As Apple's (AAPL 0.11%) growth has tapered off during the past several quarters, analysts have turned their attention to rumors of a "low-cost iPhone." The smartphone industry still has tremendous growth ahead of it, but most of this growth will be in the low end of the market (phones that cost $200 or less unsubsidized). However, Apple's "entry-level" iPhone 4 sells for $449 unsubsidized in the U.S., which places it in the high-end smartphone category.
By contrast, Samsung (the clear leader in Google's (GOOGL -0.16%) Android ecosystem) has a strong position in high-end smartphones, but it also has a substantial presence in the low-end market. The growth of mid-range and low-end smartphones has driven an explosion in Android's market penetration in the past few years. If Apple wants to reignite growth, it will need to expand its reach beyond high-end smartphones.
There are many open questions about what Apple's low-cost iPhone might look like, but the big question for shareholders is how the release of a cheaper iPhone will affect Apple's earnings (and thus, its stock price). This, in turn, depends heavily on what Apple decides to charge for the new iPhone. If the price is too low, it will have low margins and will also cannibalize sales of more expensive, higher-margin iPhones. On the other hand, if the price is too high, Apple won't be able to gain much market share. I believe that Apple will err on the high side in terms of pricing, targeting the mid-range smartphone market with a $329 or $349 price point.
Apple reportedly considered introducing a low-cost iPhone as early as 2009. However, rather than building a separate, cheaper iPhone, the company decided to use older iPhones as entry-level models. Nevertheless, by early 2013, most Apple-watchers expected the company to launch a new low-cost iPhone soon, perhaps as early as this year. On Thursday, leaked photos of what could be a prototype low-cost iPhone made their way around the Internet. According to the site that originally posted the photos, this new device will have a plastic case and will share many components with the iPhone 4 and iPhone 4S.
According to a teardown analysis by IHS iSuppli, the total manufacturing cost of the iPhone 4S was $196 as of October 2011. That included the cost of all components and manufacturing, but not the cost of software, logistics, or patent licenses. Component prices have dropped since then, and Apple would save money by moving from an aluminum case back to plastic, as has been rumored. That said, CEO Tim Cook has adamantly stated that the company will not compromise product quality, so there is a limit to how low Apple's production costs can go. It seems possible that Apple could reduce its all-in cost to $150 or $160, but probably not much lower than that.
Hitting a price
If Apple won't be able to meet its high quality standards for less than $150 (including all manufacturing, licensing, and logistics costs), the company won't really participate in the "low-end" smartphone market, per se. One well-known Apple analyst, Piper Jaffray's Gene Munster, predicted earlier this year that Apple would introduce a $199 iPhone this summer. However, it's highly unlikely that Apple would sell a device so close to the cost of production. Resellers would also get a cut of the purchase price, leaving Apple with only $175-$180 in net revenue.
Munster recently revised his expectation and now believes that the cheaper iPhone will cost $300. However, even at that price, he expects it to "cannibalize" high-end iPhone sales. In other words, some customers who would otherwise pay up for a $449 iPhone 4 -- or an even more expensive device -- will choose the cheaper iPhone. Since the iPhone's current average selling price is more than $600, and gross margin is generally estimated above 50%, Apple earns more than $300 of profit per iPhone sold (on average). If Apple makes only $100-$120 in profit per device for the cheaper iPhone, heavy cannibalization could cause the company's earnings to shrink even if iPhone sales grow significantly.
A potential solution to this conundrum would be to price the new iPhone a little higher, at perhaps $329 or $349. That would still be significantly cheaper than the iPhone 4, and it would place the new iPhone solidly within the mid-range segment. Apple has historically focused on "aspirational" products, and a $329 or $349 price point would be within reach for many customers, while protecting Apple's profits. As my Foolish colleague Evan Niu noted earlier this month, a trade-in program in India that reduced the effective cost of the iPhone 4 from $485 to $360 (or less) caused sales to triple. That suggests that a $100-$150 price drop could have a surprisingly large impact on sales in developing markets.
In other words, I expect Apple to follow a strategy similar to its iPad Mini pricing strategy. Many observers expected Apple to fight Amazon.com's (AMZN 2.57%) $199 Kindle Fire (now $159) with a tablet priced as low as $249; instead, the base iPad Mini costs $329. Despite the big price gap, Apple couldn't keep the iPad Mini on store shelves during the holiday season because of overwhelming demand, while Kindle Fire sales growth was fairly muted. Apple offers a differentiated user experience, and people will pay more -- up to a point -- for its products. Therefore, $329 or $349 seems like the ideal price point for a cheaper iPhone.
Apple hasn't even confirmed that it will make a cheaper iPhone yet. Nevertheless, it seems inevitable that this product is on the way in the next year or so. It may not be quite as cheap as some analysts expect, but that shouldn't hurt sales very much. If Apple can offer an iPhone at a mid-range price point while also adding major new carrier partners such as China Mobile (CHL), the company will probably return to solid earnings growth. With Apple stock having recently fallen below $400, the shares look like a great value in that scenario.