An upgrade to Apple’s game

First quarter (Apple’s fiscal year’s) is almost over and some analyst expectations are festive. It is not uncommon for Apple to blaze past an issued guidance. Apple outperformed the high end of the guidance by 12% in 1Q14, Morgan Stanley’s expectations, 9% higher, seems therefore attainable. Details of the guidance on margins indicate a mix highly skewed towards seasonally inflated iPhone sales.

Source: Apple

We are, yet again, on the verge of iPhone breaking another sales record, and one element has been receiving less attention than it should have. Apple’s upgrade program.

Source: Apple

It is basically a rolling contract for unlocked iPhones with a span of 24 months without an APR for the full retail price. A participant has an option to upgrade her/his phone without paying extra to a newer model after 12 months (which resets the 24 months). Program includes AppleCare+ as well.

The program in fact was nothing new for the US market. T-Mobile has already rolled out JUMP! to steal away customers from other wireless behemoths. Apple, though, has much more profound and beneficial intentions than meets the eye.

1. Minimizing hardware and software fragmentation

It comes as no surprise iOS developers spend less time to develop a better tailored application with much higher revenue generation. High rewards for developers precedes/follows more satisfied customers, and satisfied customers spend more money. It is an ironclad and hard to replicate precursor cycle. Samsung, with all its might, hasn’t been able to put a dent and gained traction at the high end, neither Microsoft.

Source: Apple, Google

Unfortunately, fragmentation increases due to intense competition relying on frequent product updates. iPhone’s performance heavily depends on superior user experience forged in a fruitful ecosystem. Apple’s de facto micro management policies, however, have been successful to a certain extent. This is where upgrade program comes in. The program relieves the stress of buying “the latest and the greatest” yearly and alleviates hardware, eventually software, fragmentation without any additional cost. Customers will upgrade without a speck of remorse to a newer model since they are obliged to pay the same bill even if they choose to stick with their older models.

2. Increasing security

One of the long term assets of Apple is the differentiation on how it handles user data, privacy and security. Apple, on strategic level, commits to the privacy of user by storing data on device for Siri and car systems, unlike Android, and refuses to provide a backdoor for government agencies.

Security doctrine states “a herd is as resilient as its weakest member”. Users with old models are the weakest members with outdated technologies that can undermine robustness of an ecosystem. Specifically, nearly 23% of installed base is older than iPhone 5s. Those models lack built-in secure enclave and are lagging behind biometrics, for starters. They may also shy away from critical software updates due to fear of slowdowns and expose themselves to easy breaches.

3.Generating additional revenue

The math is simple, Apple added the price of Apple Care+ to retail prices and divided it by 24. Equation is more or less the same for the most frequent upgraders (upgrade each year); Apple will introduce devices to second hand market to salvage remaining device value. A conservative forecast, based on the guidance, for the US market indicates a potential of approximately $0.6 bn additional revenue only from device sales in 2016. Program’s impact will increase as it geographically extends to other important markets.

Includes second hand phone sales revenues in China

4. Dominating multiple price points

Apple, however, hasn’t been able to fully monetize strong demand for iPhone, so will move the supply-demand intersection towards the left end, especially in emerging markets that lack purchasing power. A second hand market with more structured approach will provide a new mix for Apple without introducing a new model. Second hand phones will enable Apple to reduce price and squeeze challenger firms like Samsung, Sony, Motorola etc. which have been unable to match Apple at high price points and subsequently tried to dominate lower ends. Particularly in China, Apple has a very solid second hand demand, so solid that Foxconn has started an authorized second hand program.

Second hand devices will also penetrate Apple services to wider audiences and generate revenue through ecosystem (Apple Pay, Apple Music, App Store, accessories, etc.) for both Apple and third parties.

5. Cementing position in corporate market

BYOD has been an influential factor for Apple to move in to enterprise segment. Happy users forced companies to allow Apple devices to enter infrastructures. Currently iOS has the biggest share, 73%, in device activations in enterprise market (be wary, that is a skewed representation of big firms). That is no small feat. Apple wants to cement it with further dominating other parts of the corporate market as well. Upgrade program tailored for companies has the possibility to sweeten the deal by reducing procurement hassles. “Just subscribe to our service, we will take care of the rest”

It is also important to bear in mind that possible expansion of the program to iPad Pro will further solidify Apple’s presence, although initial signs indicate a weak start. Apple-IBM strategic partnership will boost sales as iOS devices coupled with a healthy corporate ecosystem on top of IBM infrastructures. In addition to all, IBM’s strong ties with China will give extra push Apple needs to enter into Chinese corporate market. One thing though, Apple may need to adjust its security and privacy practices in line with Chinese Government’s demands leaving itself in a conundrum; China will be the biggest market for Apple by the end of 2016 and requires data to be stored in Mainland China and probably will demand a backdoor for iOS devices at a certain point, a contradiction to its stance against the US government. An interesting business case to watch!

6. Increasing in logistics scale

The more people upgrade each year, the more Apple produces; the more Apple produces the cheaper materials get; the cheaper materials get, the better margins Apple reports…

Apple also pushes "scale as a competitive strategy" up by sealing exclusive deals with partners. A bigger production potential will surely attract more suppliers to tie themselves with Apple, giving edge to iOS devices over competition.

7. Decreasing reliance on third party sellers

74% of sales of Apple transpires in a third party store. Third party stores cut their share of sales and reduce gross margin and Apple, as a manufacturing company, values gross margin. Customers on a rolling contract will shrink the share of third party sellers and remove non-Apple stores gradually from the value chain. Paying commision for devices basically selling by themselves is one concern, stores Apple has little control over in terms of customer experience is another; especially telco stores, cluttered with lots of devices and uninitiated sales representatives.

Third party stores are expensive, but Apple Stores are too. High traffic avenues, well-designed interior spaces and highly trained representatives prove to be costly. Migrating online channel leftover sales traffic towards stores will decrease cost per device sold, and make opening more stores economically feasible.

8. Scaling quicker

New applications requiring hardware support such as Apple Pay will go to wider compatible device audience. It will increase Apple’s bargaining power against retailers, third party providers, etc. by leveraging bigger execution-ready base.

9. Cross selling

Selling more iPhones will introduce lots of new customers to Apple ecosystem as potential buyers of other Apple products. Evolving program to bundle other devices/services will generate additional revenues and increase retention.

10. Smartphones are getting sturdier

Probably the most common smartphone mishaps are screen shattering and contacting with liquid. This year we saw Motorola’s Droid Turbo 2 enduring heavy impacts to its screen and if Motorola is able, so will Apple. We also know iPhone 6 was not advertised as waterproof yet it resists water, likewise Apple may create durable screens, but still use screen shattering as a selling point to Apple Care+. Also they filed multiple patents that render hardware waterproof. All add up to reduce the cost of Apple Care+, increasing the margin yield.

Apple aspires to be the first company to surpass $1 tn market cap and it boils down to gross margin. Apple’s slow, but calculated, pace will educate customers through monthly payment psychology whereby will transform device sales to subscription business model and lock customers in a rolling contract. It will open up new possibilities to experiment on prices and create multiple optimal points. Constant and increasing revenue stream will manifest itself as more earnings per share, which eventually rally stock price up. All will also decrease pressure on resources to sell more iOS devices and divert some of the efforts to new lines of businesses.

I must say, with its current momentum, Apple has the potential to innovate on the way the market operates, again, as it innovates through product and service categories.

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