So the 5S is (allegedly) killing the 5C. Why is this bad news?

John Koetsier, writing at VetureBeat:

Apple has the prototypical good-news, bad-news scenario on its hands, with soaring sales of its flagship iPhone 5S contrasting sharply with souring sales of its “for the colorful” iPhone 5C.

“Our latest channel checks confirm that Apple indeed has cut back 5C production by 35 percent and increased 5S production by 75 percent,” NPD DisplaySearch analysts Tina Teng and Shawn Lee posted today.

First, the necessary caveat: Apple supply chain rumors are notoriously unreliable. But let’s assume this one is true, and see if we can figure out the bad news Koetsier is referring to.

Analysis Overview and Assumptions

The key question is the mix of iPhone sales between the 5S, 5C, and 4S. Many commentators, including myself, assumed that the 5C would be a big seller, and, indeed, it still might be after the initial wave of purchases die down. However, it seems obvious now that the 5S will sell far more overall.

Below I’ve looked at three different scenarios to better understand whether this is in fact bad news as many are assuming.

I’ve based my BOM+manufacturing estimates on iSuppli’s teardowns, and assumed a cost reduction of 10% a year for the iPhone 5 and 4S. I’ve also assumed additional costs of $150 per phone for licensing, software, packaging, shipping, etc. I’ve assumed a 50/40/10 split for the 16/32/64 GB models on the 5S, and a 70/30 split for the 16/32 GB models of the 5C. Finally, I’ve assumed 50 million total iPhones sold; this is NOT a 1Q2014 prediction, rather, just a convenient round number. All of the data is here if you want to change any assumptions.

What if Apple sold an even split of 5S and 5C?

Financials with a 50:50 5S:5C split
Financials with a 50:50 5S:5C split

If we presume that 45% of iPhones sold are the 5S, and 45% the 5C (I assumed the 4S was 10% of sales in all three scenarios), then, given my assumptions, the iPhone as a family will have a margin of 45.53%, with a contribution per share of $15.91.

What if Apple sold 3x as many 5S as 5C?

If the 5S is outselling the 5C 3 to 1, margins and profits are higher given the same number of phones sold
If the 5S is outselling the 5C 3 to 1, margins and profits are higher given the same number of phones sold

If we presume that 68% of iPhones sold are the 5S, and 23% the 5C, then, given my assumptions, the iPhone as a family will have a margin of 46.94%, with a contribution per share of $17.17. That’s a huge difference – and is exactly what is rumored to be happening.1

What if Apple had not made the 5C (and sold 3x as many 5S as 5C)?

One more scenario – presuming the rumors are correct, and the 5S is outselling the 5C by a significant margin, was it even worth the effort?

The 5C is certainly cheaper to make than the 5, making it worth the investment
The 5C is certainly cheaper to make than the 5, making it worth the investment

It clearly was, for manufacturing costs if nothing else. Assuming the 5’s costs came down by 10%, the 5C still costs $10/unit less to manufacture, and at Apple’s scale, that’s worth over $100 million per quarter. Not creating the 5C would result in a margin of $46.54, with a contribution per share of $17.04.

Tim Cook has hinted this was a primary reason for creating the 5C. From the BusinessWeek interview with him just after launch:

Q: Why not just sell the old iPhone 5, as you’ve done in the past? Why create a new phone with the 5C?

A: The business became huge. The market became huge. The customers’ desires grew. You know, people want different things. We wanted to make the phone more accessible. For us it’s all about products, and so we don’t look at things and say, “I will never sell a phone below that.” We don’t look at it like that. We say, “Let’s think about a great product that we’re doing.” If that great product can be sold for less, then we sell it for less.

There is one other benefit to having a second new design. From the same interview:

Now the great thing is we’ve grown our capability to do two phones, and when you’ve done one before, that’s a big change.

If, as I suspect, next year’s high-end model comes with a larger screen (with the mid-tier model staying the same size), developing the capability to manufacture different models will be particularly forward-thinking. Apple is teaching itself to manage two relatively similar lines before they branch out into even more significant segmentation.

In the end, this analysis is quite obvious: presuming the number of phones sold is the same, it’s great news to be selling more of the more expensive model. It’s even better news when iPhone sales are still growing, as the opening weekend indicates they clearly are.

The only objection, then, is that Apple is artificially limiting itself to the top end and not growing enough. Koetsier makes this argument in the aforementioned piece:

The bad news, for long-term investors, is that iPhone 5C is not really achieving what some — particularly those outside Apple — saw as its goal: expanding the universe of potential iPhone owners, and thereby expanding Apple’s customer list in developing countries. That said, the 5C is a great iPhone in my testing and experience, and has the potential to do very well for Apple, if the company can just get over its self-imposed need for what some would call unrealistically high margin expectations.

First off, this is a classic market share over profit share argument, and is basically advocating that Apple leave money on the table. As I wrote in The $550 iPhone Makes Perfect Sense:

No one – probably including Apple – is quite sure exactly what the elasticity will be for the iPhone. See, the demand curve is usually, well, curved. It’s not as simple as I’ve presented it. Same with elasticity – it changes depending what price point you are at. While Apple could go lower cost, there is a very high likelihood they would, like the first example above, make less money than they could otherwise. It makes a lot more sense to gradually move down the demand curve and build out your knowledge of the market.

The problems with that paragraph go deeper still, though. To Koetsier’s credit, he includes the line particularly those outside Apple, because this paragraph – and much of the 5C angst – is a statement of miscomprehension about Apple’s strategy.

Apple is focused on increasing the value of the iPhone, not only through specs, but through solving pain points like security. And it goes far beyond the phone itself. It’s increasingly clear Apple is focused on being an aspirational lifestyle brand, where specs are completely immaterial, and paying a bit more is part of the allure.

Still, it’s worth noting that if these rumors are true, even Apple itself didn’t realize how far down this aspirational road they already were. Customers don’t care that the 5C specs are good enough; are aspirations limited by such rational ceilings? To aspire is to dream, to want the best. The iPhone 5S is the best, for just $100 more, and millions of consumers – more than ever, in fact – have already demonstrated their willingness to pay just that.

This is bad news?

  1. Remember, Apple adjusted its 4Q2013 guidance in the face of higher-than-expected margins