iPhone SE Is Apple's $30 Billion Bet on 4-Inch Screens

Instead of representing a seismic shift in iPhone strategy, the iPhone SE is a byproduct of Apple's current screen size differentiation strategy. Apple has given the iPhone SE a very specific mission: succeed the iPhone 5s and entice a portion of the 240 million iPhone users still using a small screen iPhone to upgrade to newer hardware. Apple is placing a $30 billion bet that a 4-inch iPhone with a four-year old design, updated with newer components, will help accelerate the iPhone upgrade cycle. The iPhone SE is a "special" opportunistic bet set within Apple's existing strategy to expand the iPhone line. 

Background

The best way to understand why Apple introduced the iPhone SE is to look at the iPhone business over the past few years. In September 2014, the iPhone 6 and 6 Plus not only kicked off Apple's entry into multiple screen size iPhone development (4.7-inch and 5.5-inch screens), but also began a global sales bonanza as pent-up demand for larger iPhones, combined with the iPhone rollout at China Mobile, resulted in strong 37% year-over-year growth in iPhone sales for FY2015. 

However, in recent months, a few negative developments began to appear in the iPhone business. While Apple was still bringing new customers into the iOS ecosystem at a steady clip, the rate at which existing iPhone users were upgrading to newer iPhones was beginning to slow. Specifically, 3.5-inch and 4-inch iPhone users were showing hesitation towards getting larger screens. While the reasons for this hesitation vary with some preferring smaller screens and others simply being content with their current small iPhone, Apple had a growing dilemma on its hands: how to get these users to upgrade to newer iPhones. The motivation isn't just found with hardware profits, but also with services revenue since roughly 40% of the iPhone user base is using an iPhone that does not support Apple Pay in retail stores. 

To make matters worse, Apple stopped selling its low-cost iPhone 5c (an OK seller) this past September, which meant the iPhone 5s was Apple's last remaining 4-inch screen iPhone. With the device getting long in the tooth and its third anniversary quickly approaching, Apple would need to make tough choices regarding not just the iPhone 5s, but also its broader 4-inch screen strategy. It was time for Apple to place a few bets. 

The Keynote

Apple VP Greg Joswiak had one objective when announcing the iPhone SE: explain to the press why Apple is selling a new 4-inch iPhone when the trend had been towards larger screen iPhones. Obviously, he couldn't say that Apple needed a way to get existing 3.5-inch and 4-inch iPhone users to upgrade, so instead he framed the narrative that small screens were still popular among iPhone users in addition to serving as an iOS entry point for new users. Specifically, Joswiak pointed out that 13 percent of iPhones sold in 2015 (more than 30 million units) were 4-inch iPhones. Since Apple sells more than 200 million iPhones per year, even a small sales percentage like 10-15 percent is a significant number of iPhones. 

After saying that people (current iPhone users) asked and pleaded with Apple to keep a small 4-inch iPhone in the lineup, Joswiak spent the rest of his time on stage explaining that Apple was going to do just that. Instead of facing the prospect of the 4-inch iPhone form factor possibly becoming extinct in a few months, Apple would take an iPhone 5s and future proof it by adding some of the latest technology to the same "beloved aluminum design" familiar to hundreds of millions of customers. 

Slide after slide, Joswiak ran with the message that the iPhone SE was better than the iPhone 5s. Specifically, Joswiak focused on the features that would matter most to existing iPhone 5s users thinking of upgrading, discussing how the SE was faster than the 5s, had better battery life, included better cameras, and of course, supported Apple Pay.

Apple spent most of the iPhone SE slides comparing the device to the iPhone 5s. 

The message couldn't be clearer. Apple is positioning the iPhone SE as a "special edition" model targeting the 240 million existing iPhone users still on smaller screens. If the SE ends up also appealing to feature phone users or Android users in emerging markets, then the model will have done even better than expected, but this is not Apple's primary target. 

Within just five minutes, Joswiak was able to explain the iPhone SE. The presentation's brevity was due to the device being an iPhone 5s with some 6s internals. The iPhone SE isn't quite an iPhone 6s in smaller form factor as it contains the same screen and home button as the 5s resulting in no 3D Touch or second-generation Touch ID. Meanwhile, the front-facing camera is the same one included in the iPhone 6 and 6 Plus. Instead, Apple picked a component set that would not only appeal to existing iPhone users, but also be able to last for an extended period of time in an iPhone line that would see updated components in six months with new flagship iPhones.  

Future-proofing the iPhone SE.

Price

From Apple's perspective, having 30 million people buy a 4-inch iPhone in 2015 suggested that smaller iPhones still had a future. However, a key question remained. How much of this small iPhone demand was due to the iPhone 5s (and 5c) having a small screen or low price? During the first nine months of 2015, Apple sold the iPhone 5c for $450 while the iPhone 5s went for $549, followed by a $101 price reduction this past September. The fact that a greater percentage of smaller rather than larger iPhone sales went to first-time iPhone users didn't do much to answer the fundamental question concerning screen size versus low price. 

Apple was very deliberate in choosing the iPhone SE's $399 price. The device is not priced as a cheap iPhone 6s, but as an iPhone 5s successor. This means that in a world where a year-old 4.7-inch iPhone retails for $549, a 4-inch iPhone with a four-year old design needs to be priced aggressively to appeal to existing small iPhone owners. 

Pricing a new iPhone at $399 is a significant change for Apple because for the first time, a consumer could own the latest iPhone technology at a 40% discount from the traditional $649. However, instead of this change being a transformational shift in Apple pricing strategy, the move is actually based on Apple's screen size differentiation strategy kicked off in 2014 with the iPhone Plus. Apple has been positioning screen size as a way to determine an iPhone's price. The iPhone SE is the first 4-inch model to go through this differentiation strategy. As seen in Exhibit 1, the iPhone SE is positioned within the iPhone line as Apple's less expensive 4-inch iPhone 5s successor. Come September, the iPhone SE will have year-old technology and be in line with year-old $549 4.7-inch and $649 5.5-inch models. 

Exhibit 1: The iPhone SE's Place Within the iPhone Line (September 2016) 

Similar to how an iPhone Plus is priced at a premium to the flagship 4.7-inch model, a 4-inch model would be priced at a discount to the flagship iPhone model. The iPhone SE's borrowed iPhone 5s design allowed Apple to hit this $399 price without destroying profit margins. In addition, the iPhone SE is still priced at a premium internationally, similar to other iPhone models, suggesting Apple is not looking at the iPhone SE as its "cheap iPhone" emerging markets trojan horse. Instead, the iPhone SE is a special edition 4-inch model geared toward existing iPhone users that crave small iPhones.

The $30 Billion Bet

Apple is making a significant bet with the iPhone SE as billions of dollars in revenue are put at stake by discontinuing the iPhone 5s and positioning the iPhone SE as its only small iPhone. 

Over the next two years, Apple thinks it will be able to use an updated iPhone 5s to entice a certain percentage of the 240 million iPhone users still using small iPhones to upgrade. From a sales perspective, if the iPhone SE can continue to grab the same sales share as the iPhone 5c and 5s in 2015, then the device will bring in $7 billion of revenue in FY2016 (two quarters remain), as shown in Exhibit 2.

However, with the iPhone SE displaying qualities characteristic of a model that will stay around in the lineup for a while, Apple's bet could escalate to $30 billion of revenue over the span of the next two years. Of course, it is conceivable that at $399, the iPhone SE will sell even better than Apple expects and represent as much as 25% of iPhone sales, which would contribute nearly $40 billion of revenue to Apple's top line over the next two years. On top of it all, much of this revenue would be related to iPhone sales that may not have occurred if it wasn't for a new 4-inch model. 

Exhibit 2: Potential iPhone SE Unit Sales and Revenue (FY2016 and FY2017)

If the iPhone SE sells well at $399, then Apple will gain confidence with future 4-inch screen pricing strategy, especially for a completely new 4-inch screen iPhone (likely priced at $499). This pricing strategy would largely be based off of Apple's ongoing screen size differentiation strategy in which larger iPhones are sold for more while smaller iPhones are sold for less. 

A poor performing iPhone SE at $399 will provide even greater insight to Apple. If the iPhone SE doesn't sell well, then Apple knows consumers likely prefer a completely revised iPhone and not just an older iPhone with newer components. The fact that 240 million are still using small iPhones despite being able to upgrade to newer, larger models, suggests there is some level of demand for a small iPhone, even if it represents only 10-15% of the iPhone user base (translates to an eventual 50 to 100 million users).

Apple's iPhone Strategy

Apple employs a business strategy of selling a select number of iPhone models at significant volumes and premium prices in order to maximize profit. Beginning at the high-end, Apple squeezes as much profit out of the smartphone market as possible, gradually working down market, grabbing whatever profit is available at each subsequently lower price tier. The end result is that Apple holds 90 percent smartphone profit share but 15 percent sales share. 

Historically, $649 was the lowest price at which Apple was willing to sell the latest iPhone technology. Meanwhile, older iPhone models with dated technology were offered at $450 and $549. However, these prices were for an iPhone line that lacked screen size diversification. As the iPhone line matures and Apple embraces multiple screen sizes, larger iPhones are priced at a premium while Apple is pricing newer, smaller iPhones at a discount. This dynamic is now taking place with the iPhone SE.

Heading into last week's keynote, expectations were for the iPhone SE to be priced at $399 or $449, so its $399 price is not so much a shock, but rather a sign that Apple is confident it can manufacture the device quite efficiently. Given its four-year old "beloved" design and the fact that all of its components are already being produced at scale and will be included in nearly 200 million iPhone 6s and 6s Plus units sold in FY16, Apple is able to sell the iPhone SE at $399 and still retain respectable profit margins.

Apple is essentially utilizing screen size differentiation as the next step in its long-standing iPhone strategy of maximizing profit by moving downmarket. At $399, Apple would be pushing consumers in the $199-$299 price range to move up and purchase the iPhone SE. This moving up process results in value creation within the smartphone market as consumers are willing to spend more on an iPhone - a byproduct of Apple's existing strategy.  

While the iPhone SE is fundamentally different than the iPhone 5c, both devices share a few characteristics. Instead of each representing a fundamental shift in iPhone strategy, the 5c and SE are targeted Apple bets aimed at addressing friction points within the iPhone business. The iPhone 5c served as a way to sell iPhone 5 technology in a less expensive shell and also differentiate the more expensive iPhone 5s. With the iPhone SE, Apple is answering the dilemma posed with aging iPhone 5s and iPhone users still showing interest in a 4-inch screen. There is no question that the iPhone SE is a different kind of iPhone, but being different does not automatically suggest a fundamental shift in strategy. 

The iPhone SE's Future

It's too early to determine the iPhone SE's future. Since the "special edition" nomenclature denotes the device's goal of bringing in iPhone upgraders, the iPhone SE's popularity may ultimately play a factor in how long Apple keeps the SE on the market and at what price. It would seem likely that the iPhone SE will continue to be sold beyond September when Apple introduces new iPhones. There is no indication that Apple will begin selling another 4-inch iPhone at that time. This would serve as another piece of evidence that the iPhone SE is not a shift in iPhone strategy, but rather a targeted bet. If Apple continues to sell the iPhone SE well into 2017, it is not unfathomable that we would eventually see a $50 or $100 price drop as the device would then be based on a five-year-old design and year-and-a-half old technology. 

Given the iPhone's increased role in people's lives, there will likely be demand for iPhones with a compact design meant to be used differently than larger iPhones. The iPhone SE is essentially Apple's first step with smaller screens set within its screen size differentiation strategy. Eventually, this strategy will create a space for Apple to introduce new smaller iPhones alongside larger siblings. These smaller iPhones would then retain the iPhone SE's low price relative to larger models. 

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A Facebook Experiment

I deleted Facebook off of my iPhone six months ago. I had one simple reason in mind: I thought I would be able to analyze Facebook more accurately and completely by not using it or its companion apps, cold turkey. Purchasing an iPhone 6s Plus at launch gave me the perfect opportunity to begin my experiment. My initial assumption proved true. In just the first eight weeks, I learned more about Facebook, Instagram, WhatsApp and Facebook Messenger, than the last eight years. I've reached a number of observations over the past six months on Facebook's value and vulnerabilities and a definite answer to what was once a seemingly difficult question: Are Facebook and Apple becoming competitors? 

Observations

I had five overarching observations from not using Facebook properties for the past six months: 

1) Facebook is a habit, not an addiction. Within a few hours of not using Facebook, it was easy to see how much time I had been dedicating to Facebook. I began grabbing my iPhone but not knowing what exactly to do with it. Typically, I would open the Facebook app and waste a "commercial" amount of time - a minute or two of taking in random content from friends. Instead of downloading a few iOS games to keep my attention, Facebook had become my go-to game. If I was at a doctor's office waiting to be seen, Facebook would serve as that perfect attention filler. I now needed to find something else to occupy my time.

During the first few weeks of my Facebook experiment, I did have an urge to find my old iPhone 5s (which still had the Facebook app installed on it) and take a quick peek at my News Feed. However, this desire never got to the point of interrupting my daily routine, a prerequisite for a form of addiction. Instead, I realized Facebook had become a habit. As time went on, the solution to handling my Facebook habit was simply to find other apps that would fill my time. Those apps turned out to be Apple News and Twitter (and eventually Slack). Each one of those apps would offer different forms of content capable of grabbing my attention. 

2) Facebook is no longer a social network. Facebook stopped being a social network years ago. Up until this past September, I had used Facebook daily for more than 10 years. I was among one of the early Facebook users relying on the site to literally see who lived next door. As the years went by, my Facebook wall became a News Feed and with the change, Facebook changed from being about what my friends and I were doing to what my friends thought was interesting around the web. I discovered that those two things produce very different kinds of content. Facebook lost all resemblance of a social network with the presence of brands, ads and algorithms. 

3) My core communication was never on Facebook. After I stopped using Facebook Messenger, I wasn't sure if my communication with family and friends would deteriorate. Instead, I discovered that my most important communication channels were never on Facebook properties to begin with. I still used the phone app on my iPhone for most communication while iMessage also continued to play a significant role. For other forms of communication that were indeed found with Facebook, I reverted back to relying on word of mouth. The events and occasions that I needed to know I ended up finding out about, just through a third-person. The type of communication that did suffer by not using Facebook was the email variety, or messages to acquaintances with little real-world connection.  

4) I'm less informed of the local world around me. There is no denying that I am less aware of what is going on around me in terms of random daily news and events by removing myself from Facebook. I am still keenly aware of global news thanks to Twitter and apps like Apple News. In fact, I've had more time to follow those kinds of news stories since deleting Facebook. However, I have lost touch with much of the local news likely to impact my daily routine. Facebook had turned into my local paper, all the way down to nearby high school sports scores and recaps. Instead of reporters relaying the information, parents would upload pictures and stories of how their children did at the game. Not having access to that type of news makes me feel a bit more disconnected to the community around me since there is no other app or source capable of recreating that news medium other than a traditional paper or news periodical sent through the postal mail (which is still the only way I know the bare essentials of what is happening around me). 

5) Facebook's success is dependent on my time. I used to think that Facebook's success was dependent on me being an active participant by uploading content or sharing links. Instead, Facebook simply needs me to open a Facebook property for the company to remain relevant. With news organizations and other content sites now relying on Facebook for traffic, I turned from an active participant uploading content daily to a passive observer that paid Facebook with my time (and data). Facebook's transformation from a site that required me to spend time and energy to create a profile and engage with others to an app that fed me content from around the web without me needing to do much is why Facebook has become so quintessential to so many people.

Takeaways

After not using Facebook for six months, I was able to clearly see why Facebook is so incredibly popular around the world, the guiding motivation behind Mark Zuckerberg's actions, and where the company is headed tomorrow. 

What is Facebook? Facebook is a curated version of the web. Having 1.6 billion people participate in building this new version of the web is ultimately why Facebook had become a habit for me and so many other people using smartphones. There is literally a never-ending stream of information and content to consume. Talk about the advantages of having massive scale. Using the Safari or Chrome app on a smartphone to surf various websites is a pain, not to mention energy-consuming, which explains Facebook's aggressive moves in recent years to bring even more content into the News Feed. If Facebook wants to turn habits into addictions, they need to include the most sticky portions of the web including news, videos, and eventually live sports and make it remarkably easy to consume content. This explains the motivation behind Instant Articles and marketing the feature as accessing and reading news quickly and effortlessly. 

There is one very important takeaway from Facebook being a curated version of the web. Some people won't be interested in consuming this version of the web, and as I have shown by having not used Facebook for the past six months, there are other versions of the web available. Creating a non-Facebook version of the web involves more effort and dedication, but it is possible. I have found a handful of apps and websites (Apple News, iMessage, Twitter, Slack) that have contributed to a new curated version of the web. This helps explain why the 50% of the connected world that is not on Facebook can get by just fine without it and probably will not be embracing Facebook's version of the web anytime soon. If there is still any mystery as to why Facebook cares so much about connecting the rest of the world's seven billion people to the internet, look no further than those people representing Facebook's growth engine where additional users leads to a stronger version of the web and consequentially more advertisers.

The reason Instagram has become so incredibly popular is similar to how the News Feed offers a curated version of the web within the traditional Facebook app. Instagram is moving down the same path only with pictures. This opens so many more doors since photos and cameras have played an integral role in the smartphone boom. We now use our smartphones as tools to capture and interpret the world around us. Taking these photographs and then using the massive scale with hundreds of millions of users produces another version of the web that is even easier and more enjoyable to consume than compared to the traditional Facebook News Feed. 

Messaging Apps. Once the iOS versus Android war matured to a point where there were no longer the same fierce battles between the two platforms, many tech pundits and analysts turned to messaging as an answer for where consumer tech trends and interest were headed. For Facebook, both Messenger and WhatsApp were positioned as potential threats not only to iOS, but also to Android. Grandiose visions of everything and anything being put into Facebook Messenger and then crowding out competing platforms ended up being the subject of countless blog posts around the web. In reality, this messaging vision has been grossly exaggerated and like much of the tech analysis, void of reality. While 800 million people use Facebook Messenger and a billion people use WhatsApp, we rely on multiple communication channels throughout the day. The simple fact that many (most) young people are addicted to Snapchat shows that there is room for multiple messaging apps since we segment our communication channels according to our social network. And we haven't even discussed the Lines and WeChats of the world.  

When I stopped using Facebook, it became clear that iMessage, not Facebook, was the place I kept 100% of my family communication. This trend has only intensified in recent years as additional family members have purchased iPhones. While messaging will indeed continue to advance and be able to handle much more in the way of delivery content and utility, the industry is not a winner-take-all, but rather a handful of winners with the possibility of new start-ups coming in and also becoming a winner in terms of communication (hello Slack). 

Facebook vs. Apple. Facebook and Apple are unequivocally not competitors. In fact, Facebook and Apple are partners. Facebook's curated version of the web requires hardware, and Apple is a key player selling smartphones, tablets, and laptops/desktops. Instagram's growth has been fueled by smartphone camera innovation, which Apple has played a major role in. Add in Messenger and WhatsApp, and it's clear that Apple's 640 million iPhone users play a role in Facebook's success (and vice versa as many Apple consumers enjoy using Facebook properties on their iOS devices). 

However, it would be incorrect to assume the degree of competitiveness found within this Facebook and Apple relationship has remained static. Upon closer examination, Facebook and Apple are increasingly chasing similar goals. For both companies to remain relevant over time, they will need to occupy a greater share of our time and attention. Up to now, both companies are able to accomplish this goal without harming the other. A user reading an Instant Article in Facebook on his or her iPhone 6s Plus would be considered a win for both Facebook and Apple. However, listen to Mark Zuckerberg's vision for Facebook, and it's not difficult to see Facebook competing more directly with Apple. 

At first glance, Mark Zuckerberg's ideas on Facebook and virtual reality (VR) seem far-fetched, but when considering how Facebook is a curated version of the web, wanting to deliver immersive video content to users makes plenty of sense. According to Zuckerberg, instead of using our smartphone or tablet to open the Facebook/Instagram app and scrolling through a timeline of content, we can put on a pair of glasses/goggles to get a much more engaging and encompassing view of the world through VR. In essence, we would be able to see the world through other people's eyes. I still hold an incredible amount of hesitation and doubt that we will be willing to wear computers on our face throughout the day, but there is no denying that Facebook is betting big on a future beyond using Facebook on a smartphone.

The key development in Facebook's virtual reality bet has been its Oculus acquisition. With Oculus, Facebook entered the difficult world of hardware development, placing itself that much closer to taking on Apple as a more direct competitor. Of course, hardware is notoriously difficult, and I am skeptical Facebook's culture meshes well with prerequisites needed to succeed in hardware. While things are extremely early, a world where Facebook-branded VR glasses begin to take up users' time instead of iPhones or iPads would obviously mark a new type of competition. However, Apple isn't standing still and is not only investing in VR, but also showing interest in moving into entirely new categories such as personal transport and jewelry.  

While one of Apple's biggest competitors is itself (an iPhone's greatest competition is its year-old sibling), any company that is trying to build an experience out of the combination of software, hardware and services needs to be monitored. Facebook as of today does not meet the criteria for being classified as a formidable Apple competitor. However, a world in which Facebook continues to invest in hardware (much easier said than done) and begins to embrace ideals that go beyond software and hardware would certainly keep Apple executives up a few more nights.

Facebook Success

Mark Zuckerberg didn't position Facebook to replace the web. We don't use Facebook to search for something akin to a traditional Google search. Instead, Zuckerberg was interested in creating a new version of the web based on a different kind of search, one initially powered by our social fabric. For now, Wall Street and Silicon Valley seem to think both Facebook and Google can coexist peacefully despite what seems like obvious overlap in capabilities and ambition. Google's new corporate identity built around Alphabet certainly plays a role in showing that Google is looking for a future beyond search.

The primary takeaway from my Facebook experiment over the past six months is that while Facebook's popularity is unmatched on the web, the company is not invincible. Facebook's success will depend on its ability to deliver a compelling content consumption experience to its 1.6 billion users. As long as Facebook can occupy users' time, the company will do well with advertisers, helping to fund future endeavors. However, there continues to be a world outside of Facebook where billions of people live and enjoy technology with no regrets of not using a Facebook property. This world remains a vibrant place for both innovation and different ideas, leading to startups like Snapchat and Slack which begin to attract a growing amount of time and attention once given to Facebook. All the while, Apple's quest to embrace a new form of luxury will likely cap any potential near-term rivalry between Facebook and Apple. 

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The Changing iPhone User Base

A new 4-inch iPhone is coming. The best way to understand why Apple is releasing a new 4-inch iPhone in 2016 is to look at the changing iPhone user base. Apple is now selling iPhones to an installed base of more than 550 million users with a multitude of wants, needs, and desires regarding their smartphones. Apple is making a bet that it is time to expand iPhone development to three different screen sizes in order to appeal to the 20% of the user base that prefer single-handed iPhone usage over larger screen options. Releasing a new 4-inch iPhone would be an admission by Apple that the only way to maintain a vibrant iPhone upgrade cycle is to expand the iPhone line. 

The Old iPhone User Base

Over the span of nine years, the iPhone user base has undergone a significant transformation with much of the change taking place in just the past year and a half. In the early years, the iPhone user base was a relatively "small" group numbering in the tens of millions. The base displayed monolithic tendencies toward technology trends and Apple's mission with the iPhone. Even when the iPhone base grew, the homogenous nature of the user base remained quite resilient. As depicted in Exhibit 1, even though the iPhone has gone on to represent a quite sizable 15 percent of the smartphone market, this 15 percent has been concentrated at the high-end of the market characterized by higher average selling prices and stronger profit margins.

Exhibit 1: Smartphone Industry Price Pyramid (iOS vs. Android)

By targeting the premium segment of the market, Apple spent years developing a loyal iPhone base of hundreds of millions of users willing to spend an above average amount of money and time on their iPhones. This trend stood in stark contrast to the vast majority of smartphone sales taking place at the low-end of the market where consumers used their phones very differently.

The high level of loyalty and usage trends found within the iPhone user base was apparent when looking at hardware and software upgrade patterns. Once Apple released a new flagship iPhone model each year, a significant portion of the iPhone user base showed a willingness to upgrade to the latest device over the following year. A similar phenomenon occured whenever Apple released a new iOS version. Within a few weeks, the vast majority of users upgraded to the new release. In such a world, the belief was that wherever Apple went in terms of iPhone product decisions, be it larger screens or new features, the user base would follow in its entirety. 

The New iPhone User Base

Beginning in early 2015, the iPhone user base showed signs of change. After 590 million cumulative iPhone sales, the base was no longer acting monolithic. Even though Apple was still targeting the same premium segment of the market, iPhone users were beginning to show a broader range of opinions and preferences concerning technology and Apple product decisions. The days when the vast majority of iPhone users upgraded to the newest iPhone model in relative short order were over. 

One way to highlight the change that has taken place within the iPhone user base is to look at the difference in iPhone mix between the run-up to the iPhone 6 and 6 Plus launch in September 2014 and Apple's most recent quarter. As shown in Exhibit 2, the iPhone user base consisted of two groups in early September 2014: 3.5-inch screen users (iPhone 4s, 4 and 3GS) and 4-inch screen users (iPhone 5s, 5c and 5). In such a world, the difference between the two groups (and screen sizes) were rather minor. 

Exhibit 2: iPhone Mix by Screen Size - Early September 2014 (Total User Base)

Jump ahead 15 months, and the current iPhone mix now looks like a cornucopia with four different screen sizes as shown in Exhibit 3. Despite 4.7-inch and 5.5-inch screen phones being in the market for well over a year, approximately 50% of iPhone users are still using either a 4-inch or 3.5-inch screen. In fact, 11% of the iPhone user base is using an iPhone that was released more than four years ago and discontinued in 2014. 

Exhibit 3: iPhone Mix by Screen Size - December 2015 (Total User Base)

Factors Driving iPhone User Base Change

While some may look at a changing iPhone user base as merely a byproduct of Apple's move to larger screen iPhones or the result of the iPhone upgrade cycle getting longer, those developments are not the primary drivers of what is taking place within the user base. 

iPhone's Changing Role. The iPhone is occupying a much greater role in users' lives, handling additional tasks formerly given to Macs and PCs. Accordingly, the way users look at their iPhones has become more varied. A large 5.5-inch screen may be preferred by those who treat an iPhone as their primary computer while other users place greater value in single-handed use found with a 4-inch screen. This divide marks quite a difference from the early iPhone years when most users treated their small screen iPhones similarly. As the iPhone gains additional functionality and capability, there is much more diversity of opinion found within the user base in terms of what makes for the perfect device. This environment certainly strengthens the argument that a new 4-inch iPhone is needed as not everyone is interested in fitting a 4.7-inch and 5.5-inch screen iPhone into their lives. 

Used/Leased iPhones. Apple currently has an iPhone installed base of 554 million users. However, when including iPhones purchased in the grey market and hand me downs, there are well over 600 million iPhone users in the wild (the complete methodology behind how these numbers were derived is available for Above Avalon members here). With Apple moving quickly into iPhone recycling programs and annual upgrade programs, there has been an increasing supply of one and two-year old used iPhones that have eventually found their way back into the wild. This trend has resulted in the iPhone user base becoming more diversified in recent years when it comes to opinion and philosophy towards technology. 

With used iPhones effectively serving as the "cheap" iPhone, Apple has begun addressing lower price segments with less expensive iPhones. As a result, the uniformity in ideas and preferences found within the iPhone user base concerning iPhone screen size and usage is disappearing. Apple now has a wider range of users that crave vastly different things from their iPhones. 

It's Time for a New 4-Inch iPhone

Similar to how the iPad Pro was rumored to be released for well over a year, Apple has been rumored to be working on a new 4-inch iPhone ever since introducing 4.7-inch and 5.5-inch screen iPhones in 2014. Why has Apple given the green light for a new 4-inch iPhone now? Management's attitude towards 4-inch screens has changed. The verdict is in: the iPhone user base has not fully embraced larger screens. Over the past year, Tim Cook has provided a crucial metric for measuring how many iPhone users have upgraded to a larger iPhone. Exhibit 4 highlights the rate iPhone users have upgraded to either an iPhone 6, 6s, 6 Plus or 6s Plus. 

Exhibit 4: iPhone Upgrade Rate to 4.7-Inch or 5.5-Inch Screen (Installed Base)

According to Cook, approximately 60% of the roughly 400 million users that made up the iPhone installed base in early September 2014 have still not upgraded to 4.7-inch or 5.5-inch screen iPhones. This number is likely higher than management was expecting, especially when considering that the average iPhone upgrade cycle is approximately 20 months. The evidence would seem to suggest that approximately 20% of the user base has no interest in moving to larger screen iPhones. As a result, iPhone sales have taken a hit, the iPhone upgrade cycle appears to be getting longer, and a significant portion of the iPhone user base does not have access to new Apple services such as Apple Pay due to sticking with old 4-inch screen iPhones. 

For some, the thought of using a 4-inch screen iPhone instead of its 5.5-inch screen sibling makes little sense. To these users, the 4-inch iPhone's small form factor makes the device look and feel like a toy. Meanwhile, other users look at a 4.7-inch iPhone as simply too large for single-handed use, not to mention mobility. These users consider the 5.5-inch screen iPhone more like a tablet than phone. It is this varying degree of opinion that is new to the iPhone base as the differences between 3-inch, 3.5-inch and 4-inch screen iPhones were never too significant over the years.  

Apple's decision to release a new 4-inch screen iPhone is an admission that the only way to get everyone to upgrade their iPhone is to expand the iPhone line. More than 200 million users have continued to use their iPhone 5, 5c, and 5s instead of buying a larger iPhone. Instead of looking at that as a sign that the iPhone business is trouble, it is a clue that the iPhone business is maturing, and it is time for Apple to increase screen size options in order to appeal to as many users as possible. 

This diversification in screen size perference is the same reason why Apple is simultaneously moving just as fast at the high-end of the iPhone line with the iPhone Plus model. In the future, it is not unfathomable for the larger screen iPhone to see greater differentiation compared to its siblings, and the possibility of Apple releasing an even larger iPhone is no longer a stretch. 

The Future

The iPhone line will eventually consist of a range of screen sizes each having their own strengths and weaknesses. For a 4-inch iPhone, single-handed use and mobility will be the marquee features. The iPhone 5 ad narrated by Jeff Daniels concerning a 4-inch screen appearing to be perfectly sized for thumb use may still have relevancy in today's market. Meanwhile, at the other end, Apple could play up the 5.5-inch screen iPhone as being a different kind of productivity device where the additional screen real estate comes in handy. As shown in Exhibit 5, there will likely be dedicated segments of the iPhone user base that prefer different sized screens. 

Exhibit 5: Future iPhone Mix by Screen Size

While the iPhone nomenclature will likely change in the coming years, the idea of Apple selling at least three different iPhone screen sizes will continue. We will get a pretty good look at this future when Apple unveils a new 4-inch iPhone. 

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