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A Problem With Pacific Crest’s Apple Thesis

By Ashraf Eassa – Mar 15, 2014 at 2:30PM

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While Pacific Crest's upgrade of Apple on richer ASP mix is interesting, it's not as clean-cut as it initially seems.

Pacific Crest's Andy Hargreaves issued a note to investors calling for a $635 price target on Apple (AAPL 0.99%). The crux of Hargreaves' argument is that with the introduction of a higher-tier iPhone, Apple can grow total gross profit dollars as there will be a meaningful portion of the customer base that takes no issue with a $100 base price increase. This argument is interesting, but there's a bit of nuance here that makes it less "obvious" of an argument, although the general premise of upward mix-shift and share gain with a larger iPhone seem to pass the common sense test.

What happens when a 32GB iPhone 5s buyer picks up a 16GB iPhone 6 4.7-inch?
Hargreaves' assumption is the following:

  • A user who would have normally picked up a $199 iPhone 5s 16GB would then pick up a $299 iPhone 6.
  • The iPhone 6 would carry a bill-of-materials that is $60 higher than the iPhone 5s, which would translate into an additional $40 in gross profit per unit.

But what happens when you get something like the following happening:

  • A user who normally would have picked up a 32GB iPhone 5s ($299), which has a $100 higher ASP over the 16GB iPhone 5s, chooses to go with a 16GB iPhone 6 ($299) instead.
  • The incremental cost of an additional 16GB of NAND flash is, perhaps, $11. So, now Apple has actually seen a decline of $29 in gross profit per unit in having a user go from a $299 iPhone 5s equivalent to a $299 "larger" iPhone 6.

The counterargument to this is that users who are buying the more expensive phone anyway will probably want to use more apps and store more music, particularly since the larger screen promotes more media/content usage. That said, there are those (and it is probably not a small amount) who simply buy the latest-and-greatest iPhone for the brand cachet.

The share-gain story, on the other hand, is compelling
The fact is, many people seem to enjoy the larger screens of the Samsung (NASDAQOTH: SSNLF) Galaxy S products, and there is likely a nontrivial portion of the Apple user base that has defected to the Samsung camp simply because they wanted a larger screen. With a larger iPhone option, Apple can boost its retention rate and gain back share that it has presumably lost over the years to Samsung's products. This, coupled with a still-growing smartphone market, is a recipe for success -- if it plays out.

Foolish bottom line
At the end of the day, Apple can grow its top and bottom lines by taking more share at the high end of the smartphone market, and building a larger iPhone is likely to do it. That said, the claims that customers are willing to pay a ton extra for a bigger/higher end iPhone may hold water, but it's not as "clean cut" as one might initially believe as there are multiple higher-priced tiers with the current iPhone line.

Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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