The iPhone 5c Isn't Failing -- It's Doing Exactly What It Was Intended to Do

In the month since Apple (NASDAQ: AAPL  ) released its new iPhone 5s and iPhone 5c phones, the market has been deluged with the sentiment that the iPhone 5c "is a failure." Apple bears are rallying around reports that Apple has cut orders for the iPhone 5c, although they are not sure just how much Apple is cutting production.

Rumors abound that Apple is cutting iPhone 5c production. Photo: Apple.

All of these rumors about the iPhone 5c being a failure are flawed for one simple reason: They misunderstand the purpose of the 5c. Many observers -- including me -- expected Apple to release a "cheap" iPhone this year. When Apple released the iPhone 5c alongside the high-end iPhone 5s, a large contingent of Apple-watchers assumed that it was the rumored "cheaper" iPhone.

But the iPhone 5c is not a cheaper iPhone; it fits directly into the same pricing scheme Apple has used for years. It is not designed to gain market share in developing countries. It is not meant to target users who don't receive smartphone subsidies.

Instead, the iPhone 5c's primary purpose is to boost Apple's margins by cutting production costs and minimizing cannibalization of the highly profitable iPhone 5s. So far, investors have every reason to believe that the iPhone 5c is succeeding in that task.

iPhone 5c production cuts could be due to higher demand for the upscale iPhone 5s. Photo: Apple.

Margin quandary
While the financial press has extensively covered the slowdown in Apple's growth this year, the issue that has really spooked investors has been margin contraction. Apple churns out so much cash that the stock is a no-brainer even with no growth. The biggest risk for Apple investors is not slowing growth, but a potential collapse of the company's legendary margins.

Margin erosion was a key factor driving Apple stock's poor performance in the past year. Apple's gross margin has fallen year-over-year for three consecutive quarters, and will almost certainly fall again when Apple reports September quarter results next week. Sometimes the declines have been quite substantial; in the March quarter, gross margin dropped by 990 basis points compared to the same quarter in 2012.

One cause of this margin erosion has been cannibalization of the full-size iPad by the lower-margin iPad Mini. However, declining profitability within the iPhone product line has been just as important. The iPhone 5 was very difficult to manufacture, driving up production costs compared to the iPhone 4S. Meanwhile, Apple experienced a mix-shift toward older, cheaper iPhones that also pressured product margins.

The iPad Mini has been one cause of Apple's margin erosion. Photo: Apple.

iPhone 5c to the rescue!
This may be the true "origin" of the iPhone 5c. The idea that it is a cheaper phone designed to appeal to developing-world customers is fairly ridiculous, considering that it's not even the cheapest iPhone on the market!

Instead, the iPhone 5c is simply a new version of the iPhone 5 that is cheaper to produce. IHS iSuppli has pinned the manufacturing cost of the high-end iPhone 5s at $199, just above the $197 cost of the iPhone 5 from last year. By contrast, the 16 GB version of the iPhone 5c costs just $173 to build, according to IHS estimates.

Since the iPhone 5c is cheaper to build than the iPhone 5, Apple is making more money right now than it would have if the company had stuck with its old strategy of pricing last year's product (i.e. the iPhone 5) at $99 with a 2-year contract or $549 unsubsidized. The cost savings may be even greater than the IHS figures imply. The iPhone 5 was hard to manufacture, leading to high failure rates, which are not reflected in the IHS estimates. The iPhone 5c's plastic casing makes it much easier to build, avoiding this problem.

Low sales of the iPhone 5c are not necessarily a bad thing, either. (I should also point out that according to the most drastic rumors, Apple has cut 5c production from 300,000 units per day to 150,000 units per day, or nearly 55 million per year, which is hardly disastrous.) If the 5c sells poorly because of a mix shift back toward Apple's priciest phones, that would be great for the company. After all, the 5s is Apple's most profitable product!

Foolish bottom line
As soon as Apple revealed pricing for the new iPhone 5c, it should have been clear that Apple was not planning to use it to gain market share abroad. But many people had expected a "cheap" iPhone in the months prior to Apple's launch event. As a result, a large contingent of the media has become fixated on the comparatively low sales of the iPhone 5c, as if market share were the primary yardstick of success.

But the point of introducing two new iPhones was not to improve Apple's market share in developing markets. Instead Apple appears to be using the older iPhone 4 and iPhone 4S handsets -- and even used phones it is collecting through trade-in programs -- to bring in new lower-income customers.

Instead, the iPhone 5c was introduced in order to reduce Apple's production costs. Apple has already stated that gross margin will be near the high end of its guidance range for the September quarter. This suggests that the iPhone 5c is fulfilling its main purpose. If Apple forecasts margin improvement for the current quarter, that would be even stronger evidence that the iPhone 5c has succeeded.

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Read/Post Comments (13) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 21, 2013, at 6:07 PM, exeter17 wrote:

    I am sure the 5c is cheaper yet to produce. Its a plastic Iphone 5. No new tech is in the 5c at all.

  • Report this Comment On October 21, 2013, at 6:34 PM, pk22901 wrote:

    Yes. It maintains gross margin.

    AND....

    It's actually an Android Killer! It's mission is to eat into high end phones of the Android ilk!

    Looking straight at it, it's completing with colorful plastic Androids.

    Watch out!

    <Que creepy music>

  • Report this Comment On October 21, 2013, at 6:41 PM, GaryDMN wrote:

    Who will get to $700 a share first, Apple or Google?

  • Report this Comment On October 21, 2013, at 6:51 PM, rfischer314 wrote:

    "As soon as Apple revealed pricing for the new iPhone 5c, it should have been clear that Apple was not planning to use it to gain market share abroad."

    You're right. So my question is: Why did it take over a month since launch for TMF and analysts to realize this? It WAS instantly apparent that the colors plus the enhanced trade-in program (which just dumps old models overseas) was mean to ensure that you can no long have this year's look for last year's prices, AND this year's look becomes more affordable thanks to the trade-in, AND last year's look becomes more affordable abroad thanks to the trade-in.

  • Report this Comment On October 21, 2013, at 7:02 PM, larryw101 wrote:

    Great article !! Thank you !

  • Report this Comment On October 22, 2013, at 1:13 AM, rcmotohead wrote:

    After reading these terribly biased articles from the Fool, I had to register and post. They bash android and windows product alike while the praise apple like they owned 200 billion shares of it. Such terrible bias that you would think windows was such a terrible OS that the sky would fall as soon as Windows 8 hit the shelves. In their eyes Apple's sh*t don't stink and you should increase your holdings of their stock by 100%. All they do is cater to the isheep that commercials make fun of. Who else falls for their bs besides isheep? No one! It's obvious by the articles they publish and the izombies who post here that the fools are just fooling themselves. Pathetic. How much are they paying Yahoo to post this faux news anyways?

  • Report this Comment On October 22, 2013, at 12:34 PM, Mathman6577 wrote:

    To me the "c" in 5c stands for cash ... lots of cash that the company returns to me in the form of dividends and buybacks.

    It appears to me at least that $AAPL is the most talked and written about stock in history -- both pro and con. All the discussion is probably a net plus. Keep it going.

  • Report this Comment On October 23, 2013, at 5:21 PM, CoreAndExplore wrote:

    Very good point. The big knock on Apple recently has been its margin compression and the 5c should address that nicely. Apple has done a fairly brilliant thing by remaining aspirational by refusing to cheapen and commoditize their own products, and still figure out a successful strategy of addressing the lower market as well.

    Looking at the success of businesses like gazelle, it's clear that the new trade-in program was a brilliant move. For years people have been saying that Apple overbuilds and overengineers their phones, at the expense of future profitability. Now, Apple can actually monetize that build quality beyond the initial sale AND retain unmatched quality in its products. Apple is doing much more right than they are doing wrong.

  • Report this Comment On October 23, 2013, at 5:28 PM, mikecart1 wrote:

    As long as AAPL shares keep going higher, I don't care what the 5c was intended to do lol!

  • Report this Comment On October 23, 2013, at 8:52 PM, Bujutsu wrote:

    The author referenced the cannablization of the iPad by the iPad Mini, but so what?

    The profit margins on the iPad Mini are actually higher than the regular iPad.

    Despite the cheaper consumer price point, Apple still makes more profit.

    http://www.computerworld.com/s/article/9233273/Apple_s_iPad_...

  • Report this Comment On October 23, 2013, at 9:55 PM, TMFGemHunter wrote:

    @Bujutsu: That's actually not accurate. The IHS iSuppli data does not include things like shipping costs, license costs, and quality control costs (like testing and replacing faulty components).

    The best estimates I have seen for the iPad mini's initial gross margin put it somewhere between 10% and 20% (less than half of what iSuppli tests would tell you). As the manufacturing process has improved, my guess is the gross margin has moved up to something more like 25%. But it's still well below the full-size iPad, and Apple's management has been quite clear about that one fact.

    My guess is that Apple earns at least $100 more for each full-size iPad it sells compared to a Mini with the same storage capacity.

    Adam

  • Report this Comment On October 23, 2013, at 10:35 PM, DINEROne wrote:

    I think as the product life cycle continues, before the release of the iPhone 6...they will start discounting the 5c. I actually think that market share will be gained with the 5c.

    I prefer to purchase the 5s, but the younger customers (kids) will be the target market. They will replace their iPod touches with iPhones.

  • Report this Comment On October 24, 2013, at 8:43 AM, KombatKarl wrote:

    I'll never understand why people get cheap phones. The phone company charges you the same whether you have an iPhone 5S, Galaxy S4, or some Huawei piece of garbage. And $200 is a pittance compared to what you'll pay over the course of a 2-year contract.

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