Here’s Why the Apple iPhone 6 Could Be Great for the iPad

There's a lot of fear among Apple (AAPL -0.81%) investors that the upcoming larger iPhone 6 models (reportedly coming in both 4.7-inch and 5.5-inch flavors) will serve to cannibalize the iPad product lines (in particular, the iPad mini). While this may very well be the case, the end result of this is likely to be a net positive for the Cupertino-based computing giant.

The situation today and what the situation will look like post-iPhone 6
As of today, Apple's lead product line consists of the following (prices are for the base 16GB model):

• iPhone 5s (4-inch high-end smartphone) -- $649
• iPhone 5c (4-inch midrange smartphone) -- $549
• iPad mini with Retina display (7.9-inch high-end tablet) -- $399
• iPad Air (9.7-inch high-end tablet) -- $499

The argument against a larger iPhone is that users that would typically own a $549 or $649 iPhone would no longer see the need to supplement that device with a $399 iPad mini with Retina display for gaming and reading. While the screen real-estate difference between even a 5.5-inch iPhone and a 7.9-inch iPad is pretty substantial, let's assume for a moment that the existence of a 5.5-inch iPhone "eats into" sales of the iPad mini with Retina display. What then?

It's a little confusing
To keep things in perspective, let's look at iPad shipment data for fiscal 2013:

Source: Apple

Let's assume for now that the iPad hardware business carries a gross margin profile of about 30-35%. Let's also assume that a larger iPhone sells for about $749 for the base model off-contract ($299 with two-year contract). Further, it probably makes sense to think of iPhone as a 40-45% gross margin business.

So, what happens if an iPhone 6 5.5-inch replaces an iPad mini with Retina Display?
If we assume that an iPhone user who would have typically bought an iPad mini with Retina Display alongside a smaller iPhone just goes with a large iPhone, then there's a bit of a problem there. At this point, under the assumptions above, Apple is trading $1048 in revenues and $405.50 in gross margin dollars (assuming the midpoint of the category gross margin ranges) for $749 in revenue and $318.32 in gross margin dollars.

While this substitution may very well happen, it is likely that somebody buying one device to rule them all will buy a model with larger storage (since it needs to fit everything) which means that such a substitution could be very close to margin-dollar neutral.

Remember, though: the larger iPhones will drive incremental share
It is likely that the larger iPhone variants will drive greater share of the high-end market, which means more iPhone units than Apple would have if it had not launched the larger iPhone. In fact, if a larger iPhone at 42.5% gross margin and an average selling price could sell just 30 million incremental units, then that would -- in gross margin dollar terms -- be worth about 65 million iPads at $450 average selling price and 32.5% average gross margins.

Could a larger iPhone drive iPad mix up?
Another perspective to consider is that consumers who opt for a larger iPhone may not have incentive to pick up a 7.9-inch tablet, but they may still want increased screen real estate (for watching movies, playing games, etc.) over what a relatively small phone could provide. So, these users may increasingly opt for larger tablets, which could actually drive iPad mix up.

Foolish bottom line
At the end of the day, Apple understands that the iPhone is the crown jewel of its business and it will do whatever it takes to secure that business even at the expense of its less financially important businesses. That said, it is not immediately obvious that a larger iPhone will necessarily be bad for the iPad as it could ultimately drive mix up from the lower-cost iPad mini models and toward the full-sized iPads.