iPhone 6S Shows How Apple Intends To Keep Its Profit Machine Running

Apple (NASDAQ:AAPL) unveiled a host of upgraded products – including a larger-screen iPad, a revamped Apple TV and updated versions of its bread-and-butter iPhone – at a media event held on September 9. Although we didn’t see anything that was truly transformative, the event did provide confidence that Apple’s innovation engine is humming along nicely and that its core business strategy remains well thought-out. This was particularly visible with the iPhone – Apple’s biggest valuation lever, that accounts for over 60% of the stock price by our estimates – as the company made some interesting tweaks to the device, while optimizing its product strategy to appeal to more buyers, without hurting pricing or margins. As we’ve said before, maintaining iPhone pricing and margins over the long-run could prove to be big valuation trigger for Apple. (related: How The iPhone Can Drive Apple To A $1 Trillion Market Cap) Below, we take a look at look at how Apple is playing the current iPhone cycle and how it could impact its financials.

Trefis has a $140 price estimate for Apple, which is about 30% ahead of the current market price.

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Constant Refinement, One Buzz-Worthy Feature

Apple’s strategy with its ‘S’ iPhone upgrade cycles has typically been to maintain the industrial design of the devices, while refining features and improving hardware specifications. With the iPhone 6S and 6S Plus, Apple has largely stuck to this playbook, adding faster processors, improved sensors and cameras, while refining the device’s overall performance. Apple also usually adds one novel feature to its S devices (the Siri voice assistant debuted on the iPhone 4S and the fingerprint sensor on the iPhone 5S) to create a buzz and stimulate early upgrades to the device. With the iPhone 6S, the company unveiled a feature that it calls 3D touch, which is essentially a pressure sensitive touch screen that allows for contextual menus and options, much like the force touch screen available on Apple Watch. We believe that these features, coupled with Apple’s premium design and brand positioning, should allow the company to maintain its lead over rivals in the largely commoditized Android smartphone space.

Capturing The Consumer Surplus By Holding On To The Storage Mix

Apple is sticking with the same storage configurations that it offered with the iPhone 6, choosing not to upgrade memory on the base model, contrary to some reports. The base model of the iPhone 6S, priced at $649, unlocked, will come with just 16 GB of storage capacity while the mid-tier and high-tier models that offer 64 GB and 128 GB of capacity will retail for $749 and $849, respectively. While some may argue that Apple is overplaying its hand here by offering relatively meager storage, since most manufacturers provide at least 32 GB on base versions of their top-tier devices, this move should bode well for Apple’s bottom line. Many customers tend to pay the $100 premium for 64 GB model, given the higher storage-capacity per dollar, and this works very well for Apple, since we estimate that the incremental cost of a 64 GB model over a 16 GB model is likely to be under $20, translating into about $80 in additional gross profits.

Targeting Value Buyers Without Hurting Margins

During its last ‘S’ upgrade cycle in 2013, when the iPhone 5S was launched, Apple discontinued the iPhone 5 as its second-tier offering, in favor of a plastic clad model dubbed the 5C, which was priced at a $100 discount to the flagship.  However, the model failed to resonate significantly with customers, and Apple had to resort to mid-cycle discounting to bolster sales. However, this time around, Apple intends to continue to offering the iPhone 6/6 Plus to customers alongside the iPhone 6S/6S Plus. This is a smart move on Apple’s part, since the aspirational value of the iPhone 6 could help it strike a chord with price sensitive buyers and customers in emerging markets. This could also prove an important product in China – Apple’s biggest growth market – which has been seeing slowing growth and currency devaluation. Margins for the iPhone 6 should remain solid, since Apple’s contract manufacturers are likely to have ironed out any potential yield issues over the first year and component costs for the device should also be lower.

Shortening The Upgrade Cycle And Driving Volumes Via Upgrade Program

Wireless carriers in the United States have been moving away from the typical two-year contract model towards unsubsidized devices and equipment installment plans, and Apple is looking to cash in on this trend with an installment agreement plan of its own called the iPhone Upgrade Program. The program allows customers to get a new iPhone each year, along with the AppleCare+ protection plan as long as they sign on for a 24-month installment agreement. For instance, the company is offering the latest iPhone 6S for $32.41 per month. ((iPhone Upgrade Program, Apple) Although this is more than the $27 a month that AT&T and Verizon charge for their 24-month programs, Apple’s offer still seems appealing, since it provides customers unlocked phones with device protection (an additional fee on most carriers), while allowing them to upgrade annually. A back of the envelope calculation says that the deal will work well for Apple. Considering a plan taken with an iPhone 6S, Apple would garner about $388 over year 1, which should comfortably cover depreciation, interest and costs relating to the protection plan. Moreover, the move should help Apple stimulate advanced upgrade cycles, which could result in higher iPhone sales over time.

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