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How AAPL Grossly Botched the iPhone Launch

Premium quality. High-integrity brand. Innovative and unafraid.
Those are all phrases that Mac lovers apply to Apple (AAPL), and I normally wouldn’t argue with them. Today though, I think Apple shattered at least the two latter phrases when it announced something I said four months ago: the iPhone didn’t stand a chance in hell of being successful at $600.

Most of the references I’m making here go back to a piece I wrote in early May titled “AAPL Bulls are Counting Their Chickens… Incorrectly.” You can read the entire thing, but the gist of my argument is that Apple massively overpriced the iPhone above market and doesn’t have a chance of reaching their stated sales targets without a price cut. With the news out today, I might have well written a non-politically correct version of the press release - which is worth reading.

Does anyone believe for a second that Apple’s main reason for the price cut is the seemingly altruistic motive to make the iPhone more affordable for all the poor souls who otherwise wouldn’t have been able to buy one for Christmas? Or, reading between the lines, was the iPhone so expensive that Apple finally realized its revenue and sales volume numbers would look very paltry without a price cut? The actual decision-making process to answer that question is laughably simple.

This isn’t to say the iPhone isn’t a fine device, but it does say a few things about Apple. First, the enormity of the price cut: stunning, yet predictable. I noted that the lower-end iPhone priced at $500 (of which no more will be made) was priced 42% above Research in Motion’s (RIMM) average selling price in 2006 of $350, and the higher-end iPhone initially priced at $600 is 71% above RIMM’s ASP. Now, post-iPhone price cut, you are looking at a 14% AAPL-to-RIMM premium that is much more easy to justify.
I closed the discussion of ASP trends in the cell phone business by questioning a market research company’s conclusion that went along the lines of “the iPhone is going to completely change the rules and economics of the cell phone industry to the point where it will single-handedly reverse all established buying patterns.” Obviously, that didn’t happen, and it didn’t even take three months to determine that the iPhone was in a losing battle.

The second thing this price cut implies is that Apple has suddenly become very sensitive to public perceptions of price, and they have lost confidence that the iPhone is really a revolutionary, game-changing product. You don’t cut the price of a revolutionary product by 35% less than three months from initial launch date, and doing so makes the company look bad. Tim Beyers at The Motley Fool said, “This smacks a little of desperation, and it’s very unlike Apple.” I couldn’t agree more.

My conclusion four months ago about the fate of the iPhone was that “Apple needs to decide what it is aiming for with the iPhone launch: volume, or earnings. The current pricing scheme way above market says that Apple is aiming to keep the iPhone exclusive, and there is nothing wrong with that, as brand dilution has hurt many a company. If Apple is going to make serious headway into market share, though, it is going to need to either take a hit on gross margins or introduce a lesser model. Market price trends dictate the $500+ iPhone days are likely to be limited… Apple’s iPhone will likely be just like other offerings, in that it will have trouble maintaining a high ASP after just a few quarters.” I think that conclusion came true, and I’m looking forward to seeing the official numbers for iPhone sales and ASPs in the next quarterly report and digesting that information to see what kind of headway Apple has made with the iPhone.

Where to go with AAPL from here? The stock trades for 27x free cash flow, earnings estimates have trended up over the last three months, and analysts are strongly bullish. If you view AAPL as a pure-play smart phone company, it isn’t nearly as expensive as RIMM, although I wouldn’t say it is cheap by any trailing metrics. One could easily construct some forward multiples that make the stock look cheap, but considering the company just devalued what was supposed to be its primary growth vehicle in a price cut that took many by surprise, I would look for some downward revisions in EPS, growth, and whatnot. Given that there is no margin of safety in AAPL, I don’t see a good reason to get long on this pullback.