The Apple-Samsung patent trial, currently replaying its way through the courts right now, is mind-numbingly dull on the legal merits. But the rare insight it’s providing into the minds of Apple executives show a company that is well aware of the weaknesses in its core iPhone business. Apple’s smartphone has seen slowing unit growth even as the industry has continued to expand rapidly. At a company offsite last April, a corporate presentation concluded that all growth was occurring from large screens phones or models priced below $300 without subsidies. Apple offers neither, making it no wonder that iPhone had hit a wall. The title of the money slide was succinct: “Consumers want what we don’t have.”
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All is not well…
Apple’s moribund shares have traded sideways since reaching all-time highs in September 2012. The iPhone represents the bulk of Apple’s sales and profits and with its ascendance, so went Apple. The company sold 21 million iPhones in 2009, followed by 40 million, 72 million and 125 million in the three subsequent years, ending with Apple’s fiscal 2012.
In the year ending last September, Apple’s smartphone did manage solid numbers, with the iPhone eclipsing 150 million total sales, but with the industry growing by 38%, Apple’s 20% number started to look weak. And the most recent quarterly comparison is no better. In the first quarter of fiscal 2014, Apple managed to grow sales just 7%. What’s perhaps most interesting is that the company seemed well aware this was coming.
Given that Apple only sells iPhones with screens 4 inches and smaller that are priced above $300, the iPhone’s market segment was already shrinking by 2012, according to Apple’s own analysis (as seen in the slide shown above, which was posted by re/code). Phil Schiller, Apple’s senior marketing vice president, was somewhat dismissive of the document at the patent trial according to reports, but its pretty clear the folks who prepared it were onto something.
… but could it end well?
By numerous accounts, which I summarized here recently (“Is The Long Wait For A Big Screen iPhone Nearing An End?“), Apple is preparing to address the screen-size issue later this year, bringing the iPhone in line with high-end competitors. There’s a complex set of variables here because the rumors suggest Apple is toying with potentially two sizes, including one phablet-sized model and it’s far from clear when the bigger screens will trickle down into any lower-price iPhones, but this begins to address a core vulnerability in the product line and should add millions of units of incremental growth.
Indeed, Apple acknowledged that competitors had “drastically improved their hardware” and was concerned about “obscene” spending on marketing to gain share. Those fears may crop up again as the new Samsung flagship Galaxy S5 is being offered on a 2-for-1 promotion ahead of its launch with Verizon. That kind of deal costs Samsung a fortune and the company has outspent Apple by billions on marketing and carrier support in an effort to gain market share.
Priced to sell?
The price side of the ledger hasn’t provider as much rumor fodder for Apple, but another gem from the patent trial is in the form of a October, 2010 memo from the late Steve Jobs. In a section titled “2011 strategy” there’s a single tantalizing line that reads “create low cost iPhone model based on iPod touch to replace 3GS.” While it takes time to develop a phone and bring it to market, it seems that Apple either never could figure out a satisfactory way to do this or simply chose not to. That iPod Touch started at $229 for an 8GB model and it’s very hard not to wonder whether the much rumored $299 from last year couldn’t have become a reality based on such a design. But of course it didn’t.
Instead, Apple took the internals from the iPhone 5, wrapped them in a solid plastic shell and produced the iPhone 5c at a price more than twice than in much of the world (it’s $549 without subsidies in the U.S., so a bit less than that here). For all the criticism the 5c has taken, however, it’s very difficult to know how it would play at a much lower price and perhaps without 4G LTE on board. Keep in mind until the iPhone 5, that wasn’t a must-have feature here and it still isn’t in much of the world.
A cornucopia of phones?
Apple already sells four generations of iPhone globally (the iPhone 4 is still available in some markets) and with the multiple colors and memory configurations of the new models, actually has well over 100 SKUs of iPhone at this point. While the company strives for simplicity, it’s not impossible to imagine 2014 as the year the iPhone lineup begins its radical revamp, while taking on some more geographic diversity. The two brand-new, larger-screen models become the flagship phones, occupying the high margin position carved out by the 5s today. That protects the bulk of Apple’s existing profits, perhaps even enlarging them.
Beneath that, the “c” models take a radical move south on price as the iPod Touch — which Apple wrote the obituary for a few months back without actually euthanizing — disappears. Imagine something close to the existing 5c, but closer in price to $299 for the no-LTE model. Perhaps an LTE version, carrying technology from the 5s is $399 as an upsell.
What Apple learned with the 5c is that its faithful want the latest and greatest and will pay the premium to get it; that’s why 5s sales are eclipsing the 5c everywhere. Going forward it can create a bigger price gap to sell more units of the “c” model for less money without worrying that it will cannibalize the more expensive. All it has to do is make sure the desirability gap is large enough through the new design, the metal body and the larger screen.
None of this suggests Apple should try to compete with the cheapest cut-rate Android hardware. In fact, Apple will likely get away with charging $100+ premiums to excellent branded discount phones like the Moto G and Nokia X. It also begins the process of adding tens of millions more customers to the iOS/AppStore ecosystem, which today is around 10% of the company’s revenue but down the road could be a $50 billion business.
This kind of strategy also provides Apple with an important hedge. Should the market for $600+ smartphones shrink against reduced carrier subsidies, the company will be better prepared to sell greater numbers of lower-margin phones at whatever price the premium tier settles at. There’s at least some reason for concern here. In the U.S., comScore tracks the installed base on smartphone users every month and Apple had been gaining share with consistency — until recently. Over the past two months, the percentage of smartphone users with iPhones has declined sequentially for the first time since the launch of the iPhone 4.
The declines are tiny, just 0.2% and 0.3%, but the fact it hasn’t happened in years is significant. Apple still has 41.3% of all U.S. smartphone users, as many as Samsung, LG and Motorola combined, but there was a time it looked headed toward an inevitable majority in its home country and that no longer appears to be a given. A shift in tactics to a broader iPhone lineup could restore that inevitability.
None of this is easy, and any of it to work, Apple will have to follow one of its old slogans and begin to “think different.” It has had tremendous success capturing the vast majority of the smartphone industry’s profits for years now. But for all that success, it has found itself unable to do something critical: satisfy customers. CEO Tim Cook has talked passionately about his desire to do just that many times. In 2014, Apple is likely to take some critical steps with the iPhone lineup. Along the way, it just might satisfy shareholders too.