Is a Cheaper iPhone a Good Bet for Apple?

Apple Inc. (AAPL) is expected to release a cheaper version of the iPhone during 2011 to deal with growing smartphone competition. Apple may be working on a new low-end line of iPhones along with the existing line for about half the price of the standard iPhone line, according to various media reports.

The new device would get software service overhauls and would be about half the size of the iPhone 4, which would put the device more in-line with other mass-market phones, the Wall Street Journal said in a recent report.

Cupertino, California-based Apple primarily competes with Research in Motion Ltd. (RIMM), Motorola Mobility Holdings Inc. (MMI), and Nokia Corporation (NOK) in the mobile phone market.

Google Inc.'s (GOOG) Android OS-based smartphones have seen tremendous adoption growth over the past year, and the recent partnership between Nokia and Microsoft (MSFT) could pose another long-term threat to Apple.

On the face of it, cheaper iPhones should present the opportunity for Apple to sell more iPhones and further establish itself in the highly competitive smartphone market.

The move to offer cheaper iPhones should help Apple gain smartphone market share, but this could come alongside lower average pricing and reduced profit margins. iPhone constitutes 53 percent of our price estimate for Apple's stock, stock analysis from Trefis said to clients.

Bernstein Research believes that the possible introduction of a lower-priced iPhone is strategically important for Apple, and is surprised that the company hasn’t introduced a lower priced offering previously. The brokerage expects two potential approaches to a cheap iPhone: the iPhone mini and iPhone Touch.

Barclays Capital analyst Ben Reitzes believes a lower-end iPhone is inevitable, just like lower end iPods were inevitable once that category took off. While Reitzes is unsure about timing, it would make sense that Apple is working on prototypes within the supply chain with partners in case it needs to make its move.

With the iPod in mind, Apple has a clear history of creating new product category at the higher end, only to introduce lower-end products later. Getting iPhone price points below $100 (on a subsidized basis) makes sense to help Apple hold and/or gain share against Android.

The proliferation of phone market share would also enhance the halo effect on other Apple products and maintain its dominance of the supply chain, particularly when it comes to its NAND flash memory cost advantage, said Reitzes.

Like the expansion into the iPod mini and nano before it, Reitzes also does not believe that Apple is in the business of creating products that degrade its margins materially over the long-term.

Why iPhone Sales Matter for Apple

Apple’s smartphone market share has stagnated over the past few quarters, with Google’s Android making rapid strides and recently surpassing Apple’s iPhone in U.S. market share for the quarter ending November 2010, according to ComScore data.

ComScore found that 61.5 million Americans aged 13 and older owned a smartphone in the period, and 26 percent had an Android-based phone. Apple is in the third-place with a 25 percent share and the Blackberry maker RIM led the pack with a 33.5 percent share.

However, Trefis does expect an increase in iPhone’s global market share from around 3 percent in 2010 to 12 percent by the end of its forecast period of 2017.

Reitzes currently estimates iPhone units of 70 million in fiscal 2011 and 87 million in fiscal 2012, which now look very conservative in the short-term and long-term.

For the latest first quarter ended December 25, 2010, Apple sold 16.24 million iPhones, representing 86 percent growth from last year, and generated sales of $10.5 billion. As a result, iPhone accounted for 39 percent of Apple's total sales of $26.74 billion.

The cheaper iPhones could certainly help Apple target price-sensitive developing markets, where the company’s premium products may not yet have fully established a customer base.

In emerging markets, consumers are not used to buying mobile products with a contract from telecom carriers. Long-term contracts allow telecom providers to absorb premium pricing and pass subsidized pricing along to consumers.

This means that Apple’s premium products sold without contract are always priced much higher than its competitors offerings. Hence, the introduction of cheaper iPhones makes a lot of sense for developing markets.

Meanwhile, Trefis noted that if Apple is successful in emerging markets, it would boost its global market share to around 25 percent by the end of 2017 versus its current 12 percent base forecast. The move would also imply 60 percent upside to its price estimate for Apple stock.

Margin Factor

The cheaper iPhones could be available for half the price of standard models, according to a report from the Wall Street Journal.

The average iPhone pricing for 2010 was around $610, and although Trefis expects the pricing to decline to around $410 by the end of 2017, this decline could accelerate if the cheaper iPhones become a big hit.

Pricing cuts would therefore hurt profit margins on the iPhone. Apple generates over 50 percent in profit margins from iPhone sales. Since, Trefis already expects iPhone gross margins to decline to around 39 percent by the end of 2017, the reduced average pricing would add further pressure to this metric.

Meanwhile, there could be a downside of 25 percent to Trefis' price estimate for Apple’s stock if average pricing and gross profit margins both decline to half of their current levels, reaching $300 and 25 percent respectively by the end of 2017.

However, it is said that potential reductions in average iPhone pricing and gross profit margins would be more than offset by expected increases in iPhone sales.

iPhone Versus Apple Stock

Apple's stock movement is closely related with its product announcement. On Jan. 11, the stock reached a 52-week high of $344.96 after Verizon said it would begin selling a CDMA iPhone 4. Also recently, on Feb. 10 the shares touched a 52-week high of $360 after the Verizon iPhone went on sale.

We continue to believe that Apple's valuation is attractive and that the shares can benefit from strong iPad and iPhone 4 demand, Mac share gains, significant international expansion, and a pipeline of new innovations. We believe that with products like the iPad and iPhone, Apple is a major beneficiary of the 'Consumerization of IT', said Reitzes.

Apple stock closed Friday's regular trading down 2.16 percent at $350.56 on the NASDAQ stock market. The stock traded between $195.71 and $364.90 during the past 52 weeks.