The Cheaper iPhone is good for Apple (Nasdaq:AAPL), Here’s Why

by David Eller

The latest Apple (Nasdaq: AAPL) rumor is now a low priced handset ($99?) that will be released in emerging markets where a $600 phone would not gain traction with the public.

Unlike the rumors of an Apple-branded television which made the stock price go up, this announcement put pressure on the share price due to margin concerns. There are a few different issues underlying this rumor though that should be addressed individually, but the announcement will benefit shareholders in the long run.

The one thing to remember is: as investors, our biggest focus is profit growth. Whether the company sells handsets or hand lotion, it doesn't matter.

The Good

Did Apple need to maintain market share?

Some pundits are claiming that Apple needed to make this move on order to maintain its handset market share. Whether you are selling applications and content to a PC owner or a smartphone owner, the platform can, in time, generate more than the cost of the handset. This would be a very good reason to aggressively pursue a high profit market but emerging markets have been focused primarily on feature phones making this argument less likely. This probably isn't the reason that Apple pursued this course but it's a side benefit.

Are operating margins too high? Apple has a 35% operating margin meaning that for every dollar of sales Apple brings in, it retains has a $35 to reinvest in the business. This is a huge number for a company that sells hardware. The bill of materials for a handset is in the neighborhood of $200. The sale price is widely believed to be around $600. So, to have a blended margin at 35% is a remarkable feat. If Apple charged less for its phones, it would probably have more demand. But right now the company is constrained by the materials it has to buy rather than demand. Apple probably isn't trying to improve demand. As for one TV commentator saying that "Apple's margin is too high for its own good"… that's just stupid… You can't be too rich and high margins are good. Happily, they are likely to stay here.

The Bad

That being said, there will be some margin pressure. As the handset ramps in volume, it will pressure the overall iPhone margin but this pressure will be nominal and is more than offset by the benefit of profit growth. In my opinion though, margin levels in isolation just don't matter. Profit growth does. If I buy stock in a company, it's because that company that has an increasing amount of cash to reinvest in the business or to distribute to shareholders. The margin level is an indicator of profit growth - but just an indicator. Sadly, analysts and commentators like to create controversy and focus on the details rather than the big picture.

The Ugly

Will the stock go down from here? Probably, but not for a good reason. I can't predict the day-to-day movements of stock prices. The only people who can consistently make these predictions have the buying power to cause the market moves. So as small investors, we need to be focused on the fundamentals rather than the hype about future earnings growth rates. Short term, there will likely be increased volatility. The stock might retest the $500 level but the long-term direction of earnings is up.

Will a cheaper iPhone find its way into the United States? This is the bear case, because if it does, profit margins of existing product lines will be pressured. If a cheaper iPhone exists, AT&T (NYSE: T)and other carriers will want to offer it to its customers. It's crazy to think that cash strapped carriers offering handset subsidies will be content being limited to the higher end models. But this concern is not going to impact earnings estimates today or even this year. This is probably a 2014 issue.

Tim Cook, for all his faults, is a good operator. It's clear that he doesn't consider the short-term impact of his actions by apologizing for the weak maps product or putting up a slide at the analyst day that tipped off missing unit shipments in the September quarter. He is, however, a good manager that sees through the issues permeating CNBC and trade publications over the last two days. Profit growth will go up if yesterday's rumor turns out to be fact. The one thing to be concerned about is the cannibalization of existing markets and product lines. I love my iPhone and don't see myself moving from the Apple ecosystem, but I'd rather pay less for it.

Good Investing,

David

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