Apple’s Freebie IPhone Pits Premium Brand Against Bargain Fare

Apple Inc. (AAPL)’s iPhone 3GS model is more than two years old and shunned by gadget snobs, and yet it’s turning into one of the company’s bigger weapons against devices running Google Inc. (GOOG)’s Android software this holiday season.

When Apple rolled out its new iPhone 4S on Oct. 4, it slashed the price of the 3GS model to zero -- if it’s purchased with a contract. The decision thrust the company into the free- phone market for the first time and will help the 3GS account for as much as 20 percent of iPhone sales this quarter, said Shaw Wu, an analyst with Sterne Agee in San Francisco.

The move pits Apple’s iPhone against bargain Android phones, without much damage to the company’s profit. That’s because Apple gets cost savings from using older, cheaper parts. And though the device lacks some of the whiz-bang features of the 4S, such as the voice-activated assistant Siri, it’s still better than rivals of the same price, said Roger Entner, founder of market research firm Recon Analytics LLC.

“Apple can shovel them out by the millions,” he said. “What free phone or even $50 phone is going to be more appealing to consumers than an iPhone 3GS?”

AT&T Inc. (T) sold out its stocks of iPhone 3GS shortly after the price change, AT&T Mobility President Ralph de la Vega told analysts on a conference call last month. AT&T, which is the only U.S. carrier distributing the iPhone 3GS, has seen “tremendous demand,” he said. The company hasn’t said when it will have new supplies available.

Roberta Thomson, a spokeswoman for Dallas-based AT&T, declined to comment, as did Natalie Kerris at Cupertino, California-based Apple.

Gauging Sales

Apple and AT&T have used a similar strategy before, though not to this degree. The carrier sold millions of iPhone 3GS, then priced at $99, after the introduction of the iPhone 4 last June. In the quarter ended in September, “it’s not crazy” to figure that half of AT&T’s iPhone sales were 3GS models, said Craig Moffett, a Sanford C. Bernstein & Co. analyst in New York.

The repriced “free” 3GS went on sale in October, opening up the third and lowest pricing tier. The iPhone 4S sells for between $199 and $399, while the iPhone 4 goes for $99. Total revenue from the iPhone reached $11 billion last quarter, making it Apple’s best-selling product. The company expects to reach record sales of the device this quarter.

The 3GS is only free because of subsidies -- Apple still makes money on the hardware by selling it to carriers. The company gets about $381 per phone, according to Jitendra Waral and Anand Srinivasan, analysts for Bloomberg Industries.

Inexpensive Parts

While that’s well below the $620 it receives for the iPhone 4S, Apple spends much less to build an iPhone 3GS because of its older components. The analysts estimate that the camera in the 3GS costs $4, versus $19 for the 4S. And it has just $4 of RAM memory, compared with $25 in the 4S.

For that reason, Apple’s profit margin is as high on the 3GS as the pricier 4S, their research shows. Both phones carry a margin of 56.1 percent, while the $99 iPhone 4 has a margin of 55 percent. “The older the iPhone, the better the margin,” Srinivasan said.

Not everyone believes the margin is that high: Sterne Agee’s Wu, for instance, puts it closer to 40 percent. Still, Apple analysts see the 3GS as a low-cost way for the company to win back market share lost to the Android operating system. Phones running Android have done particularly well at lower price points, Moffett said.

Holiday Push

Samsung Electronics Co. has relied on Android, which Google offers for free to manufacturers, to become the world’s biggest smartphone market. It unseated Apple for the top spot in the third quarter, according to research firm IDC.

Apple’s repriced phones, plus the allure of the iPhone 4S, will set up a showdown with Samsung for the market lead this quarter, IDC said in a report yesterday.

Moffett expects AT&T to market the 3GS aggressively in the year-end holiday season, targeting price-conscious shoppers and people who want to add a phone to their family plan. Because it only works on the GSM standard, the 3GS is not available from Verizon Wireless or Sprint Nextel Corp. (S), which rely on different technology.

Apple traditionally left the low end of the market to competitors -- something that’s changing in both phones and computers. Apple now sells its iPad tablet and MacBook Air laptop at prices equal to or less than many rival products.

“The Apple of today is different from the Apple of even a few years ago,” said Wu, who recommends buying Apple stock. “They’re aggressive on price. Not only do they have the best technology, but they have the lowest cost.”

To contact the reporter on this story: Peter Burrows in San Francisco at pburrows@bloomberg.net

To contact the editor responsible for this story: Thomas Giles at tgiles5@bloomberg.net

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