Was Apple's iPhone 5c a Mistake?

Apple's (NASDAQ: AAPL  ) iPhone 5s is brilliant, internally and externally. It sports one of the best applications processors available today, a very robust and user-friendly software ecosystem, and a gorgeous physical design. While this new iPhone has been selling out in droves, the 5s's cheaper sibling -- the iPhone 5c -- hasn't quite performed up to expectations. Indeed, with reports surfacing that Apple has cut production of its iPhone 5c in half (but with 5s and 4S demand remaining robust), the question investors now need to ask is whether the 5c was a mistake.

The rationale behind the 5c
Whenever Apple launches a new iPhone, the prices of prior-generation iPhones typically become discounted by about $100, and then the two-generations-ago model is "free" with two-year contract. This business model at first seems to make sense, particularly as it saves Apple the need to have to develop a specifically targeted lower-end device. However, there is a huge problem here: production cost.

If one looks at the iPhone 5s versus its predecessor, the iPhone 5, what has really changed? Sure, the 5s sports a faster processor that's maybe a tad more expensive to build, a better camera, a fingerprint sensor, and a few other design tweaks, but fundamentally it's still a beautiful, metal chassis with the same screen, the same amount of memory, and many other similarities. While these changes are all great, and users that absolutely have to have the latest-and-greatest will buy the latest model, the reality is that smartphones are quickly becoming "good enough" and the iPhone 5 suits the needs of most buyers just fine.

So, in effect, Apple has to take a fairly non-trivial hit on gross margins when it discounts the expensive-to-build previous-generation model. In a world that is rabid to upgrade from their old, slow, and less-featured phones, this typically isn't too much of an issue, but in a world of "good enough" it becomes a much thornier issue. So what does Apple do? Bring out a cost-sensitive device that has better gross margin dollars at the lower price points than the discounted flagships. This is a gross margin play, plainly and simply.

Heads Apple wins, tails...?
If the iPhone 5c -- and its "cheap" successors -- are desirable enough to satisfy the demand of folks who want to get in on the goodness that is the Apple ecosystem, then this will be excellent for Apple's investors. Margins could actually hold flat while revenue increases. But what happens if the low-end iPhone 5c fails to gain meaningful traction? Well, that's the tricky part.

In the first case, this could drive a mix shift upward for Apple. That is, people will see that it's only a marginal increase in dollars to buy the better iPhone and simply rule out the lower-end one as an option. In this case, it would be an unequivocal win for Apple.

Unfortunately, the reality is that while the extra $100 for the "better" phone may seem trivial to some investors, many simply can't afford that incremental cost. There's a reason why sales of the older iPhones were so robust -- people wanted the high build quality and brand of Apple without paying premium prices. So, in a case where the iPhone 5c is simply rejected by the consumer base, likely due to "better" devices at those same prices from the likes of Samsung (NASDAQOTH: SSNLF  ) , Motorola/Google (NASDAQ: GOOGL  ) , LG, and HTC, Apple loses -- big time.

Indeed, Samsung sources all of its components from soup to nuts, which means it has an excellent business either selling its own phones or selling the critical components such as displays, NAND, DRAM, and even processors to its competitors. Qualcomm (NASDAQ: QCOM  ) collects a royalty fee on each cellular device sold, whether it's able to get its apps processor and/or modems into the phones. Of course, these companies have their own issues, but they're a much safer way to play the secular smartphone/mobile growth trend.

The Foolish bottom line
So, was the iPhone 5c a mistake? Only time will tell. On one hand, it's great that Apple is trying to improve its gross margin profile in the mainstream while still offering a very compelling product at the high end, but the risk is that the iPhone 5c isn't going to be as desirable as an iPhone 5 at a lower price. Time will tell, and the sales numbers over the next couple of quarters will inform investors of whether this two-tiered phone strategy wins Apple back some gross-margin dollars, or simply drives away its less affluent customers.

 

Time to profit from destruction
If the 5c is a mistake, when will Apple blow it up? Apple has a history of cranking out revolutionary products... and then creatively destroying them with something better. Read about the future of Apple in the free report, “Apple Will Destroy Its Greatest Product.” Can Apple really disrupt its own iPhones and iPads? Find out by clicking here.


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Comments from our Foolish Readers

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  • Report this Comment On October 14, 2013, at 11:24 AM, KPOM wrote:

    The current estimates are that the 5c is selling about as well as the 4s did at this time last year. According to AllThingsD, the 5c represents about 27% of iPhone sales, compared with 23% for the 4s last year. If so, even though it might not be a blockbuster that expands Apple's market share, it seems to be successful at sustaining Apple's existing market while maintaining margins.

  • Report this Comment On October 14, 2013, at 11:33 AM, khaledmrd wrote:

    wait for China Mobile.....

  • Report this Comment On October 14, 2013, at 11:46 AM, twolf2919 wrote:

    The iPhone 5c introduction is actually quite brilliant. Not only did Apple potentially improve its margins going forward - the "lower-end" device from now on will always be plastic but improve at the same rate as before by incorporating all the technology in the current flagship iPhone (always one year behind) - but they also focused consumers on the flagship product! Without an iPhone 5 and its very similar physical design distracting from the beauty of the flagship, more people will flock to the flagship. The numbers bear this out so far: initially Apple sold three times more 5s than 5c...only now that the 5s is supply constrained has that difference shrunk: but still a sizable 2-1. I don't think there was such a wide margin between the 4 and 4s when the 4s came out.

  • Report this Comment On October 14, 2013, at 11:58 AM, Mathman6577 wrote:

    The analysts "in the know" were complaining about the lack of a "low-cost" phone from Apple. They got one and now I read commentary about the fact that some retailers are dropping the price for the 5c and that there must be something wrong w/ the company now.

    Can Wall Street ever be satisfied? The answer is no.

  • Report this Comment On October 14, 2013, at 12:05 PM, GaryDMN wrote:

    Mistake? It seems to be outselling the Samsung s4 at many carriers.

  • Report this Comment On October 14, 2013, at 12:11 PM, Mathman6577 wrote:

    Good point GaryDMN. The 5c is either the No. 2 or No. 3 seller at all of the major wireless carriers in the U.S. (the 5s is No. 1 everywhere). Wait until China Mobile comes on line.

    If the 5c happened to be No. 1 the Wall Streeters will then say "what's wrong w/ the 5s?"

  • Report this Comment On October 14, 2013, at 12:52 PM, fauxscot wrote:

    A mistake? Probably not.

    Did it fulfill Apple's expectations? Maybe not,and it appears, probably not. Sitting on 150 billion bux and an extremely automated and integrated build process, turning down the volume on production and slowing it a bit seems like normal startup adjustments. Not a big deal and it is a point of strength for Apple. It's why they set up such responsive and efficient production.

    Problem? I would not think so. The 5S isn't showing signs of being a failure, and really, the price isn't that much different. For folks who think color is a feature (not me), maybe a 5C is a draw, but for the kind of money people spend on their smart phones, you'd really want bang for the buck. Bang is 5S, not 5C.

    I'm sure not running out to sell my limited holdings because a second tier product may be a few points shy on shipping, when news about China Mobile system approval (by the Chinese "FCC") arrives in my inbox the same day.

  • Report this Comment On October 14, 2013, at 2:59 PM, TMFNewCow wrote:

    FWIW, gross margin actually increases as revenue increases due to operating leverage.

    -- Evan

  • Report this Comment On October 14, 2013, at 3:25 PM, secularinvestor wrote:

    The author uses two words "good enough" which betrays that he has no understanding whatever about Apple, the iPhone and their unique position and advantages in the smartphone market.

    "Good enough" is part of the lexicon of Wall Street's "commoditisation" theory led by IT analysts. They make the totally wrong assumption that consumers buy like corporate IT departments i.e. they compare specifications and price and select the cheapest, or what they consider the "best value" "good enough" for their organisation.

    THAT IS TOTALLY NOT HOW CONSUMERS THINK. Consumers buy what gives them the best user experience and pleasure. IT departments could not care less about user experience. Their users have no choice but to accept what IT departments give them.

    Apple DON"T DO "GOOD ENOUGH" They never have. And they never will.

    Apple is imbued with the spirit of Steve Jobs in their DNA.

    Steve Jobs always said that Apple made "insanely great" products. This has led to Apple products giving users an equally insanely great user experience, which is why Apple is the leading global brand and why for 9 years JD powers have rated Apple top in user satisfaction.

    Apple products invariably head users surveys coming way ahead of their rivals in user satisfaction, in premium brand loyalty, user retention rates and in trade in values.

    In short Apple make to the most desirable and satisfying products for consumers. That is why they form long lines around the block all round the world. That is why there are gray markets in Apple products. That is why an iPhone 5S commands a premium.

    Also, Apple are totally unconcerned by market share, another WS obsession. Apple want to stay in the premium market, commanding premium prices for premium products, which provide premium user experience and create premium user satisfaction and generate around twice as much profit as all their competitors in mobile phones combined.

    The 5C was never designed or intended to be a cheap product to gain market share at the lower end of the market.

    The 5C is intended to complement the 5S by providing would be iPhone users the chance to buy into the iPhone experience and user satisfaction at a slightly more affordable rates, but to generate for Apple around the same premium margins as the 5S.

    The brilliance of the strategy is that, like BMW offering a range of luxury cars, buyers may be attracted to the store to buy the cheaper iPhone 5C, but many then decide to upgrade to the more expensive, state of the art iPhone 5S, which is a generation ahead of any of its rivals.

    Another broken WS myth is that mature markets are saturated, and Apple has to go downmarket to gain market share.

    TOTALLY WRONG AGAIN. If the analyst took a little more care reading more reliable surveys like those from Kantar, Comscore and Cannacord Genuity, and took notice of web usage stats, rather the hyped fantasy "shipment" numbers from the likes of the notoriously inaccurate Strategy Analytics and IDC (which are little more than PR outfits for their paymasters i.e. Apple's rivals) they would realise that over the last 12 to 18 months iPhones have been GAINING market share in those advanced smartphone so called "saturated" markets like the USA, Canada, UK, France, Italy, Spain, Japan, Australia and Mexico.

    Android on the other hand, while losing market share in most of the above "mature" markets is gaining market share in third world countries , where smartphones DO compete on price like Chain and India. The problem for Google is that most of these are actually white box versions using forked versions of Android which shut out Google from placing adverts, which is why Google gives away Android in the first place.

    Research by Ben Bajarin shows that Apple "own" 64% of the US market for high end smartphones over $400.

    Comscore Research shows that Android's share of the US market is declining sharply since February 2012, and is now significantly below that of the iPhone.

    This is happening in the USA, the most mature "saturated' market of all - SO MUCH FOR THE COMMODITISATION "GOOD ENOUGH" THEORY.

    The iPhone 5S and 5C will greatly increase iPhone's market share in the US and in other mature markets, as is indicated by Canaccord Genuity's survey of the 4 largest US carriers which show that in September, both the iPhone 5S and 5C are outselling the best selling Android phone, the Galaxy S4.

    In fact if the latest data is correct, showing that the iPhone 5S is outselling the iPhone 5C by 2:1 or 3:1, then iPhones are selling Galaxies by 3:1 or 4:1.

    What makes this data even more compelling is that the new iPhones were only available for just the last 10 days in September, whereas the struggling Galaxy S4 was being sold at a discount throughout the 30 days in September.

    That means the new iPhones were outselling the Galaxy at a daily rate of more than 9:1.

    So much for the "good enough" theory!

  • Report this Comment On October 14, 2013, at 3:43 PM, Mathman6577 wrote:

    @secularinvestor: Great comments especially about Wall Street being obsessed w/ market share and Apple.

    Also, Wall Street is obsessed regarding short term analysis --- 2 or 3 quarters of data is not enough when looking at Apple --- need to look at 2 to 3 years worth of data (that is the typical Apple R & D time period when rolling out a new product -- original iPhone was about 3 years).

    The U.S. (and most developed countries) will never be saturated w/ smartphones -- people like to upgrade their devices every 2 to 3 years (it's not unlike a car -- even if they don't need one they want one).

    The other thing that angers me is the constant Apple bashing when there are plenty of companies (does Amazon ring a bell?) that are actually losing money. I want to see some Amazon bashing here.

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