Note on cheap iPhones

Ever since the iPhone launched, people have been pointing out that it is very expensive, relative to the rest of the market, and wondering when, and how, and if Apple might go cheaper. Much like the 'Apple television', this is a story that's so old people have got very bored with it, but that doesn't mean we should forget it. 

First, a recap.

Apple's phones start at $400 and average $550-$600 where the average for phones globally is about $180 and the average for Android is $250-300. Apple's sales are entirely high-end. This has taken it to around 10% of all the phones sold on earth each quarter - it appears to have about half to two thirds of the high-end segment, with Android (mostly Samsung) having the rest. However, the bulk of Android's sales are actually at lower prices: hence Apple has 10% of sales and Android has another 10% selling at the high end but a further 40% selling at lower prices. Windows Phone and Blackberry have 2-3% and the rest is feature phones, which are converting to smartphones at prices under $100, which means Android. 

This difference between market share and pricing is, incidentally, the reason why the iPhone has 10% of handset unit sales but a third of revenue, and why the iOS app store has two thirds of app store revenues.  

So, maybe 20% of the phone market is premium, of which Apple has half, and 40% (say) is at $100 or lower and still mostly featurephones (though within that there's a lot of people trading up from lower prices). But there is a lot of debate within the industry about how the space in between plays out. The narrative generally splits the market into four rough segments: 

• $50-100 smartphones: currently these are dominated by companies you've never heard of using off-the-shelf chips from Mediatek, Spreadtrum and others, and though they run Android and have 3G they often have only 256 meg of RAM, which makes for a pretty poor experience. And the build quality and screens are not great. 
• $100 to (say) $200 - this is where the branded companies start playing. At this price devices like the Lumia 520, the Xiaomi Hongmi and the Motorola X provide an experience that you would not, actually, be unhappy with. I describe these phones as like driving a Toyota or a VW: you know you're not in a BMW (or a Bentley), but there's nothing wrong with them at all and some of them are pretty cool. 
• Then, $200-450 (or thereabouts) counts as mid-range, and 
• $450-500 and up counts as premium. Arguably there's a super-premium segment further up. 

One can debate where I've drawn the price bands, but the point is that there are different tiers of experience. One of the big debates in the industry is how viable the third category is. Do people who bought a $400 phone two years ago decide they can get something better for $200 now? Or do they decide to upgrade to $600? Do people move up into this segment from below? Do people who bought a $500 phone two yeas ago move down into this category? (Since these people are by definition less price-sensitive this seems less likely). 

So.

When people talk about whether Apple should do a 'cheap phone', it's important to be clear about which of these segments you're really talking about. When people say 'Apple is missing out on the next x billion people' - that is, the portion of the market that's still on feature phones - they're actually talking about the first category. Even Samsung doesn't really play here, nor Xiaomi. This is is the land of the $200 PC - very low margin commodities with a poor user experience. 

However, the second and third categories are rather more interesting. Apple says, over and over, that the objective is not to sell the most phones, but to make phones that it can be proud of. In 2007 the iPhone was an MVP lacking industry standards like 3G and a decent camera, yet it still needed to be $600 or more to deliver the vision. Today Apple could perfectly well make a phone it could be proud of at $300. Indeed, there's nothing that it would be ashamed of in the Lumia or Xiaomi at $150 and below.  

Meanwhile, if you look at the history of Apple's pricing, it has always made products at the high end but also in the mid-range. It has pushed to find the 'lowest viable price' for an 'Apple-quality experience' (and then added 10% or 20%, perhaps). In 2007 that price for a smartphone was $6-700, but now it is $200 or $300. That is, there is absolutely no technical reason why Apple could not make a great iPhone and sell it for $300 or so today. It wouldn't be the same as the premium product, but then the iMac was not the PowerMac. 

There are, obviously, a bunch of execution questions around this, such as how to avoid fragmenting the platform too much and how to segment the different product lines to avoid cannibalising the high-end too. What would the product matrix look like? Would Apple stop selling older models entirely? What happens to the gross margin with a wide range of entire new phones and no older ones? What happens to the resale value of the new flagships, and how does that affect sales? But then, Apple didn't worry about cannibalising Mac sales with the iPad. This might be, in a sense, a test for Tim Cook - whether he can do the right thing (assuming that's what it is) even if it erodes other businesses or pushes the stock price down, the way Steve Jobs could (or Larry Page, or Mark Zuckerberg) - can he behave like a founder?

There are two interesting sets of consequences from any such phone: the impact on Apple and the impact on Android. 

First, Apple. I've embedded a simple spreadsheet below calculating the financial impact on the company from a blockbuster 'cheap iPhone'. One can argue about the detail, but the key point is that if you sell 40m 'iPhone Nanos' (and presume for the moment that you actually can) at $250 at a 20% gross margin, that generates $2bn a quarter in gross profit for a company that reported almost $15bn gross profit last quarter. That is, a blockbuster iPhone that doubles Apple's market share adds just 15% to gross profit, before allowing for the inevitable cannibalisation of the high-end product. Factor that in and you probably only add 5-10% So, this does not really address the 'growth question' - it doesn't double Apple's business again. 

That does not mean it is not worth doing, of course. Even apart from the financials, the broader value is the impact on the ecosystem landscape. I am not convinced that iOS, with perhaps 500m-600m active devices already compared to Google Android's 1bn or so, can really be described as sub-scale, especially given it has two thirds of app store revenue. However, adding a 'gateway' device in the mid-range with significantly more unit sales would build a much deeper moat around that ecosystem. (Though it would also dilute that high-level customer base.)

The other side of this coin is of course the impact on Android. The two markets where iPhone sales are effectively at parity with Android are the USA and Japan, and those are also the two markets where the subsidy structure means that the iPhones is not at a big price premium to Android. This is probably not a co-incidence. Meanwhile, we also see strong indications that the second-hand market for iPhones, mostly in the $2-300 range, is also extremely strong. It doesn't seem unreasonable to suppose that a new, attractive iPhone in this segment would be highly competitive. So, such a phone would sell, and sell well, and take a big chunk of the most valuable Android customers. Not, of course, the ones who value 'open' and the Google ecosystem above everything else, but true enthusiasts are a minority on both Android and iOS. 

It is also worth noting that in the high-end, where Android is roughly equal in sales to the iPhone, two major competitive drivers for an Android purchase are a larger screen and more customization options: Apple addresses many of the second with iOS8 and is strongly rumored to be planning a large-screen phone, addressing the first.  Hence, in six months, we could see both a stronger Apple proposition at the high end and also a new and pretty compelling offer in the mid range. 

Finally, the interesting thing about all of these questions is that they are largely under Apple's control. Apple chooses not to do a large screen phone, and it chooses not to go into the mid range, and it chose not to allow, say, third-party keyboards. There were strong technical challenges for all of these, but those have probably now been removed (certainly for the third point, given the extensibility of iOS8). This means Apple has more cards to play than we've yet seen.