The Gray Market's Impact on iPhone Pricing

The expanding gray market for refurbished and previously-owned iPhones continues to gain legitimacy and influence. According to my estimate, approximately 150M iPhones in use passed through the gray market. This means that nearly 20% of iPhones in the wild, including hand-me-down iPhones, were previously owned by someone else. Along with helping Apple expand its user base, the gray market is also impacting Apple’s iPhone pricing strategy in an unexpected way: by driving iPhone average selling price (ASP) higher.

iPhone ASP

A few years ago, consensus was convinced that Apple would need to lower iPhone pricing due to competitive pressures. The iPhone 5c and iPhone SE, while very different from each other, were positioned by many as attempts by Apple to address lower-priced market segments.

However, things changed in a big way in 2017. Apple became more aggressive at the high-end of the iPhone line. The iPhone X’s $999 starting price was one of the most talked about Apple topics last year. Apple also increased pricing for iPhone 8 and 8 Plus. Management expanded on its high-end iPhone pricing strategy last month with iPhone XS Max, the highest-priced iPhone to date. In what ends up being a sign of how far Apple’s iPhone pricing has changed, Apple’s “low-cost” flagship, the iPhone XR, is priced $50 higher than the iPhone 8.

Given higher-priced flagship iPhones, it shouldn’t come as a surprise that iPhone ASP has been on the rise. As seen in Exhibit 1, which tracks iPhone ASP on a trailing twelve months basis, a notable upward trajectory in ASP began in 1Q18 with the iPhone X launch.

Exhibit 1: iPhone Average Selling Price (ASP)

The rise in iPhone ASP has led some to conclude that Apple must have shelved its strategy for growing iPhone sales and the user base by lowering prices. Instead, Apple is said to be milking existing iPhone users with higher-priced models. This school of thought ends up ignoring how the expanding market for refurbished iPhones is contributing to new user growth and a higher iPhone ASP.

Gray Market Impact

A tenet of Apple’s iPhone pricing strategy has been selling older flagship iPhones at lower prices. For example, along with selling iPhone XS Max, XS, and XR, Apple continues to sell iPhone 8, 8 Plus, 7, and 7 Plus. Apple is even selling older models such as the iPhone SE and 6s Plus in select markets. The company is able to run with lower prices for these older flagship models due to economics of scale and improved production and assembly costs.

Traditionally, older iPhone models accounted for as much as 30% of overall iPhone sales. Having such a significant portion of unit sales going to lower-priced iPhone models kept a lid on iPhone ASP. However, things are changing. In 3Q18, non-flagship iPhone models likely represented just 20% of overall iPhone unit sales. As the number of customers buying refurbished and pre-owned iPhones through the gray market increases, Apple is seeing less demand for the lowest-priced iPhones in its lineup. Customers in lower price brackets have additional iPhone purchasing options at their disposal thanks to the gray market.

Despite weaker demand for lower-priced iPhones, Apple continues to see modest growth in iPhone sell-through demand. This tell us that demand for new flagship iPhones has not subsided. Instead, demand for higher-priced iPhones is growing. The shift in iPhone sales momentum from lower-priced, older flagships to higher-priced iPhones is contributing to higher iPhone ASP.

Gray Market Ingredients

Three key ingredients are needed to sustain a functioning gray market for iPhone.

  1. Good device durability and usability. Simply put, iPhones need to hold up over time. A phone that can barely last after two or three years of usage is not conducive to a vibrant used market.

  2. Strong demand for refurbished iPhones. Many of Apple’s competitors lack a vibrant gray market given the lack of customer demand for refurbished products from that brand. In addition, other brands directly address lower-priced segments. However, given Apple’s iPhone pricing strategy and the company’s aspirational brand, there is a considerable amount of interest and demand for refurbished iPhones at lower prices.

  3. Steady supply of gently-used iPhones. Services like early upgrade plans offered by mobile carriers and Apple’s iPhone Upgrade Program are resulting in a stream of gently-used, year-old iPhones being turned in by customers. This supply of used iPhones is needed to satisfy the demand for lower-priced iPhones.

Durability and Usability

At last month’s iPhone and Apple Watch event, Lisa Jackson, Apple VP environment,
policy and social initiatives, unveiled Apple’s latest environmental goal to eliminate the need to mine new materials from the earth. In order to stop mining new materials, Apple will focus on three things:

  1. Find new ways to make products with recycled or renewable materials.

  2. Make products last as long as possible.

  3. Recycle products properly.

Increased durability doesn’t just allow existing customers to use Apple products for longer. The products can also enter the gray market and eventually be used by more people over time.

When it comes to durability, Jony Ive and Apple’s Industrial Design group have been focused for decades on the topic as it relates to product design. Good product durability is one reason there is already a strong gray market for iPhone. It is true that Apple designers sometimes find themselves between a rock and a hard place in terms of durability. Mobile batteries are a prime example. The fact that iPhone users can’t easily replace batteries is a durability trade-off in order to achieve other usability goals. However, Apple’s embrace of an iPhone battery replacement program speaks to management’s desire to elevate device durability within its iPhone strategy.

Meanwhile, Apple’s focus on having iOS 12 support older iPhone models highlights management’s motivation to improve usability. By supporting iPhone models going back to the 5s, Apple is able to keep tens of millions of devices, many of which have likely passed through the gray market, running the latest software. This proves beneficial when it comes to keeping these iPhones in circulation.

Strong Demand

Apple has the most popular smartphones in the market. This popularity translates to strong demand for iPhones, even at higher prices. The reason iPhone sales are a fraction of overall smartphone sales is that Apple is only playing in certain market segments. Such a decision ends up providing a huge boost to the iPhone gray market as there is unfilled demand for lower-priced iPhones.

The gray market allows Apple to reach customers who may not otherwise be in the company’s traditional target market. While iPhones sold in the gray market aren’t included in Apple’s revenue, the company does benefit if sales are to new users. Apple is able to sell services and additional hardware to these new users over time. This cycle becomes that much more impactful assuming an iPhone ends up being passed on to three or four owners over its lifetime, with each ownership change occurring at a lower price.

Steady Supply

Services like early upgrade plans offered by mobile carriers and Apple’s iPhone Upgrade Program are made possible by a functioning gray market. Robust residual values make it financially feasible for users to turn in gently-used iPhones after making 12 monthly payments and walk away with the newest iPhone. Many of these gently-used iPhones that are turned in are then recirculated in the market to find a new home. This creates the supply the iPhone gray market needs to sustain itself.

Exhibit 2 highlights iPhone residual value as a percentage of original launch price. After the first year, iPhone residual value is approximately 40%. This means that an original iPhone 8 / 8 Plus owner trading in the device after a year can expect to receive 40% of the device’s original cost. The percentages come from iPhone trade-in values offered through Gazelle. It is important to note that iPhone users may find better trade-in values elsewhere, such as store credit through Apple.

Exhibit 2: iPhone Residual Value Percentage

Note: Trade-in values are for unlocked iPhones in “good condition” and for the lowest storage configuration.

iPhone depreciation appears to be high in the first year (62% on average). The rate of depreciation slows to 13% in the second year and 11% in the third year. All of these iPhone depreciation rates appear to be lower (iPhone has stronger residual values) than the rates of Samsung smartphones.

My theory regarding these residual value/depreciation rates is that iPhone trade-in programs offered by some mobile carriers are beginning to result in a supply of gently-used iPhone 8 and 8 Plus iPhones entering the market. This may be leading to some weakness in trade-in offers for these models from sites like Gazelle. Interestingly, the higher-priced iPhone X has a better residual value percentage than does the lower-priced iPhone 8 and 8 Plus. This could be due to the iPhone X launch taking place in November 2017. Meanwhile, there appears to be a better supply/demand environment for customers trading in two and three year old iPhone models, as seen by lower depreciation rates.

As the gray market for refurbished iPhones grows, it would not be surprising to see iPhone residual values improve slightly over time as demand for pre-owned iPhones increases.

Stronger Flagship iPhone Sales

Earlier this year, the WSJ published an article positioning the gray market as “a culprit to blame for slumping [smartphone] sales.” The scenario painted by the WSJ was that current iPhone users were turning to the gray market when buying iPhones. This was said to result in less demand for higher-priced flagship iPhones.

The problem for the WSJ is that their thesis was built on the theory that iPhone X sales were weak. In reality, Apple sold 60M iPhone X units since launch, which is an impressive feat. The WSJ’s factually incorrect stance ended up being widely held in the press, despite Apple management declaring quarter after quarter that the iPhone X was the best-selling iPhone.

While it may seem counterintuitive, a healthy iPhone gray market can boost sales for higher-priced flagship iPhones. A functional gray market makes it possible for services like mobile carrier upgrade plans and Apple’s iPhone Upgrade Program to exist. As the number of iPhone users take advantage of these upgrade services, Apple sees a growing stream of annual iPhone upgrades. In a market in which the overall iPhone upgrade cycle is getting longer, annual iPhone upgrades, even if representing a small percentage of sales, can play a role in stabilizing iPhone demand and boosting iPhone ASP.

Looking Ahead

Apple will continue to sell lower-priced, older iPhones in in select markets, like India. However, as the gray market for refurbished iPhones continues to expand, Apple will face less pressure to come out with lower-priced iPhones with fewer features in developed markets. This dynamic bodes well for the idea of higher iPhone ASPs over time.

In 3Q18, Apple reported a $724 iPhone ASP, a record-setting $118 higher than the $606 iPhone ASP reported in 3Q17. It will be difficult for Apple to report a similar jump in iPhone ASP in FY2019. Instead, the more likely scenario is that the long-term average for iPhone ASP gradually increases. Over the past 10 years, the mean iPhone ASP was $640. It is possible that this mean ASP will move towards $700 over time.

The iPhone gray market is turning into a long-term tailwind for iPhone ASP. A major implication from such a development is that iPhone ASP is more resilient and sustainable than it may appear at initial glance.

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