Leasing Solves Apple's Cheap iPhone Dilemma

Apple is on track to sell more than 250 million iPhones over the next 12 months. When looking at overall sales share, the iPhone remains a small player, representing only 15% of overall phone shipments. However, on a profit share basis, the iPhone has rewritten the rules guiding the smartphone market, commanding upwards of 90% of the industry's profit. Even though Apple's mission has never been to sell the most of a product, there may be a way that Apple can grow iPhone's sales share rather significantly while retaining control of the smartphone industry's profits. An iPhone leasing model solves Apple's dilemma of how to address a larger portion of the smartphone market without diluting its aspirational brand and iPhone experience.  Leasing will usher in the next major phase of the smartphone industry by solving Apple's cheap iPhone dilemma.

The Changing Smartphone Market

In the early days, the prevailing way consumers bought an iPhone was with carrier subsidies. Instead of paying the $649 up-front price for the base iPhone model, AT&T would "subsidize" $450 of the cost, which would later be indirectly recouped by charging higher monthly service fees. However, as time went on and additional carriers began selling iPhone, the subsidy model represented a declining percentage of overall iPhone sales. A growing share of iPhone buyers were now paying full price for iPhone but in return getting lower monthly service fees from their carrier. Over the past eight years, in an environment where the iPhone's full cost is either born by the consumer up front or the carrier through a subsidy and subsequent two or three year contract, the iPhone was able to grab a commanding share of the premium portion of the smartphone market (>$400) with much less success in the middle market ($200-$400).

Spurred on by competition and unsustainable growth in iPhone subsidy costs, U.S. mobile carriers began to move away from the smartphone subsidy model and are currently embracing a leasing paradigm. Consumers are now able to pay either nothing up front or a small initial payment and then pay back the rest of the iPhone across a number of months, usually 24. Since carriers are no longer on the hook to "subsidize" part of the iPhone's cost, monthly service costs have been reduced although data has continued to become more expensive over the years. 

In an effort to retain the best customers, and as a sign of the iPhone's market power, carriers have included options for iPhone users to lease a new iPhone each year by simply turning in their old iPhone. The end result is a growing number of iPhone owners that lease their iPhone, paying the same price each month, but upgrading to the newest iPhone each year. 

Apple has recently gotten involved in the mix by launching the iPhone Upgrade Program in conjunction with the iPhone 6s and 6s Plus launch. While currently only available at Apple Stores in the U.S., the program is designed for those who want a new iPhone each year with the added peace of mind provided by AppleCare+. Customers apply for a loan financed by Citizens to cover the cost of the iPhone, AppleCare+, and sales tax. After the initial payment is made, the loan holder then has to pay back the price of the iPhone and AppleCare+ in 23 equal installments. However, after the 12th payment, the loan holder can hand in his or her current iPhone at an Apple Store and then upgrade to the newest iPhone by signing up for another 24-month loan. The cycle then repeats itself until the next year. Similar to what is happening at the carriers, the iPhone Upgrade Program is creating a growing number of iPhone owners that lease iPhones which shortens the iPhone upgrade cycle, boosting iPhone sales.

While we are still early in the iPhone leasing movement, early survey results suggest there is interest in leasing programs, including Apple's iPhone Upgrade Program. Since so few iPhone sales occur in U.S. Apple Stores, any near-term impact directly related to the iPhone Upgrade Program will likely be moot. Citizens expects less than one million customers to use the iPhone Upgrade Program over the first 12 months. Longer-term trends, and more importantly, the learning experience Apple is receiving by leasing iPhones, bode well for the program. It would be surprising if Apple does not expand the program to new countries over time. 

The Cheap iPhone Is a Myth

The call for Apple to release a cheap iPhone reached a fever pitch a few years ago when Apple first entered China with China Unicom and China Telecom relationships. Even though Apple has steadily grown market share and unit sales, a certain group of analysts and pundits continue to think the only way Apple would be able to do well in China and emerging markets would be to release a "cheap" iPhone. The problem with this thesis is that there were very few strategies Apple could realistically use to sell a genuinely low cost iPhone without undermining its business.

A base model iPhone 6s retails for $649 and has an gross margin of approximately 45%. In theory, Apple could sell such a device for $350 and break even, but with a business model dependent on making money from hardware, this isn't a viable long-term solution. Another possible way to sell a cheap iPhone would be for Apple to take a base model and strip out features and components. However, upon closer examination, this is much easier said than done. The iPhone's popularity is a result of the experience obtained from using it. Accordingly, it would be very difficult to maintain that experience by selling a stripped down iPhone with lower quality cameras, screens, and processors. Even then, a stripped down iPhone would still likely sell in the $300-$400 price range, which does not address the low-end of the market.

Another option to market a cheap iPhone would be for Apple to segment screen size according to price tiers. A 4-inch iPhone "mini" could sell for a lower price than bigger-screen options. However, recent iPhone sales trends would suggest a 4-inch screen iPhone would likely become a niche device as consumer preferences are overwhelmingly moving towards larger form factors like the iPhone 6 and 6s, with a growing number of users opting for the larger screens found with the iPhone 6 Plus and 6s Plus. 

Apple would have much difficulty selling a low-cost iPhone at a price that would make it competitive in completely new market segments. The most likely scenario that many have not considered is that a cheap iPhone probably wouldn't be as popular as consensus assumes. In fact, I would go so far as to say a low-cost iPhone would likely disappoint on the sales front. The iPhone's success comes from the branding and aspirational feeling attached to the device. By selling a low-cost version of this experience, consumers would likely not value the device in the same way. 

We saw a real-world example of this buyer aversion in 2013 when Apple unveiled the iPhone 5c. Instead of keeping the previous year's flagship phone, the iPhone 5, around and lowering the price by $100, Apple reconfigured the device by giving it a plastic shell. While the iPhone 5c did sell (I estimate approximately 40 million units were sold during its lifetime from 2013 to 2015), it was not enough to change the game. Instead, the device quickly gained the nickname "the cheap iPhone" as the device's colorful plastic shell easily signaled to people it was the cheaper iPhone version compared to that year's more expensive flagship, the iPhone 5s. It was never able to shake its cheap nomenclature. Many consumers buy iPhone for the intangibles that come with such a purchase such as being able to show it (and its high price tag) off to others. The iPhone 5c experiment is a preview of how an actual cheap iPhone would fare in the marketplace: not as well as many assume. 

The much bigger question to ask with a cheap iPhone is what is even considered "cheap"? Even though the iPhone 5c was mocked, the device still sold for a not cheap $549. A stripped down iPhone selling for $300 to $400 wouldn't classify as a cheap iPhone either, especially with other smartphone manufacturers selling product in the $150 to $200 range. The cheap iPhone may be a myth, but Apple is able to recreate many of its benefits, as well as come up with new benefits, by embracing the leasing model. 

Leasing is the Answer

A world in which iPhones are leased solves Apple's cheap iPhone dilemma. With leasing, multiple owners are able to value the same product differently. For some, there is value in being able to use the latest and greatest gadget while for others, the value is in low cost and being able to hold on to a device for a long time.

An iPhone leasing paradigm depends on a few variables including a functioning grey, or resale, market and healthy residual values. A grey market where buyers and sellers are able to transact in a low-cost, convenient, and safe manner is required for a leasing model to effectively move iPhone units from initial buyers to the next group of buyers. Since iPhones retain a good portion of their value as time goes on due to the device's build quality, popularity, and lack of lower cost models, the iPhone has high residual values. Accordingly, iPhones are able to be leased in a cost effective manner. If the iPhone did not hold on to its value well, leasing would prove to be a very expensive option as customers would end up paying most of the iPhone's retail price during the first year of ownership. As a result, the incentive to trade in an iPhone and upgrade would not be high. However, with a high residual value, an iPhone leasing model involves paying only 50% of the iPhone's retail price during the first year. In such a scenario, many would be willing to trade an iPhone in after a year for a new model since most owners currently hold on to their iPhones for two years. 

Leasing creates supply of one-year-old gently used iPhones that can be resold to new customers for less than the cost of a one-year iPhone sold by Apple. If we continue with this example for another year, leasing would create a supply of two-year old iPhones that can be resold to new customers for much less than the cost of a two-year iPhone sold by Apple. With leasing, iPhones make their way down to segments of the market that are not addressed by Apple. Even in an environment without leasing, there is a thriving grey market due to resales. Leasing would only legitimize and expand the grey market. The following chart compares new iPhone pricing at Apple to used iPhone pricing at Gazelle and eBay. Notice how used iPhone pricing currently stabilizes around $200.

Notes: Pricing is for entry-level storage. Gazelle and eBay prices are for unlocked models.

While Apple would not make money on these iPhone resales, Apple would benefit by selling new iPhones to its installed base each year. Apple would therefore be able to address a larger portion of the smartphone market while not jeopardizing its profit share. The cheap iPhone dilemma would be solved. 

The key reason someone would purchase a used iPhone that was previously leased instead of a cheaper iPhone with stripped down parts is that used iPhones retain Apple's aspirational brand characteristics. Instead of using a cheap iPhone that either looks or behaves differently than other more expensive iPhones models, used iPhones would appear and act the same as brand new iPhones. The iPhone user experience remains intact much more in a leasing paradigm. We see this play out in the automobile industry where premium brands such as Mercedes-Benz, BMW, and Audi each have vibrant leasing ecosystems where consumers can lease two to three-year-old automobiles for a much lower price rather than buy scaled-down, low-priced models that question premium car brand attributes.

Follow the iPhone

To better understand how leasing can help Apple address the low-end of the smartphone market, we can follow the path of an iPhone from original purchase to final destination a few years down the road, taking a look at the various owners and pricing along the way. 

  • Step 1: A customer buys a new iPhone 6s 16GB for $649 at an Apple Store using the iPhone Upgrade Program. A two-year loan was originated to finance the cost of the iPhone and AppleCare+.  
  • Step 2: At the end of the first year, the original owner returns the iPhone 6s to Apple. The original loan is then paid off. The one-year old iPhone 6s is then transferred to a third-party specializing in recycling or reselling used smartphones. The original owner leases a new iPhone from Apple with a new two-year loan. 
  • Step 3: The gently used one-year-old iPhone enters the grey market and is resold to a different customer for $450. A comparative one-year-old model would sell at Apple for $550. 
  • Step 4: A year later, the now two-year-old iPhone can still fetch $200 in the grey market. The second owner then decides to sell the device to someone on eBay for $200. A comparative two -year old model would sell at Apple for $450. 

In this timeline, a $649 iPhone was able to be "bought" by three customers over the span of three years for a collective $1,299. The difference in prices helps facilitate the grey market transactions. A larger and more robust leasing paradigm would make this process much more efficient and legitimate, similar to how leasing used cars pretty much involves the same process and players as leasing a new car. Over time, used iPhones would be able to be purchased or leased at many of the same locations where new iPhones could be purchased. 

One consequence of additional iPhone supply entering the grey market as a result of additional iPhone leasing is that resale prices may fall in order to match demand. However, there appears to be significant room for prices to fall without impacting the leasing paradigm, as displayed in the following chart. The black dashed line represents the point where iPhone resale values could fall to in order to still work with Apple's iPhone Upgrade Program.

Notes: Pricing is for entry-level storage. Gazelle and eBay prices are for unlocked models.

Financial Impact

Apple currently has an iPhone installed base of approximately 500 million users. When taking into consideration hand-me-downs and the resale market, the total number of iPhone users exceeds 500 million. If we were to assume leasing will be the only method by which iPhones will be purchased in the future, than theoretically, Apple would sell 500 million iPhones a year (every iPhone user would simply lease a new iPhone every year). A 500 million iPhone annual sales rate would be 98% higher than the current 253 million sales that I expect Apple to sell over the next 12 months. 

In reality, we are still in the very early innings of the iPhone leasing model, and not everyone will want to lease their iPhone. However, running with conservative estimates of 20-25% adoption rates for iPhone leasing over time, it does not take much to begin seeing a tangible benefit to Apple's iPhone sales. At 20% adoption, Apple would sell an additional 50 million iPhones a year. Said another way, if 100 million iPhone users leased their iPhones each year, Apple would see a 50 million unit boost to unit sales each year. The other benefit from leasing would be that used iPhones would help expand the iPhone user base benefitting the iOS ecosystem which may come in handy as Apple continues to push on content deals (Apple Music, Apple Video in 2016) and services such as Apple Pay. 

With iPhone leasing at 20% adoption, it is conceivable for iPhone's smartphone sales share to increase by 4-5% to 20% without even needing an entry-level low-cost iPhone to boost sales.  

iPhone Leasing Momentum

Ultimately, the only reason leasing iPhones makes sense in the first place is that the iPhone is becoming the primary computing device for hundreds of millions of people. There is a significant need and desire to use the newest iPhone each year. This would be a new type of hardware paradigm compared to previous computer technology eras where consumers bought and then held on to gadgets for years. Another reason an iPhone leasing model works is that consumers have noticed Apple's iPhone development cycle and the company's ability to ship new iPhone features each year. Mediocre annual iPhone upgrades would likely make leasing a much harder sell as consumers would decide just to hold on to their new iPhone for a few years, a much cheaper alternative than leasing. Ultimately, leasing changes the smartphone game by expanding Apple's addressable market and solving the company's cheap iPhone dilemma. 

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