Apple, Inc. Brilliantly Destroys This Bear Argument

Back in March, I offered my views on a note from Pacific Crest's Andy Hargreaves regarding Apple's (AAPL 0.64%) next iPhone. Hargreaves asserted the following:

• Apple customers who would have picked up a $199 iPhone 5s would now go and buy a $299 iPhone 6.
• The iPhone 6 would cost $60 more to make, meaning Apple would generate an incremental $40 in per-unit gross profit.

Now, following the iPhone 6 and 6 Plus launches, we know that Apple is actually selling the 4.7-inch phones at the same price points as their 5s counterparts and also introduced a 5.5-inch phone at a higher pricing tier.

Nevertheless, I responded to Hargreaves' argument with the following point:

• A user could potentially shift from buying a 32GB iPhone 5s to a 16GB iPhone 6, which would lead to a per-unit decline in gross margin.

It turns out, though, that Apple brilliantly destroyed the value proposition of doing this, which breaks the major concern I had with Hargreaves' point.

Apple's brilliant pricing scheme
When Apple launched the iPhone 6 and 6 Plus, it pretty brilliantly offered the following pricing tiers (with a two-year contract):

iPhone 6:

• $199 -- 16GB
• $299 -- 64GB
• $399 -- 128GB

iPhone 6 Plus:

• $299 -- 16GB
• $399 -- 64GB
• $499 -- 128GB

As fellow Fool Sam Mattera notes, the 64GB and 128GB models of both the iPhone 6 and the iPhone 6 Plus start to look a lot more attractive for the money than the 32GB models did over the 16GB versions of prior iPhones.

Mattera also notes that a mix shift to higher storage tiers should help boost Apple's iPhone average selling prices, as well as potentially gross margins. This, in a nutshell, is "having your cake and eating it, too."

The offset: iPhone 6 and 6 Plus are more expensive to build
While Apple is likely to benefit from a meaningful mix shift upward, do keep in mind that these new iPhones are almost certainly more expensive to build than their predecessors were.

According to Credit Suisse via G for Games, the 16GB iPhone 5s cost $274.30 to build, while the 16GB iPhone 6 costs $350.60 to build. This means, in a nutshell, that Apple is raking in fewer gross profit dollars per iPhone sold at a given tier.

That being said, let's take this a bit further by looking at the cost structures and gross profit profiles of the iPhone 5s and 6 at the various storage tiers based on Credit Suisse's estimates and average NAND flash prices, sourced from DRAMeXchange.

Sources: Credit Suisse, author estimates, DRAMeXchange.

It's clear that Apple is making significantly less per unit at each storage tier. A common argument is that Apple will simply make up the gross profit dollars via volumes, but, as I noted, Apple is also probably banking on a mix shift up.

Though Apple doesn't give a detailed breakdown by storage tier, I would imagine that the current iPhone sales distribution is very heavily weighted toward the 16GB model. So, working under that assumption, I'm going to guess that Apple's mix looked something like this for the 5s:

• 60% 16GB
• 30% 32GB
• 10% 64GB

This would imply average gross profit per unit of approximately $320.

If Apple ends up seeing a distribution for the iPhone 6 that looks like the following:

• 20% 16GB
• 70% 64GB
• 10% 128GB

Then this would lead to average gross profit per unit of $315, or just slightly below what the estimate for the iPhone 5s was. Apple, in this case, would probably be more than able to make it up in volume.

The iPhone 6 Plus also helps a mix shift up
Keep in mind, too, that Apple will also probably see users go for the iPhone 6 Plus, and could also gain share with it, so this further skews Apple's potential mix upward. I haven't seen good estimates for the cost of the iPhone 6 Plus, but I would imagine it's more expensive to build since the display is more expensive, the battery is significantly larger, it includes optical image stabilization, and it features a larger chassis.

I would expect, though, that most iPhone 6 Plus buyers will opt for the 64GB and 128GB models, particularly as "phablet" users probably want to store as much content on their phones as possible.

Foolish bottom line
I'm not too worried about driving incremental volume shipments with iPhone 6 and 6 Plus. Further, while the cost structures on these new iPhones are indeed higher, I do tend to agree that the new storage tiers will help drive the mix toward the 64GB and 128GB models, which could help offset the increased cost structures.

It'll be interesting to see what Apple guides to for next quarter for both sales and gross margin.