Will Apple need to cut margins on the iPhone?

Many comments on and off this blog raise the specter of the inevitable decline in Apple’s margins due to two forces:

  1. The iPhone begins to reach into more markets or points of distribution without exclusivity.
  2. The Android surge will apply competitive pressure forcing Apple’s pricing and hence margins.

The first claim can be countered by observing that Apple has not cut margins when switching from exclusive to non-exclusive distribution in several markets. In fact, Apple made this information public: When Tim Cook was asked in October 2009 earnings concall “So when you go from exclusive to multiple, you don’t change the charge to the carrier?” Cook answered, “Correct.”

The second claim can be countered by observing that innovation trumps pricing every time. When looking back at the three years’ history of the industry there is a clear but counter-intuitive demonstration of the power of innovation in the market.

Whereas one would expect that in a highly competitive market torrid growth would only be possible with lower pricing and hence margins, the opposite is observed in the phone market during the last three years:

[HTC data is over a two year period]

The graph shows that companies that grew the fastest had the highest margins, and the companies that grew the slowest had the lowest margins. The trend line in the graph above is precisely orthogonal to what would be expected in a commodity market.

The orthogonality of growth vs. margin points to the effect of innovation in this market. In a non-commoditized market (i.e. one where usable improvements in a product are quickly absorbed and highly valued) high growth and high margins are correlated.

In a commodity market (i.e. one where improvements in a product are neither absorbed nor valued) growth can only come at the expense of margins.

Being able to spot when a market tips from innovation-driven disruption to price-driven commodity sales is an essential skill for both investors and managers. It requires a comprehensive and integrated analysis of technology, finance, consumer behavior, competitive forces and a lot of faith in theory to make the right call.

As a keen observer I think the market still has a long way to go before it reaches this tipping point. I don’t see it happening in the next three years (which is just 2 product cycles–the most an outside observer can hope to roadmap).

  • David Chu

    Another awesome graph and analysis.

    I started reading Clayton Christensan's Seeing What's Next because of your blog. Many thanks and keep up the good work!

    • Tom

      For the same reason, I'm reading the innovator's Solution by the same author. Great site!

  • Niilo

    Very interesting!

  • Mike11

    Very interesting. But you're assuming that Apple can keep innovating above average in the smartphone market. One could argue that we saw more innovation in the last 12 months from Google's Android and all the Android hardware manufacturers. And that Apple did start on innovation but is now still successful in the smartphone market because of hype and past glories.

    • For innovation to be driving both growth and margins it has to exhibit two characteristics: 1) it has to be an improvement that is absorbable and 2) the improvement will be something people are willing to pay for.

      This has nothing to do with competitive pressure. If Android vendors are able to do the same thing they will also see healthy growth. (see also RIM vs. Apple)

      Furthermore innovation is not quantifiable (i.e "more innovation" is meaningless). Innovation is measured by its effect.

    • Narayanan

      Copying an established system is not innovation.
      All the competition has done is to run faster along a path at was cleared by Apple.

      But one thing at concerns me is that the tipping point may be reached earlier due to the mad rush to catch up and by market flooding.

      Thanks for the analysis.

    • RattyUK

      @ Mike "One could argue that we saw more innovation in the last 12 months from Google’s Android and all the Android hardware manufacturers."
      Would you care to illustrate what you mean? Adding a plethora of features is not innovation. That is the old feature phone "improvement" technique – a tired method that he established players have trotted out for years.
      "And that Apple did start on innovation but is now still successful in the smartphone market because of hype and past glories."
      If you think that the iPhone sells merely because of "hype and past glories" then you really don't understand what is going on.

  • The graph also shows the companies that don't license out their OS have done best and even Nokia, which has controlled Symbian, has better margins than any of the Androids. So will Samsung, despite all the recent noises about how wonderful Android is, concentrate resources on establishing Bada in Korea?

    • If Samsung could develop Bada into a viable ecosystem they would certainly be better off than relying on Android since they could differentiate.

  • Rob Scott

    @ asymco:

    First thanks for a great blog. Now I have four great blogs I read rather religiously: Daring Fireball, Roughly Drafted (wish he would post more), Counternotions (same wish here) and this blog. This is on top of other great content from other “Apple Press and people”. I found this blog via Philip Elmer-DeWitt and John Gruber; I thought I should mention that.

    Thanks for the graphs. I download them for future use and copying for my own projects.

    Apple is not going to cut margins for a very long time. Here is why:
    Apple sells the iPhone as a premium device. Market share is secondary. They are undersupplying the market by 40 – 80%. There is huge pent-up and unfulfilled demand for iPhones and this will remain so for years. This allows Apple to charge what it thinks is the right price for its wares.
    This undersupplying guarantees that the iPhone will almost always sell out. No obsolescence to deal with for carries. No huge marketing spend to move the devices.

    Obsolescence and distressed stock is one of the biggest costs for telecoms companies. With iPhone, you do not have to deal with this at all. On the other hand this is already the biggest problem with Android devices: they cost telecom companies serious money. This forces the telcos to negotiate harder on the cost of devices and later for marketing help to move the devices.

    iPhone generate the highest ARPU of all mobiles OSes 2X higher than an Android device. Lastly iPhone has the lowest churn.
    All Apple needs to do to keep its high margins is to continue to innovate faster than Google, keep the phone a premium device, everything else follows. For the telcos a device with high cachet, high ARPU, low churn, and no obsolescence deserve every penny you pay for it.

    • poru

      Good points esp re the marketing and inventory issues (which for Apple are hardly problems). Much easier to handle both with all the free advertising Apple gets, the simplified product line, and of course the huge demand. Months after the launch there is still a 3-week wait for an iPhone here (in FR, and elsewhere I believe).

      As for the "churn," the tremendous investment many if not most iPhone users will have in iTunes media and apps is another disincentive to change brands. With both the huge range and generally high quality of Apple's apps another phone would have to be pretty damn good to seduce me away.

  • you're doing a great job clarifying the market with unique information. thanks.

    Apple's ability to maintain high margins has been consistent over time and over multiple products. I think there are 3 main reasons:
    1) Product differentiation. Through hardware, software and multiple product integration (ie, macs, iPhone, iPad, iTunes, iWork, MobileMe, etc all feed into each other) and Apple's unique flair with design, marketing and support, Apple continues to provide lust worthy products which appeal to large numbers of people despite a mild price premium. Apple speaks of increasing value to customers which includes intangables such as user friendliness, the genius bar, etc etc. It's because of this increased value that Apple can maintain high margins while others have to fight a war of price.
    2) Ironically I think mid-priced and cheap Android products are going to provide huge price pressure on the upper end of the Android market leaving this high margin section of the market for Apple to dominate. As in the PC market, most Android oriented consumers will not have to pay for the upper end Android products when they can get essentially the same phone minus some questionable "high end" features for a lot cheaper. And like in the Win-PC market, if you want an Android phone you can get a cheap one, if you want an Apple product you'll pay the exclusivity price. Apple has shown they know how to pull this off and maintain high margins.
    3) Apple have a purchasing power advantage. Android is not a company that buys physical parts. HTC, Motorola, etc are. Android may well surpass iOS in sheer numbers but when it comes to making a profit on phones its how many chips and boards and buttons and screens you buy which determine your price.

  • Philip Bergen

    The textbook example of innovation as keeper of high margins is Gilette. For decades they have been able to maintain awesome margins in a commodity market.

  • Given their current stance, I don't think that Apple will have to cut margins. The best-of-class nature of the iPhone means that it will never get majority market penetration — it is the high-end choice, and serves as an anchor in the smartphone market, shaping people's pricing expectations for smartphones. Apple has chosen this position, and unless they show signs of offering a telephone at a reduced price compared to an iPhone, I don't see how this could change.

    A majority of people in the world buy mediocre cars, eat mediocre food and so on, just because their self-image is of someone who lives "reasonably". These average men and women don't go to nice restaurants, and even in mediocre restaurants, they don't order the most expensive dish (though they could easily afford it), just because they've accepted their fate as someone reasonable. As long as the iPhone is the most expensive phone, it's going to be off the table for this (vast) group of people, who think "the iPhone is nice, but I don't deserve it/can't afford it". These people have historically been Windows buyers and are now Android buyers.

    Apple will never be able to convince these people that their phone is better — these people know it's better but it's because of that they they won't buy it. Apple could combat this by making a better, more expensive phone, just to make the normal iPhone seem like less of a luxury, or by creating a less-expensive telephone to sell to the masses. However, historically Apple has shown little interest in pursuing this part of the market — it would be like Mercedes targeting Chevrolet buyers.

    • What about the iPod?

      • Rob Scott

        The iPod touch is available on contract on Vodacom (South Africa). It is marketed as a data device. I suspect that this is going to be more popular with the advent of the iPad. So if you have Mifi or the like you can get the iPod touch on contract for ZAR 139.00 for 300MB.

      • kevin

        The iPod was introduced and defined as a music player, and given the new iPod nano, is still focused on being a music player. Over time, Apple determined that there are multiple distinct music player configurations: iPod shuffle – simple, light, clip-on, sports; classic – high storage capacity; nano – now just the basic music player; and touch – all-purpose for those who want more including gaming, video, camera, apps. (Clearly, Apple is pushing potential nano owners to think about touch instead. And classic is an ignored niche.)

        iPhone was introduced and defined as a multi-touch iPod, phone, and internet communicator; apps were later added. Are there now distinct markets that want different physical/pricing configurations but still include all 3 (or 4, apps) elements? Maybe if the new nano is a superhit, Apple may think about releasing a phone and music player (just 2 elements). From another perspective, does iPhone 4 add a 5th element with Facetime and HD video recording; or is that just an adjunct like video was to the iPods?

        For now, I think the older 3GS is just a "pricing" play by Apple – it allows Apple to have a lower starting price, makes the iPhone 4 not seem as expensive in comparison, puts pressure on cheaper competitor phones, and gives Apple some time to roll out iPhone 4 thruout the world (i.e., South America, Africe: 3GS is not obsolete!). And it gives the user a choice, but not a complex one.

    • ericgen

      Also, for the past two iPhone product cycles they have been selling the previous cycle's iPhone for $99 along with the new model of iPhone. Anyone who knows the iPhone is better but has to be 'reasonable' would by last year's model for $99 as it's obviously a steal and supports the notion that they're being 'reasonable'.

    • Tom

      @Andrew Swift: apple does make a better phone than its current phone and market it at a higher price each year! We just watched the introduction of the iPhone 4, much better than the iPhone 3GS. The 16GB 4 sells for twice the price of the 8GB 3GS, and the reasonable people push right past the 3 to get to the 4.

  • The iPod doesn't compete directly with Android devices because people buying Androids are looking for a telephone first and foremost, and because Androids are sold with carrier subsidies (if I understood your question).

    • Tom Ross

      I think the point was that Apple is selling both expensive and cheap iPods. So we might expect Apple to do the same with the iPhone over time.

      The conclusion that Apple is deliberately limiting the iPhone's market share is rather premature when you look at their growth rate of 65 % over the last twelve months (or 80 %, purely in terms of sell-through). For now I would much rather argue that they are expanding production as fast as possible and price is dictated by that supply limit. Apple's strategy may very well be to keep the iPhone growing by 50 %+ per year for the next 5 years, and drop prices only when that goal is in danger.

  • I almost added, to my initial comment, that one reason for the success of the iPod Touch may be that the iPhone, acting as an anchor, means that people that are trying to be "reasonable" can buy themselves a Touch instead of an iPhone. That was certainly my own case.

  • I agree that the sale of older-generation iPhones goes some ways towards serving all the "reasonable" people out there, but my own observations among people I know are that 1) it still feels like too much of a luxury purchase and 2) there's a strong resistance to buying a "new" product that came out more than a year ago.

    Even if a year-old 3GS iPhone is objectively better than a new Android phone, many people would rather have the new Android. They just assume that if the iPhone is a year old, it's not much good anymore — it must be too slow, and the screen probably isn't good, you can't update it, etc. The fact that it's directly comparable to a new iPhone 4 makes it look bad.

    There are lots of people who buy new (but mediocre) bicycles at the shopping center for $129 when they could obviously get a much better bike, used, for the same price.

    • Gandhi

      The iPhone 3GS currently sold for $99 is sold as a loss leader. It is to entice the cheapstakes to come in and kick the proverbial tires. Since the iPhone 4 was introduced, I have yet to see any older 3GS demo units in any of the Apple stores. You walk in to an Apple store, try out the iPhone 4, and Apple hopes you fall in love with it. Over the course of a two year contract, an extra $100 is nothing. Apple hopes you splurge and get the latest iPhone 4. And for the truly determined, they will sell you a 3GS once you specifically ask for it. Or if the 2-year contract commitment scares you, you can buy the iPod Touch. And if you want to go even cheaper, a refurb iPohd Touch. Either way, Apple has added an iOS device user.

      And after all this you still do not buy, well then Apple can wait for you to succumb, as they are not in a hurry to lower prices because Apple sells every iOS device they make. And if you don't succumb, there is a buy 1 get 1 free Android device waiting for you at Verizon.

      • A loss leader implies they lose money on it. I strongly doubt it. Rather, I think it's a product that induces a cognitive illusion.

        “Imagine I give you a choice. Do you want to go for a weekend to Rome? All expenses paid. Or a weekend in Paris? All expenses paid. Now, these are different things. They have different food, different culture, different art. Now imagine I added a choice to the set that nobody wanted. Imagine I said, “A weekend in Rome, a weekend in Paris, or having your car stolen?” It’s a funny idea. Because why would having your car stolen, in this set, influence anything? But what if the option to have your car stolen was not exactly like this. What if it was a trip to Rome, all expenses paid, transportation, breakfast. But doesn’t include coffee in the morning. If you want coffee you have to pay for it yourself. It’s two euros. Now in some ways, given that you can have Rome with coffee, why would you possibly want Rome without coffee? It’s like having your car stolen. It’s an inferior option. But guess what happened. The moment you add Rome without coffee, Rome with coffee becomes more popular. And people choose it. The fact that you have Rome without coffee makes Rome with coffee look superior. And not just to Rome without coffee, even superior to Paris.”

        The older (3GS) model is “Rome without coffee” and competing products are “Paris with coffee”. By offering “Rome without coffee” Apple guarantee higher orders for “Rome with Coffee”…


  • Tom Ross

    That still leaves the question if both Verizon and AT&T can afford a $400+ subsidy once the iPhone is not exclusive anymore. Unless Apple wins some stunning negotiation victory, either the retail price of the iPhone in the US will go up or the wholesale price will go down.

    • I'm becoming very comfortable with the assumption that the selling price for the iPhone is the same for all operators world-wide and that price is very similar to what it charges in its stores for unlocked phones. Apple has a simple negotiating tactic: take it or leave it.

      • Rob Scott

        That is true. iPhone cost the same everywhere in the world, Verizon will not negotiate it down or any other carrier for that matter. When it comes to Apple carriers are price takers.

  • Rob Scott

    Another important point I failed to mention is that the difference in subscription on an iPhone at USD650.00 and an Android device at USD450.00 is very small, sometimes they are on exactly the same plan for the same subscription price.
    Carrier funding is important piece here:
    A carrier’s main objectives are to sell devices that attract customers – Acquisitions (Gross Connections plus Upgrades). iPhone delivers on this without fail, every time.
    Two, those devices must generate higher ARPU than everyday run-of -the-mill devices. Again, the iPhone delivers.
    Three, people must want to upgrade to a better device which is usually available only on a more expensive plan.
    Carries throw promotional funding to the devices that meet these conditions highlighted above. This in turn lower the subscription required from the customer, nullifying the cheapness advantage of competing devices.
    Example: BlackBerry devices are cheaper than any iPhone but the difference in subscription is very small. So, if you are looking for a premium device an iPhone becomes a no brainer, despite the fact that BlackBerry is costing the carrier less than an iPhone. When a carrier puts promotional funding to an iPhone, RIMs price advantage gets wiped out as the devices are available at the same subscription to the customer..

  • rd

    Only thing I don't like about the current pricing
    structure is that unlocked iPhone customers
    are paying what is essentially subsidy that
    Apple gets from phone companies.
    That is where is margin is unseemly.
    Apple would sell even more if the unlocked prices was around

    • Gandhi

      I believe the unlocked price for a iPhone 4 16 gig model is $599

    • Unlocked iPhones are available in many countries. I did a quick analysis and found that when excluding the VAT, the price is pretty much the same.

  • Iphoned

    To second some other folks opinions, this is a very good blog. One of the best.
    Thank you, Horace

  • ericgen

    Piling on here, but yes, this is an excellent blog with wonderful analysis and lots of food for thought.

    Thanks Horace!!!

    • No, thank you all. The audience makes the blog. I learn from it every day.

  • Gandhi

    I would be curious to see where HTC sits within this group. I would think it would be closer to SonyEricsson, than to Samsung or LG.

    • I updated the data with HTC. I did not have volume data for the full period so I used only two years' growth. [I also had an error in my formula for CAGR where I was over-stating the growth–though it applied to all competitors equally. It's now corrected].

      HTC is actually closer to the green quadrant than to the red, but still in the middle (yellow) cluster.

  • gctwnl

    Apple also has high margins on the Mac side of business. I just compared a comparable i7 2.93GHz iMac with a comparable Dell and the Dell was hundreds of $ more expensive when everything was added up. If Dell as a firm has low margins, it must mean they either are not able to produce as well as Apple or they mostly sell low margin cheaper boxes.

  • Carniphage

    The problem for Android manufacturers is they have outsourced their innovation to Google.

    Android is a free lunch. And this saves them money and effort. That’s got to help them compete with Apple right?

    But remember, some free-lunches are just bait in a trap.

    Every Google innovation is shared equally by all Android manufacturers. All Android devices are then functionally equivalent. The HTC becomes the same as the Samsung and so on.

    And just like Windows PCs, the only way for hardware manufacturers to compete is on price. Margins are cut. Profits decline. Great news for consumers, dreadful news for manufacturers.

    Apple does not need to play this stupid game. And now it has its own OS. Neither does HP.


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