Apple’s iPhone Problem

by Brad Moon | January 18, 2013 8:00 am

Apple‘s (NASDAQ:AAPL[1]) amazing growth has come on the back of several key developments, starting with the return of co-founder Steve Job in 1996. Soon after, its computers (the iMac, iBook and PowerBook) began giving Apple new oomph, which only increased with the introduction of the iPod.

However, it’s the iPhone that has provided the rocket fuel for Apple’s historic rise over the last three years. The iPad has helped, but the iPhone is the big one.

Now, it looks as though the competition has figured that out — and Apple may have a problem. If so, ripple effects could mean Apple stock not only fails to recover to its 2012 peak (and all-time high) of $705, but it could slide further in 2013. Some analysts are considering the possibility of AAPL hitting $440.

The challenge Apple faces is that its iPhone strategy has always been to release a premium product, at a premium price that supports extremely high margins. While other smartphone makers struggled to make money selling budget models to the masses, Apple’s iPhones were the “must-have” device. And with carrier subsidies helping to sooth the burn of that steep price, the iPhone became Apple’s virtual license to print money.

This approach has worked so well that Apple reached the point where it received 75% of all smartphone profits worldwide[2], while selling only 9% of the phones.

Consider its latest model, the iPhone 5. According to GigaOM, the base model 16GB iPhone 5 costs Apple $207 for parts and manufacturing. It then sells that phone for $649, resulting in a very tidy 68% profit margin[3]. Boost the storage, and it gets even better: The 64GB iPhone 5 costs $238 and retails for $849, increasing that margin to 72%.

Those iPhone profits have become incredibly important to the company, far eclipsing the computers that were Apple’s bread and butter a decade ago. In the last quarter, the iPhone accounted for 48% of  total revenue[4], or $17.13 billion.

Unfortunately for Apple investors, the iPhone model is showing cracks.

One of the takeaways I noted from this year’s Consumer Electronics Show (CES) was the proliferation of premium smartphones[5]. It’s not just the established contenders like Samsung or the also-rans that have switched gears and come charging back with a compelling products — like Sony (NYSE:SNE[6]) and its Xperia Z. Chinese companies like ZTE are preparing to enter the U.S. market. Nokia (NYSE:NOK[7]) is making some strides with it’s flagship Lumia 920 Windows Phone 8 smartphone, and even left-for-dead Research In Motion (NASDAQ:RIMM[8]) is on the verge of releasing a brand new mobile operating system (BB10) and new flagship smartphones.

Add in Google’s (NASDAQ:GOOG[9]) Skunk Works project with its Motorola division, the so-called “X-Phone”[10] that’s directly targeting the iPhone, and the message is clear: Apple is facing more competitors than ever in the smartphone market in 2013, and this time they’re coming at the iPhone with high quality, premium models[11] instead of chasing budget-conscious consumers.

This might less worrisome to Apple investors if the company released new iPhones that blow away the competition, but that’s not the case so much now. The first iPhones were head and shoulders above everything else, and even the iPhone 4 had a real competitive advantage. But the past two years have seen Apple falling into a cycle of incremental upgrades.

There’s nothing wrong with the iPhone 5. It’s an improvement over the iPhone 4S, and it’s certainly one of the best smartphones available. But the gap between it and competing smartphones has been closing.

Rival mobile operating systems are improving, and the hardware specs for other smartphones — from CPU speed to camera capability and display size (and resolution) — are beginning to eclipse the iPhone. Design is getting better too, and other manufacturers are incorporating high-end materials like aluminum and glass instead of cheap plastics.

This makes it tougher for Apple to justify its lofty prices and huge margins. Adding to the problems, the trend for iPhone owners or new buyers to trade-up or grab the flagship iPhone by reflex is also faltering. According to BGR, in the month after its launch, the iPhone 5 made up 68% of all iPhone sales, while discounted older models like the iPhone 4S were still selling well[12]. In comparison, when the iPhone 4S was released, it took 90% of iPhone sales.

We’re already beginning to see the results of increased competition through iPhone 5 sales that are softer than Apple anticipated. Reports over the weekend said Apple had slashed iPhone 5 component orders by 50%. Although subsequent clarifications point toward a less drastic cut[13], the reduction is still substantial and likely indicates lower-than-expected demand.

On Wednesday, Business Insider reported that analysts from Pacific Crest were downgrading their call on Apple, pointing to saturated smartphone and tablet sales and calling out Apple on its incremental hardware improvement[14] strategy. They’re setting a price target of between $440 and $550 for AAPL over the next year.

If Apple goes after the Chinese market in a big way with a cheaper iPhone as rumored[15], or it it follows its recent pattern by releasing an iPhone 5S or iPhone 6 this year that’s merely an incremental improvement over the iPhone 5, those profit margins will be under further pressure.

Consumers vote with their wallets, and Apple may have to either lower prices or accept lower volume. Either outcome means no blockbuster quarters like last year’s.

In the face of real competition for the premium smartphone market, Apple needs to step up its game and go for revolutionary instead of evolutionary if it wants to maintain the revenue and profit growth levels that drove its 2012 run.

Or find some entirely new segment to disrupt.

As of this writing, Brad Moon didn’t hold a position in any of the aforementioned securities.

Endnotes:
  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. 75% of all smartphone profits worldwide: http://news.cnet.com/8301-13579_3-57371790-37/iphone-soaks-up-75-percent-of-all-mobile-phone-profits/
  3. resulting in a very tidy 68% profit margin: http://gigaom.com/2012/09/25/improved-iphone-5-less-expensive-to-make-than-iphone-4s/
  4. In the last quarter, the iPhone accounted for 48% of  total revenue: http://www.nytimes.com/2012/10/26/technology/apple-profits-rise-24-on-iphone-5-sales.html?_r=0
  5. proliferation of premium smartphones: http://investorplace.com/2013/01/ces-2013-microsoft-wont-leave-premium-smartphone-market-gets-bigger/
  6. SNE: http://studio-5.financialcontent.com/investplace/quote?Symbol=SNE
  7. NOK: http://studio-5.financialcontent.com/investplace/quote?Symbol=NOK
  8. RIMM: http://studio-5.financialcontent.com/investplace/quote?Symbol=RIMM
  9. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  10. the so-called “X-Phone”: http://www.informationweek.com/byte/personal-tech/smart-phones/googlemotorola-x-phone-tries-to-push-tec/240145250
  11. high quality, premium models: http://techcrunch.com/2013/01/11/sony-may-kiss-low-end-smartphones-goodbye-to-better-compete-with-samsung-and-apple/
  12. iPhone 4S were still selling well: http://bgr.com/2012/12/03/iphone-profit-margin-analysis/
  13. subsequent clarifications point toward a less drastic cut: http://bgr.com/2013/01/15/iphone-5-order-cuts-displaysearch-292077/
  14. incremental hardware improvement: http://www.businessinsider.com/pacific-crest-were-downgrading-apple-2013-1
  15. cheaper iPhone as rumored: http://news.msn.com/rumors/rumor-apple-to-release-dollar99-iphone-this-year

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