Apple: The 2019 iPhone Problem

About: Apple Inc. (AAPL), Includes: GOOG, GOOGL, SSNLF
by: Bill Maurer

High pricing last year led to falling demand.

Are phones getting more expensive even without tariffs?

Google's latest phone should be a wakeup call.

Now that we're halfway through May, recent history suggests we're about four months away from technology giant Apple (AAPL) unveiling its newest lineup of iPhones. After last year's devices effectively saw a price raise, consumers pushed back, and when a China slowdown hit, the company was forced to warn that holiday period revenues would miss prior guidance. With hopes that this year could see a turnaround for the iPhone, current rumors make me wonder if the situation will only get worse.

If you want to read every particular rumored detail about this year's lineup, MacRumors has a great rundown here. Apple is expected to launch three new phones, basically successors to the XR, XS, and XS Max, with similar screen sizes to those devices. The XR is expected to continue using an LCD display, while the two XS models will continue to use an OLED display. The image below shows what the two OLED models could look like.

(Source: MacRumors article linked above)

Those squares in the upper left are the biggest change that is expected to come this year, and that's a triple-lens setup. The current XS models have a dual camera setup, but Apple is expected to add a third camera, like most other major smartphone makers are doing currently. The XR is also expected to move to a dual camera setup, while all three phones could get a major upgrade to their front-facing camera.

There are a number of other rumors out there, the most important of which is that Apple will feature larger batteries in these devices. This could allow bi-lateral charging, which means you can charge any Qi-based device from your iPhone, a feature that Samsung (OTC:SSNLF) has already launched. Beyond the usual processor and other upgrades expected, the XR may also get a RAM boost from 3GB to 4GB. There is also the potential that these phones get Apple Pencil support, but that's unclear right now.

With Apple introducing new camera setups across the iPhone lineup, as well as providing the usual next-generation upgrades, the issue I see currently is that pricing would have to go higher yet again. I don't see Apple budging on margins, which already are under a little pressure, and this is even before considering the impact of tariffs thanks to the US/China trade war. I could easily see a scenario where each phone goes for $50 more at launch than its prior generation counterpart.

The impact of pricing is an even larger question now after Google (GOOG) (GOOGL) recently came out with a new budget-friendly Pixel smartphone. The just-launched Pixel 3A models feature the great camera the phone line is known for, although not every tech spec is top of the line, allowing for the smaller screen version of the two to be priced at just $399. Additionally, Google has added a number of new US wireless carriers this year, as opposed to previous models that were Verizon (VZ)-exclusive.

(Source: Verge article, seen here)

Those that have followed my Apple coverage known that I, like a number of consumers out there, am a big fan of smaller screen devices, and I certainly love my iPhone SE. Apple has not launched a second generation of that phone, and there aren't any major rumors out there suggesting one will come. However, from all accounts, it seemed that the device sold pretty well, especially considering its size and price point, so I wonder if Google's new Pixel price point will make Apple rethink its strategy.

By eliminating the Home button, Apple could come in with a larger screen on the same form factor as the SE, or the same rough screen size in a smaller device. Those that are looking at a phone in this price point aren't looking for top-of-the-line specs everywhere, so Apple could follow the Google strategy and go halfway in certain respects. This would allow the company to maintain decent margins, and boosting total iPhone unit sales would allow the company to sell more Apple services as it looks to grow the revenues of that segment.

Now, I am not here today to say that Apple is dying, but there are some implications that investors need to be aware of. As you can see in the graphic below, iPhone revenues were still 58.3% of Apple's total in the first half of the fiscal year, despite the more than $15 billion revenue drop. At present, there is simply no way the company can grow its total revenues if iPhone revenues are plunging by this much.

(Source: Apple fiscal Q2 supplement, seen here)

It's not just about revenues, either, as the iPhone drives a good chunk of Apple's profits. Hardware gross margins in fiscal Q2 were down 265 basis points over the prior year period, and that's worse than the 180 basis points seen in fiscal Q1. That's likely partially due to some discounting as Apple tried to drive sales, but losing high margin revenues definitely hurts the gross margin line. As I mentioned above, the best way to protect margins is to raise prices, but that likely comes with a hit to unit sales.

The hit to gross margins also flows down the income statement quite a bit. With operating expenses also rising a bit year over year, Apple reported a 12.8% decline in operating income for the six-month period. Net income wasn't down as much, but that's only because the prior six-month period still had one quarter before the US tax cuts went into effect. Harder comparison periods are coming, and cash generated by operating activities was down by $5.5 billion for the six-month period.

I do think investors need to temper expectations a bit for this year's iPhone launch. While the new camera setups will be nice, Apple's pricing strategy will definitely be a key to this line's success. There will likely be an even larger focus on price, since most expectations don't have Apple launching a next generation 5G compatible phone until the fall of 2020. This could lead sales to be a bit soft as investors wait for that major leap forward.

In the end, Apple could be in a repeat of its iPhone problem from last year in regards to high pricing. Ignoring the tariff issue, which itself could be a big deal, the rumors that the technology giant will have a newly major upgraded camera setup this year could make the smartphone even more expensive. With Google having launched a budget-friendly Pixel phone recently, Apple would seem out of touch if it raises prices yet again. This could further hurt unit sales, not only impacting the bottom line but also reducing the potential for Services growth from additional users. Apple shares currently trade $25 below the average street price target at the moment, but that cannot happen if we see another year where the iPhone lineup disappoints.

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.

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