The rise in iPhone ASP has led some to conclude that Apple must have shelved its strategy for growing iPhone sales and the user base by lowering prices. Instead, Apple is said to be milking existing iPhone users with higher-priced models. This school of thought ends up ignoring how the expanding market for refurbished iPhones is contributing to new user growth and a higher iPhone ASP.

Gray Market Impact

A tenet of Apple’s iPhone pricing strategy has been selling older flagship iPhones at lower prices. For example, along with selling iPhone XS Max, XS, and XR, Apple continues to sell iPhone 8, 8 Plus, 7, and 7 Plus. Apple is even selling older models such as the iPhone SE and 6s Plus in select markets. The company is able to run with lower prices for these older flagship models due to economics of scale and improved production and assembly costs.

Traditionally, older iPhone models accounted for as much as 30% of overall iPhone sales. Having such a significant portion of unit sales going to lower-priced iPhone models kept a lid on iPhone ASP. However, things are changing. In 3Q18, non-flagship iPhone models likely represented just 20% of overall iPhone unit sales. As the number of customers buying refurbished and pre-owned iPhones through the gray market increases, Apple is seeing less demand for the lowest-priced iPhones in its lineup. Customers in lower price brackets have additional iPhone purchasing options at their disposal thanks to the gray market.

Despite weaker demand for lower-priced iPhones, Apple continues to see modest growth in iPhone sell-through demand. This tell us that demand for new flagship iPhones has not subsided. Instead, demand for higher-priced iPhones is growing. The shift in iPhone sales momentum from lower-priced, older flagships to higher-priced iPhones is contributing to higher iPhone ASP.

Gray Market Ingredients

Three key ingredients are needed to sustain a functioning gray market for iPhone.

Good device durability and usability. Simply put, iPhones need to hold up over time. A phone that can barely last after two or three years of usage is not conducive to a vibrant used market. Strong demand for refurbished iPhones. Many of Apple’s competitors lack a vibrant gray market given the lack of customer demand for refurbished products from that brand. In addition, other brands directly address lower-priced segments. However, given Apple’s iPhone pricing strategy and the company’s aspirational brand, there is a considerable amount of interest and demand for refurbished iPhones at lower prices. Steady supply of gently-used iPhones. Services like early upgrade plans offered by mobile carriers and Apple’s iPhone Upgrade Program are resulting in a stream of gently-used, year-old iPhones being turned in by customers. This supply of used iPhones is needed to satisfy the demand for lower-priced iPhones.

Durability and Usability

At last month’s iPhone and Apple Watch event, Lisa Jackson, Apple VP environment,

policy and social initiatives, unveiled Apple’s latest environmental goal to eliminate the need to mine new materials from the earth. In order to stop mining new materials, Apple will focus on three things:

Find new ways to make products with recycled or renewable materials. Make products last as long as possible. Recycle products properly.

Increased durability doesn’t just allow existing customers to use Apple products for longer. The products can also enter the gray market and eventually be used by more people over time.

When it comes to durability, Jony Ive and Apple’s Industrial Design group have been focused for decades on the topic as it relates to product design. Good product durability is one reason there is already a strong gray market for iPhone. It is true that Apple designers sometimes find themselves between a rock and a hard place in terms of durability. Mobile batteries are a prime example. The fact that iPhone users can’t easily replace batteries is a durability trade-off in order to achieve other usability goals. However, Apple’s embrace of an iPhone battery replacement program speaks to management’s desire to elevate device durability within its iPhone strategy.

Meanwhile, Apple’s focus on having iOS 12 support older iPhone models highlights management’s motivation to improve usability. By supporting iPhone models going back to the 5s, Apple is able to keep tens of millions of devices, many of which have likely passed through the gray market, running the latest software. This proves beneficial when it comes to keeping these iPhones in circulation.

Strong Demand

Apple has the most popular smartphones in the market. This popularity translates to strong demand for iPhones, even at higher prices. The reason iPhone sales are a fraction of overall smartphone sales is that Apple is only playing in certain market segments. Such a decision ends up providing a huge boost to the iPhone gray market as there is unfilled demand for lower-priced iPhones.

The gray market allows Apple to reach customers who may not otherwise be in the company’s traditional target market. While iPhones sold in the gray market aren’t included in Apple’s revenue, the company does benefit if sales are to new users. Apple is able to sell services and additional hardware to these new users over time. This cycle becomes that much more impactful assuming an iPhone ends up being passed on to three or four owners over its lifetime, with each ownership change occurring at a lower price.

Steady Supply

Services like early upgrade plans offered by mobile carriers and Apple’s iPhone Upgrade Program are made possible by a functioning gray market. Robust residual values make it financially feasible for users to turn in gently-used iPhones after making 12 monthly payments and walk away with the newest iPhone. Many of these gently-used iPhones that are turned in are then recirculated in the market to find a new home. This creates the supply the iPhone gray market needs to sustain itself.

Exhibit 2 highlights iPhone residual value as a percentage of original launch price. After the first year, iPhone residual value is approximately 40%. This means that an original iPhone 8 / 8 Plus owner trading in the device after a year can expect to receive 40% of the device’s original cost. The percentages come from iPhone trade-in values offered through Gazelle. It is important to note that iPhone users may find better trade-in values elsewhere, such as store credit through Apple.

Exhibit 2: iPhone Residual Value Percentage