Apple (AAPL) could surprise the market, analysts, and customers by launching a flagship iPhone at one of the cheapest price points in its history. It has focused on improving the average selling price, ASP, in the last product cycle through pricey iPhone X and big price jump for iPhone 8. However, this has had a negative impact on its unit shipment growth.

It has also led to greater sales fragmentation because customers have opted for lower-priced, older models. In order to improve its addressable market and improve its ecosystem, Apple could launch the basic iPhone at sub-$650. Eventually, it would need to balance the need to expand ecosystem and unit shipments against margins.

Source: CIRP

Benefits of opting for a lower base price

In the past two years, the smartphone market has seen substantial changes. In markets like China and Europe, there has been an increase in the market share of major Chinese players like Huawei, Xiaomi, and BBK group (Oppo/Vivo). These companies have tried to entice more customers in the mid-price segment of $400-600 with better specs and design. Apple sells its older models in this range which have to compete with many of the flagship models of its competitors. This has led to major headwinds for Apple in China and other territories.

Apple still has a stranglehold in the premium segment through its iPhone X, which has outsold other phones in this category. But it also needs to address the challenge faced in the mid-tier segment. According to Bloomberg report, Apple will come out with three iPhone models. One of them will be a successor of iPhone X sporting a 5.8-inch display and another iPhone X Plus with a 6.5-inch display. The third iPhone, let’s say iPhone 9, will have a 6.1-inch display.

The iPhone 9 model will have an LCD screen instead of OLED screen which will be available for other two models. This option alone reduces the bill of materials by $80, according to IHS Markit breakdown. The basic model will not have Apple’s 3D Touch feature and have a single rear camera. However, it will have an edge-to-edge screen and facial recognition, which are highly appreciated by customers across all regions. The edge-to-edge screen could push more customers to upgrade their older models.

Another big issue faced by Apple in this cycle was sales fragmentation

In the previous iPhone cycle, the flagship models cornered over 80% of the total sales. However, in this cycle, the share of the three flagship models is barely over 50%. Customers have been opting for older, lower-priced versions of iPhones in greater numbers. Ideally, Apple would like the flagship models to make a significant portion of total sales as these models provide the best margins and ASP.

By lowering the base price of iPhone 9, Apple would be able to reduce the models available. It can discontinue all previous models and keep just an optional iPhone 8 at a more subsidized price. There are already reports that this model will be in the price range of $600-700. I believe going under $650 mark would be a necessity for Apple if it is serious in expanding its ecosystem and transitioning into a bigger Services revenue base.

Margins over ecosystem

Apple has a huge pricing power over its competitors as shown by iPhone X. It also does not have to go for a race to bottom pricing strategy. However, Apple does not function in a vacuum. We can see this from its HomePod pricing. Most of the customers think that HomePod is an expensive smart speaker. HomePod’s pricing is actually very low compared to the margins made by Apple on other products. HomePod’s bill of material, BOM, was $216, while it retails for $349. This means BOM makes 62% of the retail price. On the other hand, an iPhone 8 has BOM of $247.51 compared to retail price of $699. Hence, BOM is only 35.5% of the retail price.

Apple wasn’t able to have a higher retail price because of the domination of this market by Amazon’s (NASDAQ:AMZN) Echo and Alphabet’s (NASDAQ:GOOG) (NASDAQ:GOOGL) Google Home. According to recent reports, Apple is now considering lowering the price of its HomePod. This shows that Apple needs to actively change its pricing strategy to reflect the change in the competitive environment.

There has been a substantial shift in competitive landscape in the smartphone segment due to rapid growth of Chinese OEMs. In the U.S. market, there is less competition because of a regulatory bottleneck for Huawei and other companies. But we need to consider that Apple made only 42% of its total revenue from Americas region in the last fiscal year. Besides the benefits of a lower priced iPhone 9 model mentioned above, Apple needs to make sure that the pricing of new iPhone reflects the increased competition.

Apple’s Services segment is heavily dependent on the market share of iPhone. Apple’s management is already focused on rapidly increasing the Services segment by building a much stronger ecosystem. This is possible only if Apple is able to grow the market share of iPhone through decent jumps in unit sales shipment. A $649 or even $629 base iPhone model could provide the requisite impetus for customers to upgrade and also attract more customers from Android base.

iPhone 8 had a BOM of $247.51 which was $9.57 higher than iPhone 7. If Apple maintains a similar jump in BOM for iPhone 9, it would come at $257.08. A retail price of $629 for iPhone 9 will increase the BOM percentage to 40.8% compared to the retail price. This would be significantly higher than iPhone 8 which came at 35.5%. Apple has already seen its operating margin fall for the past 11 quarters. A big reduction in margin from the biggest revenue contributor will be a further headwind for the company.

Hence, Apple’s management will need to walk a tightrope between expanding its ecosystem and the negative impact on margins. From a long-term perspective, ecosystem easily trounces short-term margins. This can certainly push the management to increase unit sales shipment through aggressive pricing of iPhones in the next cycle.

Investors should note the possible impact on margin as Apple’s management tries to deliver better unit shipment growth.

Investor takeaway

Apple’s next iPhone cycle will determine the future direction of its ecosystem. Apple could still deliver a super cycle through aggressive pricing of its base model. This model could have a pricing under $650 and still boast off edge-to-edge screen and facial recognition. A double-digit unit sales growth should go a long way in improving the bullish sentiment for the stock. However, it would also be important to see the margin impact due to this pricing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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