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Margins Will Drive Apple’s iPhone 5S and 5C Outcome

publication date: Sep 11, 2013
author/source: RJ Towner

Apple (click ticker for report: AAPL) announced the release of its iPhone 5S and its even longer-awaited “cheap” iPhone 5C Tuesday, both of which we believe will be a big hit with consumers. The firm is also reportedly close to announcing a deal with China’s largest mobile carrier, China Mobile, which will help Apple sell even more units.

The 5C

Image Source: Apple

The iPhone 5C is one of the most anticipated products in Apple’s history, and not because people thought it would be the best product ever, but rather because it is believed to be Apple’s emerging-market solution. The phone will retail (unlocked) for $549, $100 below the price of the 5S.

The phone contains an internal steel construction and polycarbonate (plastic) encasing. The phone will also run iOS7, and it is roughly on par with the iPhone 5, technically speaking. Somewhat surprisingly, the phone will replace the 5 as the “middle phone,” with the 4S model becoming the cheapest iPhone on the market ($450 unlocked, free on most major US carriers).

In our view, the pricing signals that the iPhone 5 had a poor gross margin profile, but we do not believe the same can or will be said about the 5C. Though we do not have access to precise gross margins from the company (nobody does at this time), we think 5C's gross margin is better than those of the 4S—Apple’s previous highest-margin phone. And while we think the 5C won’t cannibalize too many sales from other iPhone versions, the margin profile/differential could make cannibalization a positive for total gross margin dollars, and thus profits.

Still, we fully expect skeptics to attack the 5C on the basis of its still-hefty price tag, arguing that the phone is not yet priced for emerging-market success. In any case, Apple has left a lot of room with respect to price (given our assumptions regarding gross margins on the phone), and introducing its first emerging-market solution at a $549 price level will make another one rolled out in the future at a lower price even more attractive. Apple has long been successful at gauging consumer psychology, and this could be the first step at preserving its brand as it eases into lower-priced solutions.

The 5S

Image Source: Apple

Apple also did a fantastic job with the 5S, in our view. Though the 4S and 3GS had incremental upgrades, neither really provided that much of an incentive to upgrade from the 4 and 3G, respectively. The 5S is clearly superior to the 5, making it more likely that consumers opt to upgrade early or sell previous models to pay for the 5S.

By adding a fully functional fingerprint scanner to grant access, the 5S immediately becomes more attractive to enterprise customers that may fear phone theft and information breaches. This also hurts Blackberry’s (click ticker for report: BBRY) reputation as the leader in phone security.

Additionally, Apple has come out with its A7 processor for the iPhone 5S, giving the smartphone computing power on-par with a desktop computer and similar battery life to the 5. This chip allows the phone to have more realistic graphics for mobile gaming and better picture capture. The chip is probably an underestimated development as Apple could now become a more prominent player in video gaming. We believe it’s even possible that the firm may be planning to get into the console wars at some point.

The iPhone 5S will also have a new M7 chip. The chip sounds like a tremendous value-add to the iPhone ecosystem. Here’s Apple’s own description:

“It’s designed specifically to measure motion data from the accelerometer, gyroscope, and compass — a task that would normally fall to the A7 chip. But M7 is much more efficient at it. Now fitness apps that track physical activity can access that data from the M7 coprocessor without constantly engaging the A7 chip. So they require less battery power.

M7 knows when you’re walking, running, or even driving. For example, Maps switches from driving to walking turn-by-turn navigation if, say, you park and continue on foot. Since M7 can tell when you’re in a moving vehicle, iPhone 5s won’t ask you to join Wi-Fi networks you pass by. And if your phone hasn’t moved for a while, like when you’re asleep, M7 reduces network pinging to spare your battery.”

It is clear that the M7 lays the groundwork for the iWatch, particularly since it is designed to track movement while consuming less power. Historically, Apple has loved to tease users with potential new products, and this may be the first hint we receive that the iWatch is real. More importantly, it may suggest that the iWatch’s battery life exceeds that of the ill-fated Galaxy Gear smartwatch.

With this load of upgrades, plus an improved camera, we believe Apple has successfully maintained product differentiation between the 5S and the 5C. There’s no doubt that the 5S is the superior product, but the 5C is no slouch either.

Valuentum’s Take

When it comes to Apple, it can be hard to draw a distinction between what the finance community and what the average consumer thinks. Investors are constantly viewing blogs, reading rumors, and essentially getting information about Apple products before the general public. This doesn’t mean that Apple is “out of surprises” but rather it signifies how badly the investing public and Apple fans want information about Apple products before Apple reveals them.

For many consumers in the US, purchasing an iPhone every 2 years isn’t a decision, but rather an afterthought. We think demand will continue to be strong for the iPhone, and we think the 5C and 5S carry stronger gross margins, which will help reaccelerate Apple’s earnings expansion. The less expensive 5C and 4S could also be what are necessary for the firm to improve its performance in emerging markets like China without diluting the Apple brand. 

Both phones also come with colorful cases that should fit the phone perfectly since the cases are made by Apple. These cases aren’t expensive ($29 for the 5C and $39 for the 5S), but likely carry robust gross margins as well, helping the company take some of the revenue away from case designers that have made fortunes of the iPhone in the past. With margin upside possible in the near term, we continue to hold shares of the firm in both of our actively managed portfolios.


RJ Towner owns shares of the following companies mentioned in this article: AAPL

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