Apple's (NASDAQ: AAPL) Great Dilemma

The End of an Era

By Jason Stutman
Friday, August 16th, 2013

Steve Jobs is rolling over in his grave right now.

Movie makers seeking to profit off of his death earned an embarrassing 43 percent Metacritic score on the recent motion picture Jobs.android apple

At the same time, the company he built from the ground up is quietly buckling at its knees.

Like clockwork, the mainstream media is drooling over the upcoming release of Apple's (NASDAQ: AAPL) new iPhone. Optimism is everywhere, visible with Apple's rebound past $500 on the NASDAQ.

But below the surface, Apple faces a fundamental crisis that could ultimately destroy the company as we know it.

The Apple Dilemma

It is no secret that the market for high-end smartphones has become completely saturated. And though this saturation affects the entire mobile industry, the most profound consequences are being faced by Apple Inc.

In the second quarter of 2011, Apple held 24 percent of the smartphone market. In the second quarter of 2012, that number dropped to 19 percent. In 2013, that figure fell even further to just 14 percent. And of the top five smartphone companies, Apple was the only one to lose a share of the market in 2013.

Android phones are absolutely dominating the smartphone market, and they have recently reached a market penetration of 79 percent, up from 51 percent in 2011. In the international market, Apple is being crushed by Samsung, with the latter company more than doubling global unit sales.

Much of Apple's global woes are due to extremely weak penetration in China. Samsung holds a 20 percent market share in that nation, while Apple is at just 4 percent. Apple's minimal market share is largely a product of its focus on high-end devices.

China's smartphone market growth is coming from mid-end to low-end segments, and Apple currently has no product for that target market. Furthermore, Apple does not offer a device through China's largest mobile provider, China Mobile Ltd.

China Mobile holds a dominant 70 percent market share in China, which is greater than the U.S. market share of Verizon, AT&T, and Sprint combined. In total, China Mobile covers a network of 700 million consumers.

Apple has yet to penetrate this market because China Mobile uses an air interface that has historically not been compatible with Apple's chipset. However, the redesigned iPhone expected next month uses Qualcom Inc. (NASDAQ: QCOM) chips, which can reportedly operate on China Mobile's 4G platform.

But product compatibility isn't the only thing holding back Apple – China Mobile is widely opposed to subsidizing the expensive iPhone, as is standard practice in the U.S. When a consumer buys a phone through a major U.S. mobile carrier, prices are generally subsidized through a 2 year contract.

However, China Mobile does not operate under this business model, instead selling phones at full price. This is bad news for Apple, as an unsubsidized iPhone 5 will sell for around $700. Simply put, there is no market growth for a product at that price.

Getting Desperate

Rumors have been heavily circulating that Apple is planning to release a cheaper version of the iPhone, which will be available on China Mobile's network. The product is currently being dubbed the iPhone 5C, with unsubsidized cost estimates ranging from $200 to $330. This could offer a significant boost in global market penetration for Apple, but there is no guarantee the 5C will take off, let alone exists at all.

An incredibly important factor to consider here is brand recognition. While consumer recognition of the iPhone in the U.S. is incredibly high, 80 percent of Chinese consumers name Samsung as the first smartphone brand that comes to mind. The premise that a lower price will automatically translate to high sales volumes for Apple overseas is misguided and Americentric.

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Even if we make the generous assumption that the 5C will take off, there is a catch-22 that Apple now faces. Apple is known for its high-end products, and much of what has made Apple so appealing to consumers is that its devices serve as a status symbol. If Apple begins to flood the market with cheap iPhones, it will forever change how the company is viewed by consumers.

Believe me when I say that by creating a cheap alternative to the iPhone, Apple will either destroy its brand or its flagship product, or possibly both. Apple essentially has two options if it goes ahead with providing the 5C.

The first option is that Apple impairs the software of the 5C to set it apart from the high-end iPhone. In order to justify a $500 difference in unsubsidized pricing, that downgrade would have to be incredibly significant. By doing so, Apple will be flooding the market with a low quality product, crippling its status as an exclusively high-end tech company.

The second option is that Apple produces an incredibly similar product but re-brands it by simply framing it in plastic and removing a minimal amount of features. In this scenario, the 5C kills the flagship iPhone because consumers will realize the two products are largely identical and opt in for the less expensive option.

Apple's financial success has historically been a result of high margin products, and such a shift could be disastrous for the company.

Irrational Trading

Apple shares have been on the rebound as of late, with a solid 3 percent boost coming from Carl Icahn's increased stake in the company and his strong push for share buyback.

If you're looking for short-term gains, Apple is a solid bet right now. The company is currently being cheer-led, and bulls are heavily buying on intangibles. However, if you are looking at Apple long term, you probably want to steer clear of the stock.

Going forwards, Apple's global significance will continue to plummet unless it is able to innovate its product line-up, not just dumb it down. 

 

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