Apple iPhone Pricing Could Trim Margins, But 1.4 Billion Base Remains Compelling

Apple Inc. (AAPLGet Report) shares were indicated modestly lower in pre-market trading Wednesday as analysts and investors reacted to the tech giant’s much-anticipated product launch event that included three new iPhones but hinted at a focus on lower prices and narrower profit margins in the years ahead.

Apple released three new versions of its iconic smartphone yesterday during its typically glamorous event broadcast from the Steve Jobs Theater on the company’s sprawling Cupertino, California campus, marking the 11th upgrade of its top-selling product. However, the benchmark iPhone 11 version was priced just under $700, a $50 discount to the current iPhone XR, and pricing for older adaptations of the phone will either be held in check or modestly reduced in order to spur demand as customers continue to extend the life of their current handsets.

Apple also indicated a drive towards more competitive pricing with a $4.99 base cost (as well as trials and discounts for new hardware buyers) for its Apple TV+ streaming service, a similar tag for its gaming offering — Apple Arcade — and a reduced $199 price for its retained AppleWatch 3, announced alongside a new fifth generation offered unveiled by CEO Tim Cook yesterday.

“As expected, the event featured only incremental iPhone enhancements, with triple-camera the biggest addition year-on-year; as a result, we think the replacement cycle continues to extend ahead of 5G coming in (the second half of next year), said Credit Suisse analyst Matthew Cabral, who carries a $209 price target and a ‘neutral’ rating on the stock.

“The two biggest surprises for us were the $699 price point for iPhone 11, as Apple reverses the steady upward march of (average selling prices) over the past few years  and very attractive pricing for TV+, a move that suggests Apple may be more focused on seeding the subscriber base for the long-term rather than maximizing near-term profitability on the offering, particularly when factoring in the free year for device purchasers,” he added.

“With Apple trading at a peak multiple (16x our CY20 EPS), we expect the stock to remain range-bound near-term as another lackluster iPhone cycle and the ongoing overhang from the US/China trade dispute remain on the front burner.”

Apple shares were marked 0.1% lower in pre-market trading Wednesday, after rising 1.18% on the session yesterday, to indicate an opening bell price of $216.70 each, the highest since August 1 and a move that still leaves the stock with a year-to-date gain to around 37.5%.

Apple’s gross margins have been narrowing for the past few quarters, falling 700 basis points from the same period last year to 37.6% over the group’s fiscal third quarter. Apple no longer provides a breakdown of iPhone unit sales, making average selling price estimates nearly impossible to calculate, but indicated a 12% year-on-year contraction last quarter as customers — particularly outside of the United States — balked at the $1,099 price point for last year’s iPhone XS Max.

“Apple’s new iPhones were largely in line with our expectations and seem unlikely to drive a material increase in unit volume. Pricing for the iPhone 11, which we expect to be the highest selling model by volume, was $50 below the iPhone XR that it replaced,” said KeyBanc Capital analyst Andy Hargreaves. “While we are not changing our estimates at this point, this could create modest risk to our hardware gross margin estimates through the FY20 cycle.”

The pricing impact on Apple’s services margins could also be diluted by the competitive entry points for Apple TV+ and Apple Arcade, but at a healthy 64.1% last quarter, with an installed base of 1.4 billion, yesterday’s new additions to the services suite won’t likely have a meaningful near-term impact. 

“We believe Apple is well positioned with multiple levers to monetize its 1.4 billion device
installed base and achieve services revenue doubling from 2016 and reaching 500 million
subscribers by 2020,” said Canaccord Genuity’s T. Michael Walkley. “Coming off strong Q3/F’19 results, $7B in debt recently raised at attractive pricing which could bolster share repurchases and dividends further, we believe Apple continues to execute its high margin Services-driven growth strategy, and we maintain our BUY rating, estimates, and $240 price target.”