the customer base shunning the iPhone 6 upgrade cycle, if the iPhone SE also can't turn sales around, then probably nothing will. I for one will be watching results closely in the coming months to measure how much further this iPhone money machine has left to run.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.