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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Thursday, March 5, 2009

Apple Inc (AAPL): Examining the Prospects of a Low-Cost iPhone

Apple Inc (nasd:AAPL) For some time, many have speculated about an arrival of a $99 iPhone. Some analysts expect a low-cost model with scaled back features, such as 2.5G instead of 3G, no GPS, and possibly a smaller form factor. While I believe a lower iPhone price point is possible, I don’t expect Apple to go backwards by removing features that reduce device functionality to achieve a lower-cost offering. The price of the handset is much less significant than the lifetime cost of the required $30/month data plan. Therefore, crippling device functionality to lower handset price makes no sense when the primary cost component is the data plan.

I believe if Apple were to pursue reducing the price of the iPhone to the consumer, it should first explore offering alternative pricing that doesn’t necessarily lower selling price and margins. Offering cheaper data plans that coincide with less usage would allow consumers to be able to pay according to usage, rather than being required to pay for unlimited when their usage is actually quite limited. Carriers would apply less subsidy and charge more for the handset, yet consumers would still save over the life of the contract. Carriers would still benefit from increased demand even though ARPU may not be quite as high. Carriers could capture the iPod touch demand that arrises from those who wish to avoid the required data plan.

Low-Cost Model With Less Features- Unlikely:
While unit demand increased dramatically from previous price reductions, ($599 - $399, $399 - $199), I don’t expect unit demand to be nearly as responsive to a $100 price reduction, from $199 to $99. At this price level, demand elasticity begins to evaporate, as consumers are less responsive to further price cuts. At $199, the iPhone is competitively priced, opposed to when it was priced out of the market at $599. The bulk of the pick-up in demand from cutting handset price has already been realized.

Reducing hardware cost is another challenge. Eliminating or scaling back certain features through cheaper or fewer components won’t significantly impact build costs. The obvious modifications that many have cited are removing GPS, 3G baseband, and installing less flash memory for media storage. These actions would likely only lower component cost by $15-$20. Additional cost reductions could be brought about with a smaller form factor, however the savings wouldn’t be great enough to offset the burdens it would create on the software development side.

Perhaps the most crucial aspect is it’s the cost of the service plan, not handset, that is the most costly. The iPhone requires signing a 2-year contract for the $30/month smartphone data plan. Over the life of the agreement, this amounts to $720. For those who currently have a $15/month data plan for a non-smartphone device, the incremental difference over 24 months is $360. However, AT&T offers a bundled unlimited text & data plan for non-smartphone devices for $30/month, instead of $35/month ($15 data + $20 text), which raises the monthly price difference to $20, or $480 over 2 year contract for those affected customers. AT&T subscribers who use a smartphone other than the iPhone wouldn’t pay more since the price of the data plan is the same as the iPhone.

Lowering the iPhone handset price by $100 accomplishes little in the sense of affordability due to the $720 24-month cost of the required data plan. I frequently track online discussion forums (such as AT&T iPhone support) as an informal survey tool. The amount of discussion regarding the iPhone handset price pales in comparison to the required data plan. People tend not to have any problem with the $199 price, but are very vocal about the recurring $30/month for the data plan. In fact, there have been a couple individuals who weren’t adverse to pay $399 since they weren’t eligible for an upgrade, but were inquiring if there were a way to circumvent the data plan requirement. There is little evidence suggesting a $100 price drop will have a profound impact due to the large number of consumers who find the data plan requirement inhibitory.

Reducing the data plan fee, or eliminating the requirement altogether, would have the most substantial impact on demand. The problem with this alternative is that Apple receives a ~$400 subsidy based the higher ARPU generated by the data plan. Therefore, if the iPhone ARPU were to decrease from reducing the price of the data plan, then the iPhone subsidy would decrease as well.

Assuming that hardware costs can be reduced by $50, and the subsidy falls to $200 from $400, gross margin would decline to 33% from 58%. In order for earnings to increase, unit volume would have to rise by a factor of 3.5x.

Assuming a more generous subsidy of $250, perhaps with required $10/month plan, gross margin would only fall to $43%, but volume would have to increase more than 2.3x.

A scenario where a $20/month data plan produces a $300 subsidy, gross margin would only drop 800 bps to 50%, and volume would only have to rise 75% to be cash flow neutral. However, consumers still face an incremental $480 increase from the data plan, which will limit the impact on demand.

Even if the economics of reducing hardware and service costs were to make sense, there are other issues. Crippling device functionality takes away from the user experience, which is the primary focus of Apple products. Substituting 2.5G would significantly worsen web browsing and video streaming.

The tests I have been conducting show iPhone 3G data speeds are currently 7-8x faster than 2.5G. In the months following the 3G iPhone release, speeds were only 2-3x faster than EDGE. Obviously, AT&T has made substantial progress in improving its network, which significantly enhances the iPhone user experience. With many competing devices beginning to offer 3G, a slower iPhone might damage consumer perception and lessen its appeal. The iPhone is designed for heavy internet usage, thus a much slower connection would dramatically lessen the iPhone experience. This move would probably only save $5-$10 in hardware costs.

Removing GPS would only save ~$5 in component costs as iSuppli lists the price of the GPS radio at $3.60, and the impact on user experience would be considerable. Many apps are designed around the user’s current location, which requires GPS to obtain an accurate position. The integration of location services with other iPhone features is a major factor that differentiates the iPhone from other devices. Therefore, without any real cost benefit, offering a model without GPS makes no sense.

Altering the form-factor is another alternative for reducing costs. A smaller device could reduce hardware costs to a degree, yet it would require a relatively large size reduction to meaningfully affect hardware cost. This would pose several challenges. Apps are developed for a specific display size, thus duplicate versions may be required to accommodate different displays. The challenge may be further exacerbated due to input commands being handled by the multi-touch display. Therefore, modification may be needed not just for output, but input as well. In addition, a smaller viewing area would reduce the user experience, and a smaller area for input commands may cause navigation to suffer. To achieve meaningful savings, the handset size would have to be reduced to a point at which the user experience would highly suffer.

I don’t believe there should be any change to the iPhone hardware since potential cost savings are rather insignificant. The only exception would be offering 2.5G models in markets where 3G is unavailable as long as it were accompanied by a cheaper data plan. This might help spur demand in non-3G markets where consumers must pay $30 for 3G service and aren’t even able to take advantage of the faster speed.

Possible Alternatives:
The best course of action would be to offer multiple data plan choices, and adjust the handset price accordingly by applying less subsidy. The consumer would have to pay more on the front-end, yet would save money over the 24 month agreement. A cheaper data plan results in less handset subsidy which would be absorbed by the consumer. Thus, it wouldn’t affect the economics of the iPhone with respect to Apple, yet it would provide flexibility for consumers. If a particular individual plans to use very little data, then he/she could select a cheaper plan with less data usage included. They would pay more for the handset, but would still save money over 2 years from the cheaper monthly cost of the data plan. The savings will come at the expense of AT&T, yet it’s not a real expense, rather the opportunity cost of not receiving $30/month for the unlimited data plan. However, this could be offset (or overcome) with sufficient increase in demand.

A scenario with a $10/month data plan would raise the handset price to $349, a $150 increase, but reduce lifetime service fees by $480. Including the price increase of the device, net savings over 24 months is $330. A second scenario with a $20/month plan for heavier data usage would increase the iPhone price $100, to $299, but lower service fees $240 over 2 years, resulting in net decrease of $140. If an individual pays the extra $100 for the cheaper $20/month plan, and later decides he/she needs the unlimited data plan, the carrier could offer a $25/month instead of $30/month since $100 was collected on the front-end. If one wanted to switch to a smaller data plan, then the handset discount could be recovered from lowering the monthly fee by less than the full amount.

There is one scenario of a low-cost model that I do think is a possibility. Bernstein Research’s Toni Sacconaghi has broached the idea of an “iPod phone” which makes a lot of sense. The premise is that music is moving onto many basic mobile phones which may pose a threat to iPod sales. The concept of a converged device means that users won’t prefer to carry both a phone and an iPod. For those who don’t want an advanced phone with internet capability, such as the iPhone, but want a media player combined with a basic mobile handset, an “iPod phone” would be a suitable match. Essentially, a iPod classic or nano could be married with a basic mobile device that wouldn’t require a data plan. Possibly, it may offer some “widgets” such as stocks and weather, but not email or internet browsing. The sole purpose would to counter iPod defection from those using their mobile phones more and more as a music player. I don’t foresee such a device anytime soon, however it remains a viable possibility down the road.

I do believe a $99 iPhone is inevitable. However, it wouldn’t be a “low cost” model, rather Apple could offer the current iPhone model for $99 in light of an introduction of new advanced models. I expect new iPhone models to arrive this summer, which will have faster processors, and advanced graphics chips that will allow multiple apps to run simultaneously and video capability. There has been an un substantiated rumor that AT&T might buy back iPhones since current 3G owners would be ineligible for a subsidy on a new iPhone model if one were to come this summer. These phones could be sold for $99 or less. AT&T has been running deals for $99 on refurbished iPhones.

Apple’s iPhone Vision:
Management has stated it doesn’t intend making an iPhone for everybody. Apple says it isn’t interested in selling the most units, but rather committed to being the leader in the market segment it prefers to serve. Comments from Apple contradict many pundits and analysts that claim the firm is limiting the iPhone’s potential by addressing such a small portion of the overall mobile handset market. However, Apple is a company that demonstrates patience. Steve Jobs once said rather than crossing a river to get to someplace else, Apple waits for the other side of the river to come to it. The smartphone market is growing considerably, thus there isn’t much reason to stoop down into the basic handset market that will be contracting.

Disclosure: Long AAPL


pats said...

I don't think ATT will change their data rates until they are forced to due to competition. That said as long as the big players charge the same for similar products then all Apple must do is provide better value. The device subsidy in my mind just allows the consumer to finance the phone on a 2 yr plan. What drives Apple's ability to negotiate a higher subsidy is its ability to increase the ARPU and also attract users from other carriers. As long as the 3G capacity is not exceeded. The added cost per user for ATT is minimal. But as we have witnessed in places like NY or San Fran. The Iphone overwhelmed the existing cell network architecture and is a much larger user of 3G data capacity. I would expect over time the Iphone subsidy will drop, but at that point Apple will offer the phone via all carriers. ATT is paying for exclusivity. If this years pricing strategy for computers is any indication, I would expect a new model on the top end with the low end (current 3G Iphone remaining basically the same with reduced price). I just don't see any major change in existing functionality at the low end. I agree with your thoughts on reducing hardware the only component which might get removed on a low cost design in my mind would be the 3G. Qualcomm use to get 5% of handset net cost in royalties for 3G so going with an GSM/Edge/WIFI phone for Russia/China/India/rural America etc. makes sense if it allows for a lower overall cost.

Ankit Gupta said...

I don't like the idea of a lower cost iPhone because as you pointed out, volume would have to significantly ramp up to maintain the same cash flow.

Also, as you said, the cost of the device isn't what gets people, it's the data plan. I know many people that are fine with paying even $400 for a phone if the data plan was cheaper.

Personally, I would be very disappointed in Apple if they were to remove features to offer a lower cost iPhone. The whole idea of technology is to take steps forward, not steps backward, and the features that we think they could cut out are ones that add a lot of value to the phone itself.

I don't expect to really see any changes from Apple in terms of the hardware on the iPhone other than maybe the camera, memory storage, and processor, but those are just sustaining updates (Read The Innovator's Dilemma) and nothing to change the game. The software is a different story though and I actually do expect some major changes to happen, it can definitely be improved a lot. (Not that it isn't great already... there are some aspects that have a lot of potential that hasn't been tapped yet)

It'll be interesting to see how the iPhone sells in other countries and what they do to sell it there in terms of the data plan, cost of device, etc. once it really gets market share across the globe.

Did they ever reach a deal with the company in China? I remember there were issues with who would get to operate the App Store and that's not something Jobs would let someone else handle, and I fully agree with that, it's just a matter of time before they give in and agree to do this on Apple's terms.

KC said...

They should allow those people adverse to a data plan to buy a pay-as-you-go phone. Obviously, it would be unsubsidized. I believe the original EDGE iPhone had this possibility if you punched in a fake SSN at signup. I vaguely recall Glenn Fleischman of Tidbits going this route as he didn't need a cellphone with regular monthly minutes.

As far as offering an iPhone downgrade, like Turley, I'm opposed. There's not many cost savings in mfring an old EDGE phone to make it worthwhile. However, it might be worth it to explore the option of just having an EDGE plan available for those who aren't living in a 3G area, or who don't feel they need 3G as they have lots of wifi networks around.

Interestingly, I have a 3G iPhone, and I'm on a $20 EDGE plan, but I get 3G when I'm in a 3G area. I'm not sure how it happened, but perhaps it was due to the fact that when I signed up, there wasn't a 3G area within 100 miles of me. Anyhow, now 3G is right around the corner from me, and I'm still on a $20 EDGE plan with my 3G iPhone, with 3G speeds when available. I'm happy.

Ankit Gupta said...

@KC - Why a pay as you go plan and not just a monthly $10-15/month plan?

With $10-15/month, the cell providers still have some reason for subsidizing the phone apart from exclusivity, and they get their contract put in place that they love so much.

Anonymous said...

All speculation surrounding the prospects of reducing the cost of owning an iPhone have been focused on reducing the initial cost of the hardware itself or reducing the cost of the data plan.

There is another possibility that I have not heard mentioned, likely because it has been assumed that it is a requirement. That possibility is to eliminate the "phone" component and charge only for data.

Personally, my needs are primarily data, with only an occasional need for phone use.

I would like to see a contract that offered data use only and no conventional "phone" usage fee. That would have the potential to knock about $50.00 per month off ATT's monthly phone bill. This would be much more effective in inducing me to get a "data only" iPhone.

I have a phone contract with Verizon which provides for free phone calls with any other Verizon user. As my family all use Verizon, my kids friends all use Verizon, my employer has a contract with Verizon and consequently all fellow employees use Verizon, so most of my calls are with individuals that use Verizon. My existing monthly costs for 5 phones is about $120.00, which AT&T will never be able to match with an iPhone.

This would require me to carry two devices, but I am willing to do that as I would be choosing to separate out the plans to save costs.

Personally, I think there is more opportunity for growth with this approach, but is likely to be constrained by contracts as long as AT&T is involved with Apple.

Ankit Gupta said...

You know, that's an interesting thought. I like it.

My spin on it would be to some day sell internet access for your home and portable device(s) into a single package. Imagine a user with a laptop and a cell phone. The idea is that he pays maybe $30/month and that gets him data on both his laptop and cell phone.

In 2 years or so, as the Intel Atom makes steps forward, they will have WiMax, LTE, 3G, etc. integrated into the chipset and so we'll see more of it then. It'll also take having more wireless choices built into laptops, but again, give time, I think we'll see it much more.

In general, there is something that should be done with the data plan, and it might not be by lowering the price, but rather finding a way to give the consumer more value.

The one thing this does is increase wired internet connection competition by letting people get it over a wireless network, but the networks can't really handle that much bandwidth yet to take over the load from the wired infrastructure.

Anonymous said...

Great job on AAPL outlook.....

fatalbert said...

Hey Turley, I don't know where to email you instead of just posting a comment on a topic that is irrelevant to my question. Anyways, good job on getting aapl Q2 just about perfect. I have a few questions with regards to how you estimate apple's OI&E. I know what figures apple uses after they report just not before. I know they use cash and cash equivalents (end of period) at what ever the average weighed percentage was for the quarter.... example, March quarter cash/equiv was $4.466 Billion at 1.53% giving them the 68 million. I guess they had 5 million in expenses somewhere to make it $63 million? From quarter to quarter this cash number changes so much like December quarter it was $6.820 billion. How do you try and estimate that figure? Also as far as what they are invested in with short term securities, how do you estimate at what rate they will receive? Do you use an index to best try and guess? Like the one-year MTA treasury index? Also is that 1.53% they made on their cash last quarter, actually derived from a 6.12% Annual rate from all securities? If you can explain how you find OI&E I would appreciate it as I am trying to learn this with the help of others and have no formal financial accounting background. Thank you.

Turley M Muller said...

Fatalbert- you can email- turleymuller me,com

I'll get you an answer for this, I walking out of the house, but the short answer, at these low rates, I just pretty much go by guidance since not worth time when it really won't improve accuracy because the variance is so low. My OI estimate was 10M off or little more than a penny a share. But it will become important rates go back up

Sierra said...

This is very informative. You managed to include good points!

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