In the month since Apple (AAPL +2.63%) 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.
