What happens if consumers had to pay $500 or more for an iPhone?
FreedomPop is a new start-up that plans to challenge AT&T (T) and Verizon (VZ) by providing free mobile data--500 MB per month. Both AT&T and Verizon have huge margins on mobile data because of the lack of competition. AT&T and Verizon use these big margins to subsidize Apple's iPhone, Google's Android and other devices.
The big carriers provide a higher amount of subsidies on iPhones than on Android devices. An iPhone that costs the consumer $199 may cost a carrier $500 to $700 even though they may be buying millions of these devices. The carriers more than make up for the upfront subsidies over the life of the contract due to huge margins on data plans.
Major carriers have already conceded that the money is not in voice but in data. Similar subsidies are offered by carriers in most developed markets.
Imagine what will happen if subsidies go away and consumers have to pay $700 to $1000 for an iPhone. My own research at The Arora Report shows that in such a scenario, Apple may easily lose over 50% of its sales of iPhones. Considering that Apple derives over 70% of its profits from iPhones, such a scenario will be a virtual death knell.
Our research shows that Apple is more dependent on subsidies than its competitors. Many other analysts have come to the same conclusion. Most of such research is proprietary, our readers can refer to excellent work done by Sameer Singh in his pieces iPhone market share heavily depends on carrier subsidies and The iPhone's Churn Rate Illusion: Carriers Revolt over Subsidies.
It is widely accepted that iPhone users are more affluent. Again most of the hard data is proprietary. One published work shows that 38.5% of iPhone users have income under $75,000 and 61.5% have income over $75,000; 63.9% of Android users have income under $75,000 and only 36.1% of Android users have income over $75,000.
Our proprietary research shows that availability of phones roughly at par with iPhone 5 have made consumers more price sensitive. Competition is bound to increase.
According to our model, if subsidies were completely eliminated, Apple will lose about 40% of its sales of iPhones. The effect will be a direct drop of about 28% in Apple earnings. Such a scenario may turn into a vicious circle.
During Apple's ascent, Apple's other products have benefited from the halo effect of iPhones. In a descent, the halo effect will be in force but in reverse. In such a scenario, as a vicious circle takes hold, Apple earnings may drop to around $30 per share. Considering that Apple has been dependent on hit after hit and for this reason even during its ascent, Apple has been able to garner a forward P/E of only about 12, in a descent Apple forward P/E may fall as low as 6.
Not only Apple’s earnings will drop, its stock price will drop under $200 in such a scenario supported mostly by the cash that Apple holds. Arguments such as Apple is fundamentally cheap close to its cash value will not hold water. Just take a look at forward P/E of Hewlett-Packard (HPQ); it is about 4 and many astute investors still do not consider the stock cheap.
The FreedomPop Challenge
FreedomPop is offering 500 MB of free mobile data; compare this to 300 MB through AT&T for $20 per month. FreedomPop is offering 5 GB of data for $35 per month; compare this to $70 per month through Verizon for 4 GB.
FreedomPop is backed by Niklas Zennstrom, co-founder of Skype. FreedomPop intends to do to mobile data what Skype did to voice a long time ago.
No Immediate Worry But Longer Term Concern
There is no reason for Apple stock holders to worry right away but there is a longer term concern. The point is that Apple stock is over owned and in the event of adverse developments only the first few will be able to get out of a narrow door at decent prices.
FreedomPop is currently using Clearwire (CLWR) WiMax network; this network is available to only about a third of consumers and is slow. FreedomPop also requires users to put a deposit for a USB device or a Hotspot; some consumers may find this a hassle. FreedomPop also plans to use LTE network from Sprint (S). Considering that Sprint is still building its network there is enough breathing time for carriers. The point is there is a long way to go before FreedomPop and similar initiatives threaten Apple. There is always the possibility that such initiatives may meet a premature death.
Carriers are not likely to change their subsidies right away.
If FreedomPop starts becoming successful, there is no doubt that other copycats will also pop up. This will put huge pressure on carriers.
In a momentum stock like Apple, it is important to sell it correctly; otherwise unrealized gains can disappear quickly. Those who exclusively rely on traditional fundamental analysis will simply miss the boat. Those relying on technical analysis may get some ambiguous signals. A better way for investors to consider is to focus on change and use their analysis of change to make their exit decision on Apple. My method accomplishes the foregoing in a systematic manner and is staying long on Apple for the time being.
FreedomPop shows one scenario under which Apple as we know it may die not too far in the future; investors need to be on high alert.
About Me: I am an engineer and nuclear physicist by background. I founded two Inc. 500 companies, and have been involved in over 50 entrepreneurial ventures. I am the chief investment officer at The Arora Report, which publishes four newsletters to help investors profit from change. Write me: Nigam@TheAroraReport.com. Follow me here and get email notification when I publish a new article.
Full disclosure: Subscribers to The Arora Report are long Apple from $131 and have taken partial profits at $360, $525, $629 and $568.
