Apple: Possible iPhone Scenarios and Stock Price Implications

| About: Apple Inc. (AAPL)
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This will be the first of a series of articles over the next two months examining what could possibly be the most important year for Apple (NASDAQ:AAPL) in its recent history. I'm going to review industry trends, outline Apple's public response to these trends, and then make informed guess (or at least give plausible options) as to Apple's plans. I'll start with phones, then move on to tablets, Macs, and cloud services. Why is this year important for phones?

1. We are in the middle of a huge shift from 'feature' to 'smart' phones. Apple accelerated this trend (and changed the design of phones forever) in 2007. Both Apple and Android are vying to at least keep major shares of the smartphone and OS platform market.

2. Microsoft (NASDAQ:MSFT) has all but killed its old Windows Mobile platform (though astonishingly, some vendors still sell handsets using this OS). Microsoft is desperately trying to get more than a token adoption of Windows Phone 7 (including paying developers to port apps and paying Nokia (NYSE:NOK) to build phones).

3. Nokia has signaled the slow death of the Symbian OS. As a result, about 30% of the smartphone market is up for grabs as Nokia tries to market phones using the obsolete OS while tooling up for Windows Phone 7 phones at the end of 2011.

4. HP (NYSE:HPQ) is still pushing the interesting Web OS in a few phones, and could grab some market share.

5. China (and India) are growing rapidly, and offer a huge opportunity for smartphone manufacturers, though sales gains may be limited by the cost of smartphones, the cost of monthly data plans, and the large number of prepaid customers.

Currently, Apple sells the iPhone 4 for $600-800 to carriers and the iPhone 3GS for $450-500 to carriers. iPhone sales have been growing more rapidly than the market (110% in Q1 2011) and ASP has been increasing. But competition is intense and getting more so. Over the past 3 months there have been three developments relevant to Apple's plans:

1. A spate of very well sourced articles early this year suggested Apple had intense interest in developing a cheaper iPhone. Initially, some stories set this up as a cheaper, smaller 'iPhone Nano', but that was rapidly changed to just cheaper with further input from more 'authoritative' sources. Some rumors and patents have suggested that Apple is working on an innovative technology and billing mechanisms whereby a user could switch from carrier to carrier based on 'spot' cost of data, voices and messages.

2. Apple has publicly expressed an interest in serving the pre-paid market in developed, and especially developing, countries. To do this they need a cheaper iPhone, but perhaps also cheaper data plans. They have achieved the latter in the US with ATT's (NYSE:T) tiered pricing, and other countries and carriers will likely follow.

3. Based on presumably similar sources, it is now widely reported that Apple will not launch a new iPhone in June (as it has done in each of the past 4 years). The launch will instead be apparently deferred to September. This was reported in February, BEFORE the Japanese earthquake.

There's something wrong with the last point. It seems insane that Apple would choose this year of all years to deliberately delay its annual iPhone update. Examining the possible scenarios may allow us to make some informed guesses about iPhone development.

Apple has a roadmap and OS planning process that looks at least 10 years forward (Jobs said this about 4 years ago). Their R&D spending has been increasing at an annual rate of more than 50% recently. They will have been designing and engineering iPhone 4 successors for at least 3 years. Clearly, they have had the time and money to design, engineer and build a new iPhone by June 2011. Thus, a 3-month delay would only happen with a very good reason. Possible explanations include:

1. A delay gives time to secure cheaper components (and in huge numbers) for a substantially cheaper low-end iPhone (maybe $300 instead of the lowest cost $450 now). This would presumably use the iPhone 4 design, but with either the same or even downgraded specs - perhaps only 8 GB memory, a 3 MP camera with no flash. It seems extremely likely that a ‘cheap’ iPhone would have the same screen size and resolution, same A4 processor, and the same sensors in order that apps could continue to work seamlessly.

Launching a cheaper iPhone 4 (requiring no subsidy) could have a huge impact on Apple's market share. Presumably, the carriers would be happy to subsidize it down to $0 for a contract, but the real target would be the post paid market in developing countries. Apple may be aiming to sell 20-50M per quarter of these cheap iPhones, on top of their higher-end versions. The risk here is that such a cheap iPhone could slow sales of the premium versions. So:

2. A delay may allow Apple to incorporate some components into a new higher-end iPhone that would simply not be available by June. The major one here would be LTE 4G chipsets that meet Apple's demands for battery life and size. The other item that may be taking extra time would be a faster but small processor (i.e. A6 because the iPad's A5 might be too large for an iPhone). Another likely change would be a substantially better camera to differentiate from a cheaper model. The antenna may be changed and more memory would be added (RAM and storage). But improvements in the memory, camera, and antenna are not sufficient to explain a 3-month delay.

I do NOT think Apple will change the design appreciably in 2011. They have sold the iPhone 3G/GS design for 3 years. I cannot see them dumping the iPhone 4 design after one year. It seems likely that most developed world buyers would continue to pay $200 (after carrier subsidy) for a faster iPhone 4S with more memory, better camera and 4G wireless (though some might be tempted by $0 for a slower model with less memory).

What are the implications for Apple's stock price?

If Apple chooses the low-risk approach, and remain on their usual course with a June update to the iPhone, they likely would be able to offer more memory and a better camera but not much else if they did not want to change the design (which seems very unlikely to me). They would probably be on course to continue to see substantial increases in sales of iPhones in 2011, but I think they would reach saturation in late 2011 or early 2012 and would then only grow as fast as the overall smartphone market. While this would imply 50-75% y/y sales growth, they would not be increasing market share.

And there would be a danger that low priced Android phones would grab large market share in many countries. Apple stock would do well short term, but longer-term growth rates could come down. Perhaps it would hit $500 once valuation caught up with growth in 2012, but then grow perhaps 30% y/y after that (i.e. assuming Mac growth of 20% and iPad growth of 40%). Still good for what would then be the largest company in the world, but only addressing the top 30% or so of their markets.

Alternatively, they could take the high-risk approach. Delaying a new iPhone release in order to expand market size by offering a much lower priced version (iPhone 'cheap' not 'nano'), and substantially upgrading the high-end version could have substantial upside. The high-end version would sell very well, but likely much the same as smartphone market growth by the end of the year (say 60% y/y compared to over 100% now). But the low-end version could add another $6B (20M) to $12B (40M) in quarterly sales.

The risks are: a) that a 3-month delay irreversibly hurts Apple; and b) that low-end iPhones will cannibalize sales of high end ones. I do not think a 3-month delay will have an appreciable impact on sales (but be prepared for a dip in iPhone sales this Q3 - could be a buying opportunity). As for cannibalization, Apple has HUGE experience in preventing this in their Mac, iPod and iPad businesses. They know exactly how much the iPhone 3GS at $50 affected iPhone 4 sales in the last quarter (probably not much given the fact that iPhone ASP increased after the price cut). So this should not be a concern.

Bottom Line: Apple has the potential to add $24-48B in sales in the 12 months ending September 30, 2012 from a new cheaper iPhone line over and above their current lines. If we assume $30B extra sales, with a net profit margin (i.e. after margin, opex, capex and administration) of 20% (average currently is about 25%), this represents net profit of $6B. Give this a multiple of 15, it would add $90 to share price beyond current growth rates, and more importantly give Apple exposure to a much much larger share of the mobile phone market (not all of it but perhaps 60% instead of 30%). So share price by Q3 2012 could be $600, but with long-term earnings growth of over 60%.

One other option is that the rumors are untrue and Apple launches a new updated iPhone in June/July as usual. It still seems likely that they will introduce a cheaper iPhone fairly soon. They could do this in September.

Disclosure: I am long AAPL.