The iPhone is a juggernaut with unit sales up 25% in 2014, representing close to 70% of Apple's operating income. Many market observers are wondering if Apple is approaching a limit to iPhone sales growth. With the iPhone 6 and 6 Plus representing possible inflection points in the phone market, the ingredients are in place for Apple to sell 300 million iPhone units annually within three years, which would represent 50% growth from the 193 million iPhones sold in 2014. By executing on a number of achievable tasks, including taking advantage of weaker smartphone competition, building a wider sales distribution network, broadening the iPhone lineup, and increasing the iPhone's value proposition, Apple would be in a position to increase its phone market share by more than 400 basis points from 11% to 15% within three years.
The iPhone Growth Strategy
I continue to view doubling down on iPhone is in management's best interest as the iPhone 6 and 6 Plus serve as possible inflection points, reinvigorating the iPhone line. Apple can market the larger-screen iPhones to the hundreds of millions of smartphone users who did not buy an iPhone as their first smartphone over the past few years.
There are a number of pieces that need to come together for Apple to sell more than 300 million iPhones annually within three years.
Maintaining the iPhone Upgrade Cycle. With approximately 80-85% of iPhone unit sales coming from previous iPhone owners, it is crucial that Apple maintains a healthy iPhone upgrade cycle. Assuming a 2-3 year life cycle and relying on a few data points from Apple's recent earnings call, I estimate that approximately 185 million iPhone users are likely to buy a new iPhone in 2015, up from 165 million users in 2014 and 130 million users in 2013. Exhibit 1 highlights how crucial iPhone upgrades are to total iPhone sales.
Exhibit 1: iPhone Unit Sales Breakdown (iPhone Upgrade vs. New to iPhone)
The significant increase in iPhone upgrading in 2014 was driven by the iPhone 6 and 6 Plus and that trend will continue in 2015. As the iPhone user base expands, it is not hard to fathom that close to 250 million iPhone users will be upgrading their iPhones on any given year by 2017. Apple would likely position the screen, battery, and camera as some of the more marketable upgrades each year, as well as upgraded components including the fingerprint sensor, speakers, headphone jack (or lack thereof). In addition, Apple will continue to update the iPhone's form factor, including cosmetic chances, as well as altering width and weight.
Appealing to Android Users. Android represented approximately 80% of global smartphone sales in 2014, depicted in Exhibit 2. In order for Apple to achieve 50% iPhone unit sales growth within three years, Apple needs approximately 40-45 million iPhone unit sales annually to come from new users who currently don't own an iPhone. Android would be positioned as the most likely target for these platform switchers given Windows' low market share and Blackberry's lack of sales.
Exhibit 2: Smartphone Shipments and Market Share
Tim Cook mentioned on Apple's most recent earnings call that iPhone 6 and 6 Plus saw a higher Android switcher rate than the previous three iPhone launches. Exhibit 3 highlights this increasing trend of non-iPhone users making up a larger share of total iPhone sales. Given market dynamics, it will be difficult to have non-iPhone users make up more than 20-25% of iPhone sales, unless the iPhone upgrade cycle slows or Apple is more successful in getting new users to the platform.
Exhibit 3: Percent of iPhone Sales to Non-iPhone Users
Considering that Apple sold 20-30 million iPhones to new users annually since 2012, it is achievable to grow this to 40-45 million new users a year (the range required to grow iPhone shipments 50% by 2017). China Mobile alone may represent 15-20 million new iPhone users a year.
With a target of acquiring 40-45 million new iPhone users each year, Apple would be aiming for the top 4% of the Android base, which is a plausible goal. In terms of the most appropriate Android competition, 40-45 million represents less than 15% of Samsung's annual smartphone shipments. The high-end Android phone environment is quite different in 2015 as Samsung has lost momentum and Apple has a more competitive phone in terms of screen size. Samsung still has 20-30% share of the smartphone market in many developed countries, and those users will eventually be ready to upgrade their phone. Samsung has loyalty rates close to 60% in its strongest market (U.S.). Apple has a 90% loyalty rate. While 60% loyalty may seem high, the other way to look at it is 40% of Samsung's base will likely look at what else is in the market when it is time to upgrade phones. This trend may represent Apple's best opportunity to convert Android users to iPhone in developed markets. For the first time, premium Android users will walk into a mobile carrier store and compare similar-sized iPhones and Samsung Galaxy phones.
Appealing to Feature Phone Users. If Apple picked off 40-45 million premium Android users each year, within three to four years, much of the high-end Android market would have switched to iPhone, which may not be the most realistic assumption. In that case, Apple will also likely need to rely on feature phone users looking to buy their first smartphone. With smartphone penetration around 75% in the U.S., according to comScore, and lower penetration rates else where in the world, there is still opportunity for Apple to appeal to customers looking to buy their first smartphone. Gartner estimated there were around 900 million feature phones sold in 2013. While some may think late adopters in developed markets will gravitate towards low-end smartphones, I actually think the opposite may occur as late adopters (especially the top 5-10%) may look at a smartphone as a laptop/desktop replacement and be willing to spend more money on an smartphone.
Exhibit 4 displays overall phone shipments, including the roughly 600-700 million feature phones likely shipped in 2014. Samsung's market share decline (22% from 25%) was likely a result of Apple's stronger iPhone lineup and more competitive offerings from Chinese smartphone vendors.
Exhibit 4: Overall Phone Shipments and Market Share
In China, 20% of iPhone sales last quarter were to first-time smartphone users. Add these first-time smartphone buyers to premium Android switchers, and the goal of getting 40-45 million unit sales annually from the 1.7 billion of non-iPhone phone shipments seems a bit more attainable.
Expand Distribution. Apple now has 72% of the world's mobile phone subscriber base covered with 375 carriers supporting iPhone. In recent years, Apple has benefited greatly by adding carrier distribution partners, such as NTT DOCOMO and China Mobile. Apple is still seeing a positive impact from China Mobile despite it being a full year after launch as Apple continues to work on expanding distribution points in China, both in terms of brick-and-mortar retail as well as online. The easy growth phase may be over in terms of carrier expansion, which is why appealing to Android and feature phone users may represent most of the iPhone's near-term growth potential. Nevertheless, countries such as India and Brazil represent untapped sales potential. While such markets are not as established compared to China, there is room to expand iPhone's reach.
Expand iPhone Product Line and Price Points. While a "cheap" iPhone may not fit in Apple's strategy, I would expect management to continue debating the merits of releasing a new 4-inch screen iPhone that is sold at a slightly lower price than the iPhone 6. A smaller iPhone wouldn't be a top seller when compared to the bigger screens counterparts, but I don't think management will consider that as a factor for whether or not to release a smaller iPhone. The fundamental question comes down to whether the experience produced by using a 4-inch iPhone can be better for some users than using a larger iPhone.
In regards to overall iPhone pricing, I would expect Apple to continue bringing down the entry-level price of older iPhone models. I previously laid out how Apple is able to successfully maintain user experiences by selling older models at a lower price. Such a pricing strategy will help maintain iPhone momentum as Apple focuses on grabbing as much profit share as possible at each price level before moving further down market.
Increase iPhone's Value Proposition. Apple is positioning iPhone into critical aspects of our lives (home, health, car, finance) using HomeKit, HealthKit, CarPlay, and Apple Pay. Such efforts are not only to prevent Android from establishing insurmountable positions in key parts of our daily lives, but also to increase the iPhone's value proposition. The Apple Watch may also come into play as an ancillary device meant to break complex tasks into simpler, more manageable ones, may prove to increase iPhone loyalty and serve as a catalyst for driving news users to iOS.
Selling approximately 300 million iPhones annually (up from 193 million units sold in 2014) would boost Apple's annual revenue by $60 billion. Assuming Apple is able to maintain iPhone margins, boosting iPhone's share of the phone market from 11% to 15% would equate to an additional $25 billion of operating income, or close to $20 billion on an after-tax basis (roughly $4.00/share). Considering that Apple reported $7.42/share EPS in CY2014, it becomes clear that the iPhone is one of the more important drivers for Apple EPS going forward in the near-term, especially with the Apple Watch accounting for a relatively small share of the revenue pie in the first 1-2 years on the market. Exhibit 5 includes Above Avalon's iPhone units sales and growth estimates.
Exhibit 5: Above Avalon's iPhone Unit Sales and Growth Estimates (Calendar Year)
The Big Picture
In 2014, the iPhone represented approximately 11% of phone market sales. While some question if there is much growth left in iPhone, I think there is an attainable strategy that can lead Apple to grow annual iPhone sales by 50% from 193 million units in 2014 to approximately 300 million units in 2017. In such a scenario, the iPhone would represent 15% of the phone market. For some perspective, even after growing iPhone sales by 50%, five out of six people buying a phone in 2017 would still be choose something other than an iPhone.
Obviously, execution remains key, and I continue to think maintaining the iPhone upgrade cycle is Apple's most difficult task. If users stop seeing the need to upgrade their iPhones every 2-3 years, it will be difficult for Apple to achieve 300 million unit sales within three years as there won't be enough new users coming from Android and feature phones to offset the decline. In terms of appealing to Android and feature phone users, the current iPhone lineup has never been stronger. For the first time, Apple will have iPhone models that display very well next to big Android phones in mobile carrier stores. Many consumers go to carrier stores not knowing which phone they will end up purchasing, so having a competitive product with a large screen may be a big factor in explaining how Apple can grow market share. In emerging markets, Apple continues to improve iPhone's distribution infrastructure in order to sell less expensive, older models at additional points of sale. It is in Apple's best interest to double down on the iPhone given current market dynamics and the 2-5 year outlook.
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