The Economics Of The iPhone

| About: Apple Inc. (AAPL)

Many people have recently criticized the cost of iPhone subsidies and have commented on the poor economics of iPhones for the cell phone carriers. In particular, many have become more negative on Sprint (NYSE:S), following their recent iPhone deal (because of the assumed costs of the Apple (NASDAQ:AAPL) contract).

Now, I believe that Sprint's high iPhone commitments ($15.5 billion over 4 years) are a legitimate cause of some concern; however, I am surprised that so many also seem to question the economics of the individual iPhone subscriber contracts (not only for Sprint, but also for Verizon (NYSE:VZ) and AT&T (NYSE:T). To me, it seems that many are confusing high upfront costs with an overall lack of profitability. The iPhones are clearly expensive for the carriers (with estimated subsidies of around $400), but I believe that the contracts are highly profitable over their lives.

So, to better understand the economics of the iPhone, I did a back-of-the-envelope analysis on the economics of a single 24-month iPhone contract for Sprint. My assumptions are for a subsidy of approximately $400 (an estimated $600 phone less the $200 cost to the consumer), a service margin of 68% (in line with Sprint's overall service margin in Q1 2012), and an ARPU for Sprint's iPhone subscribers of $89.99(their iPhone contracts, with data plans, range from $79.99 to $109.99/month).

Using these estimates, the economics of an iPhone contract would be as follows:

Initial outlay: $ 400.00  
Monthly contribution: $ 61.19 ($89.99 ARPU x 68% margin)
contribution for 24 months: $ 1,468.56  
Return: 367%  

Again, this is a simplistic analysis based on estimates and it does not factor in any incremental SG&A expenses and/or involuntary churn. That said, even when considering these other factors, it appears clear that iPhone customers are highly profitable over the lives of their contracts; notwithstanding the high iPhone subsidy that must be paid up-front.

With that in mind, let's look at the implications, over time, for the company selling the iPhone. To do this, I modeled out a cohort of subscribers over the first 24 months after a company starts selling the iPhone. I assumed 1.5 million iPhone additions per quarter and a quarterly contribution per subscriber of $183 ($61/month). Again, this is a simplistic analysis (in reality, all subscriber won't sign up exactly at the beginning of the quarter and there will be involuntary churn and incremental SG&A over time), but this gives you an idea of the very high profit potential that the device offers a company selling the product.

  Year 1      
  Q1 Q2 Q3 Q4
Subscribers (in millions): 1.5 3.0 4.5 6.0
Financials (in millions):        
Revenues (1): 275 549 824 1,098
Less subsidies (2): 600 600 600 600
Quarterly profit: (326) (51) 224 498
Cumulative profit: (326) (377) (153) 345
  Year 2      
  Q1 Q2 Q3 Q4
Subscribers (in millions): 7.5 9.0 10.5 12.0
Financials (in millions):        
Revenues (1): 1,373 1,647 1,922 2,196
Less subsidies (2): 600 600 600 600
Quarterly profit: 773 1,047 1,322 1,596
Cumulative profit: 1,118 2,165 3,486 5,082
  Year 3      
  Q1 Q2 Q3 Q4
Subscribers (in millions): 13.5 15.0 16.5 18.0
Financials (in millions):        
Revenues (1): 2,471 2,745 3,020 3,294
Less subsidies (3): 1,200 1,200 1,200 1,200
Quarterly profit: 1,271 1,545 1,820 2,094
Cumulative profit: 6,353 7,898 9,717 11,811
(1) $183 quarterly ARPU times subscribers    
(2) $400 subsidy x 1.5 million adds/ each quarter    
(3) $400 subsidy x 3.0 million subscribers.    

While the, above, model reflects a cumulative loss for the first three quarters (after offering the device), the iPhone ultimately becomes profitable in Q4 and profits grows rapidly, thereafter. This is a result of the dynamic of equipment subsidies remaining constant each quarter (with the constant level of iPhone addition) while revenues continue to increase with cumulative subscriber gains.

I also added a third year, to show the impact of the earlier 24-month contracts ending (and those customers presumably getting a new subsidy/iPhone). As a result of this dynamic, you will notice that subsidies double in year three -- as you have the cost of new additions AND you first begin to have the cost of "re-subsidizing" those customers rolling off of their 24 month contracts from the prior years. This results in a temporary reduction in the absolute level of profitability for one quarter, but profitability then increases, again, going forward.

In summary, I believe that the economics of the iPhone for cell phone carriers is misunderstood. It can result in high upfront costs, but the contracts, overall, appears to be highly profitable. Furthermore, the iPhone offers benefits with respect to churn, customer loyalty, and marketing that are not factored into this analysis. While Apple certainly makes a healthy profit off of the carriers, that doesn't mean that it can't be a win-win for all involved.

Disclosure: I am long AAPL, S.

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