A Cheaper iPhone Is Coming, and It’s a Good Idea

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Apple (NASDAQ: AAPL) rumor mill is running faster than ever, and the Wall Street Journal has even reported that the company may be planning to launch a cheaper iPhone with a price range in the area of $99-$149.  That's not very likely, since Apple could hardly reduce the price from $650 to those levels and still deliver a high quality product for a profit.

Apple would never go to a pricing segment where the quality is too compromised and/or there is no room to make money. That doesn't fit its competitive strategy, brand identity or corporative culture, so I wouldn't expect and iPhone at those price levels anytime soon.

On the other hand, there are strong reasons to believe that new iPhone models with different prices and characteristics are coming this year. Apple has produced a wide variety of iPods, and the iPad Mini is a great example about how the company is widening its product lines, including lower priced devices.  In fact, a cheaper iPhone sounds like a very reasonable idea from a long term pint of view.

Market Share

A cheaper iPhone would be great for Apple's competitive strength outside the US. Especially in emerging markets, where carrier subsidies aren't such an extended practice and Apple has been losing market share versus Android smartphones because of its prices.

Google´s (NASDAQ: GOOG) Android platform for smartphones has been growing faster than iOS on a global scale, and it stands as the undisputed leader in market participation.  Samsung has delivered some very competitive products over the last years, and low cost manufacturers from Asia have gained a lot of market share in the lower end of the pricing spectrum by capitalizing on the popularity ecosystem depth provided by Android.

As the smartphone revolution expands to emerging markets like China and India, the lower priced products will become increasingly important. Apple is a very popular brand in those countries, but its products are just prohibitively expensive for most people. The unsubsidized iPhone starts at $650 and it sometimes goes over $1000 in emerging markets, this is clearly a problem considering income levels in those countries.

China is a very special geography for Apple; Tim Cook has repeatedly said that the country will be a tremendous driver for the company in the coming years, and a cheaper iPhone looks particularly well suited for that market.  The timing looks good too, Reuters reports that Tim Cook just met with the Chairman of China Mobile (NYSE: CHL) Xi Guohua on “matters of cooperation” on Thursday.

China Mobile is the biggest carrier in China, with a market share of nearly 64% and more than 700 million users. Its smaller competitors, China Telecom and China Unicom already carry the iPhone, and they have been gaining market share versus China Mobile over the last years. An agreement with China Mobile and a cheaper iPhone to go with it could mean a tremendous boost for Apple sales in the country.

Margins

One big concern about this possibility is that it would likely have a negative effect on profit margins, especially in its first stages. Production costs are usually higher when a new product is launched, so a cheaper iPhone would certainly have a lower contribution per unit, and lower profit margins in the first quarters of production

On the other hand, higher sales and production levels are a big plus for margins, and this should compensate the problem, at least partially. If the product sells well, margins will have a double tailwind from higher production levels and bigger operating efficiencies as time goes by.

We still need to keep in mind that Apple has extraordinary margins above 35% at the operating level. Even if margins were cut down by half, the company would still be more profitable than any of its competitors.

Besides, thinner margins don't necessarily mean lower earnings, only that the company keeps a smaller percentage of the sale price as profits. Even with lower margins, earnings can still expand at a nice speed if sales growth compensates the margin compression.

Brand Value and Cannibalization

Damage to brand image is probably the biggest risk with this idea. If Apple starts producing low quality products to compete based mostly on pricing, it risks hurting its most valuable asset: the brand. That's why I think an iPhone for $100 or $150 doesn't make any sense at all.

Apple needs to make sure that any new product will still be worthy of the Apple logo when it comes design, functionality and overall “look and feel.” The company has proven that it can deliver high quality products at a lower cost with the iPad Mini, and launching different iPod models with various price levels has also been a smart idea. That's the way to go with the iPhone.

Cannibalization will most likely happen to some degree if the company launches lower cost iPhones, but I don't think Apple should be concerned about that. Like Steve Jobs said: “If you don't cannibalize yourself, someone else will.” Apple has never feared cannibalization, and this has proven to be a very successful philosophy in the long term, product quality and innovation should always come above short term profits.

The Platform War

Attractive big masses of consumers into the company's ecosystem could ultimately be a very effective move. After all, this is a platform war, not only a competition among different products. Apple's ecosystem has proven to be very sticky; consumers tend to choose other Apple products once they already have one, so this decision could reward Apple with bigger profits and a stronger competitive position for decades to come.

Cheaper iPhone models would mean that the company is probably leaving some money on the table in the short term, but at the same time it would be strengthening its competitive position in the high growth areas of the world. That's a smart and audacious move, and it means putting long term growth above short term profits.

Bottom Line

The “ultra cheap” iPhone mentioned in the Wall Street Journal doesn't make any sense. But Just like Apple has done with the iPod, and has recently started doing with the iPad Mini, I think we should expect a wider variety of iPhone models and prices in the middle term.

Wall Street analysts are already jittery about Apple's margins, and a cheaper iPhone will likely create even more uncertainty. But long term investors have no reason to fear, this strategic decision goes in the right direction.

 

 


acardenal owns shares of Apple and Google. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple, China Mobile, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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