Since the introduction of the iPhone in 2007, Apple (NASDAQ: AAPL ) has reliably updated the device once a year. For the past several iterations, beginning with the release of the iPhone 3GS in 2009, Apple has dropped the price of the previous model by $100 to provide a lower-cost option for price-sensitive customers. Thus, the typical price structure for the current iPhone options in the U.S. -- assuming a two-year contract and a carrier subsidy -- is the following:
Standard U.S. iPhone Pricing
| iPhone 5 | $199 |
| iPhone 4S | $99 |
| iPhone 4 | Free |
Last week, The Wall Street Journal reported that the next-generation iPhone, thought to be called the "iPhone 5S," will enter production this quarter. Analysts believe that time frame puts Apple on track to release the iPhone 5S in June or July. But I don't think Apple will follow its previous custom by dropping the iPhone 5 subsidized price to $99 this summer.
The iPhone 5. Source: Apple.
Instead, the company may choose to discontinue the iPhone 5 when its replacement arrives. That would line up with the strategy Apple followed for the most recent iPad update: The fourth-generation iPad replaced the third-generation iPad as the high-end model, with the iPad 2 remaining in production as a cheaper alternative.
New iPhone coming
The main rationale for a new high-end iPhone is to keep the pressure up on Apple's competitors. BlackBerry (NASDAQ: BBRY ) finally released its new Z10 all-touch smartphone in the U.S. last month, and CEO Thorsten Heins has publicly called the iPhone "outdated." Meanwhile, major Google (NASDAQ: GOOG ) Android vendors such as Samsung and HTC are releasing new flagship phones this spring. Last year, Samsung used the gap between its spring release of the Galaxy SIII and the iPhone 5's fall debut to pick up significant market share.
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Apple needs to update the iPhone sooner rather than later to keep its products in the spotlight and bolster its position vis-a-vis Android phone vendors. However, it needs to do so without putting further pressure on its profitability, which has become a concern recently.
Gross margin is the key
The introduction of the iPhone 5 dented Apple's gross margin, which dropped 610 basis points year over year, from 44.7% to 38.6%, in the fall quarter. Some of these increased costs relative to the 4S were temporary, as the iPhone 5 required a new manufacturing process, new equipment, and other upfront costs. However, while those initial cost headwinds may be subsiding, the iPhone 5 still includes more expensive components than the iPhone 4S -- better screen, LTE modem, and the like.
In the fall quarter, Apple was able to make up for the lower-margin profile of the iPhone 5 and other products by boosting revenue. In contrast, the company is expected to post a significant year-over-year decline in profit this quarter. To restart earnings growth, Apple needs to halt or (preferably) reverse its gross-margin decline.
Most Apple followers don't expect the iPhone 5S to boast any life-changing upgrades: It will be faster than previous models and may have a built-in fingerprint reader, but otherwise it's likely to resemble the iPhone 5. If Apple were to drop the iPhone 5 price by $100, many customers would take the discount rather than buy a similar, if slightly more powerful, iPhone 5S. That would reduce the iPhone's average selling price and pressure gross margin even more.
No need to keep the iPhone 5
By contrast, a lineup consisting of the iPhone 5S, 4S, and 4 would make more sense for Apple. There would be clear differentiation between the products. The iPhone 4 provides the base iPhone experience, the iPhone 4S is faster and adds Siri voice-recognition software, and the iPhone 5S would be even faster and include LTE support, a larger screen, and -- potentially -- a fingerprint reader.
The continuing popularity of the older models proves that there's no need to upgrade the lower end of Apple's iPhone lineup. In fact, Apple CEO Tim Cook noted that demand for the iPhone 4 outstripped supply in the fall quarter. This makes sense, insofar as customers who are willing to take an older model to save money are by nature more concerned with price than with having the most powerful device.
Foolish conclusion
There's a good chance that Apple will simply replace the iPhone 5 with the 5S at the top of its smartphone lineup this summer, rather than dropping the iPhone 5's price and keeping it in production. This move would be positive for Apple's gross margin and would probably help Apple return to solid profit growth beginning this summer.
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