Apple (NASDAQ:AAPL) is scheduled to release its Q4 FY2014 results on October 28th. Last quarter, the company beat market expectations with record iPhone sales, as it increased its focus on emerging markets by aggressively promoting the older discounted iPhone models. It will be interesting to see how much of the emerging market focus helped prop up Q4 results considering that many higher-end customers would have deferred their purchases until later in the quarter when the iPhone 5S was launched. The huge pent-up demand saw Apple sell 9 million units of the new iPhones in its opening weekend of sales, about 80% higher than the 5 million iPhone 5 units it sold a year ago. As a result, the company increased both its revenue as well as gross margin guidance for the quarter to the high end of its earlier estimate of $34-37 billion and 36-37% respectively.
The initial sales number released included sales of the iPhone 5C as well, which probably skewed the y-o-y comparison. Apple also added NTT Docomo in Japan to its carrier partners and two new countries to its initial iPhone launch markets, one of which was China. Both of these new additions are likely to have contributed heavily to the impressive launch numbers. That said, there has been speculation that the iPhone 5C is not selling as well as expected with production cuts being rumored at the supply-side. Meanwhile, the higher-end 5S seems to be supply-constrained, as revealed by Verizon in its recent earnings call. If the rumors are true, Apple could benefit from the 5S supply crunch easing up in the holiday quarter, offset by the inventory that has built up for the 5C initially. We will be watching the company’s guidance for the next quarter so as to gauge how the two iPhones are expected to fare relative to each other, and if the 5C could be part of a broader strategy to push emerging market sales going forward.
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5C to increase the market for iPhones
Margin improvement is one of the main reasons behind Apple’s introduction of the 5C this year. By pricing the 5C at a high $550, Apple is more intent on maintaining its brand image than making a market share play. The iPhone 5’s discontinuation, and the introduction of the iPhone 5C in its stead shows that Apple is more focused on defending its gross margins. The 5C may not be very different from the 5 on the inside but is held together by a single polycarbonate shell, which likely makes the 5C cheaper and much easier to assemble than its premium predecessor which had an anodized aluminium casing. It will be interesting to see Apple’s guidance for its next-quarter gross margins as the sales mix of the 5C increases following the initial launch euphoria, which might have caused sales to skew towards the 5S initially due to the higher number of purchases made by hard-core Apple enthusiasts.
Along with the gross margin improvement, we believe that Apple will be looking to derive value from the additional sales that the iPhone 5C is going to help bring in. While nothing has changed in terms of the range of prices on offer in the iPhone family (with the 5C just replacing the older 5 at what would have been its new discounted price), the company now has two new phones to promote instead of the usual one. This may not have led to the 5C performing as well as expected so far, but these are still early days and we could be seeing the impact of the huge initial pent-up demand that had built up for the 5S. Since Apple generally doesn’t refresh its products for a full year, the sales mix of the cheaper iPhones should increase going forward, with additional marketing for the 5C helping the company sell more iPhones over an entire product cycle than it would have with the older-generation iPhone 5. At the same time, the price differential of only $100 lowers the risk of cannibalization of the higher end 5S, which should help margins and ASP levels improve in the near-term.
Deal with China Mobile essential
However, this may not help Apple’s case much in the emerging markets, even in places like China where carriers have started subsidizing smartphones. The iPhone 5S and 5C are being sold in China at unsubsidized prices of $867 and $735 respectively. Even carrier subsidies do not lessen the pain as Chinese subscribers have to fork out the entire cost of the phone at the time of purchase. The subsidy is then adjusted against the service fees, reducing only the future monthly payments and not the upfront cash outlay.
Apple could still drive growth in the emerging markets by bringing other carriers such as China Mobile into its fold. With a subscriber base of almost 750 million and 3G penetration of about 20%, China Mobile is a big untapped opportunity for Apple. While Apple has yet to reach a deal with the carrier, one of the company’s handsets that runs on China Mobile’s network seems to have received a “network access license” from Chinese regulators.  Handset vendors generally tend to start selling new phones within months of receiving regulatory approval.
A China Mobile deal is essential for Apple to improve its fortunes in China, which has increased in significance to become its third largest market overall. Apple’s sales in Greater China declined by 14% last quarter. While Apple has been increasing focus on China, as its decision to include the country in its initial iPhone launch markets amply suggests, it is unable to access a vast majority of China’s wireless subscribers due to the China Mobile conundrum. While technological incompatibility with China Mobile’s 3G network was one of the initial concerns, that doesn’t seem to be the case any more with Qualcomm’s new chipsets. A lack of agreement on a proper subsidy deal is likely to be the main issue here. Considering that the 5C isn’t priced at a level that will significantly reduce subsidy costs, investors need to watch out for more intricate details in any potential arrangement between the companies that could harm Apple’s margins (see Apple Could Sacrifice Margins To Bag China Mobile Deal).Notes: