Why Apple Needs A Cheaper iPhone

| About: Apple Inc. (AAPL)
This article is now exclusive for PRO subscribers.

On January 6, I wrote an article saying that Apple (NASDAQ:AAPL) needs to offer two additional lower priced iPhones (please consider: Apple Needs Product Diversification). Much to my surprise, several days later news broke out that Apple was indeed planning to make a cheaper iPhone. I don't think Apple was reading my mind or something and the timing of my article was pure luck, however, the idea has been on my mind for some time now.

Today I want to expand a little on that idea and explain why it's vital for Apple to offer lower priced phones and why it might make a big difference in the expansion of its ecosystem.

Margins will not shrink by much

Many investors fear that Apple's margins will shrink. Yes, Apple's margins will be compressed, but not by much. Let's say that Apple produces and sells 100 million phones at $120 a phone wholesale. That will add about $12 billion to total revenue. However, please note that $12 billion is less then 10% of Apple's current total revenue. So while margins will be compressed, total margin compression will be less than most people fear.

It's about profits, not margins

Companies are valued based on total profits not margins or after-tax profits as a percent of sales. Like I said in my previous article, if Apple can make a few billion more selling a lower-cost line of phones, why should it turn down the opportunity?

It's about world-wide market share

Yes, Apple can continue to sell only its top line iPhone 5, but it will lose out on the opportunity to be a true world player. Yes, Apple has sold several million iPhones in developing markets and can probably sell several million more. But there are hundreds of millions of users around the world that Apple will never be able to sell to, unless it offers a lower priced phone. And if Apple doesn't sell to them, then maybe Samsung (OTC:SSNLF) or Nokia (NYSE:NOK) will. Why would Apple want to miss out on gaining world market share?

It's about China

As of Q3 2012, Apple is not even in the top five smartphone selling brands in China. Local manufactures selling Android phones under $100 have taken over. Samsung, however, maintained its spot as China's leading smartphone vendor with a 14% share in shipments, while Chinese PC maker Lenovo trailed behind at second place with a 13 percent share. There is only one way for Apple to entrench itself in China, and that is via a low cost handset device.

Apple's CEO Tim Cook knows all too well just how important China is. He is currently on tour in China and his presence has sparked more buzz than Richard Nixon's China tour many years ago. Cook recently confirmed that the iPad mini is coming to China in late January.

He also said that eventually China will be Apple's biggest market. In fact, China and the greater China region of Hong Kong and Taiwan is currently Apple's second-largest market, accounting for 15% of revenue last year. I see no reason why Apple can not increase that by a lot.

China Mobile (NYSE:CHL) has 700 million subscribers. A budget iPhone will defiantly take market share from the Android space. Why would Apple want to walk away from such an opportunity? In fact, Apple Is not shying away from China Mobile at all. China Mobile has hinted that it is working with Apple to deliver a lower-cost iPhone that will be compatible with its network.

It's about the ecosystem

While the term ecosystem is irrelevant in the phone market, that is not the case with Apple. Apple has always had an ecosystem, but it was miniscule. But with the arrival of the iPhone and the iPad, that has changed. Remember, Apple doesn't only sell phones, but computers also. Today, Apple computer sales are on the rise. Not only because Apple makes better computers than anyone else (they always did), but because of the influence of the iPhone and the iPad on computer buyers. And the iMac is probably one of the best selling desktop computers on the market right now.

As proof, while PC shipments in Q4 2012 were 4.5% lower according to IDC, Apple PC shipments fell by only 0.2%. And that's only because the company had supply issues and was not able to sell enough iMacs. But IDC admits that these figures don't include Apple's international sales, which are rising faster than U.S sales. However, according to Gartner, U.S. Mac shipments didn't shrink at all but grew by 5%. Both however admit that international sales are growing faster than U.S. domestic shipments. And the reason for this (I say) is that people have been introduced to the Apple ecosystem via their iPhones and then purchased a desktop Mac also.

If Apple wants to keep this momentum alive, it has to introduce to consumers around the world to the Apple ecosystem -- via a cheaper iPhone -- and then sell them computers also.

Phones are sometimes paid for in cash

The iPhone as well as many other high-end phones sell very well in the U.S. because of carrier subsidies. However, in many other parts of the world people pay for phones in cash. Many people -- even in Europe -- don't want to get tied down with long term contracts. As such, Apple would be able to sell several hundred million more phones to this segment of consumers that simply cannot, or will not, lay out a huge lump sum to buy an iPhone 5. I think this includes many consumers in the U.S. also.

It's about the threat of Samsung

Samsung is turning out to be a threat for Apple in more ways than one. For starters, Samsung is now the biggest smartphone maker in the world. Many analysts are turning bearish on Apple, voicing concerns that iPhone sales have been weak as a result of the pressure Samsung is putting on Apple.

In a funny way, Apple is helping and abiding its own doom by being Samsung's largest customer. Apple needs to do something about this threat here and now. And the threat includes Google (NASDAQ:GOOG) as well. By going after Samsung, Apple will be striking two birds with one stone. And the only way to do this is with a lower priced phone.

Bottom line

In the long run, market-share is more important than short term profit margins. Also, the ecosystem is about selling different products to the same customer. There are limits to how many people can afford Apple's high-end gear. And we have probably reached those limits as of this moment.

If Apple wants to move on and if management wants to see its stock go to $1,000 per share, then it has to think of ways to expand its global market share. The only way to do this is to offer lower-cost smartphone alternatives (and probably computers also), to a wider spectrum of the world that does not have the purchasing power to buy Apple's high-end gear.

If not, then Apple's stock will become what I have said since my initial coverage (please consider: Apple: Take The Money And Run), a dog stock that will be good for swing trading, but not for long term investment.

To the extent that Apple initiates such a strategy, I will change my stance on the company and become quite bullish on the stock. For now I voice my support for such a strategy and I am waiting to see how it unfolds.

Disclosure: I 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.