Apple's (AAPL 0.32%) 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, 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 (QCOM +0.61%) 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.
