Another Music Phone? Yawn…

What if Apple made a cell phone and no one cared? Talk of the elusive iPhone heats up again, but analysts see marketplace obstacles

Today, the iPhone is talked about in roughly the same tone that people use when they're speculating about life on Mars. Sure, it's possible, even probable, that Apple (AAPL) will introduce an iconic cell phone. But the iPhone seems to have become the stuff of folklore, partly because of patent filings and veiled executive comments, and partly because the product introduction has been said to be imminent for so many months. Is it about to become real?

Rumors that Apple will introduce an iPhone rose yet another notch (if that's possible) this week, when Prudential Equity Group analyst Jesse Tortora penned a note saying that Apple is readying a music phone—and a separate, combination video and music phone. He expects Apple to introduce the devices in January at Macworld, a conference for Mac enthusiasts where the company typically debuts new products. At least one of the phones will offer Wi-Fi connectivity, he says, and both will become available in the March quarter of 2007.

Analyst Skepticism

Contrary to expectations, the news doesn't have Wall Street doing cartwheels. Apple shares fell after the Prudential report came out on Monday and before the company's strong earnings report on Wednesday evening. Why? Even Apple seems less than confident about the iPhone's prospects. One line of Tortora's report: "Our checks indicate that Apple will produce these phones in limited quantities initially due to concerns over market acceptance and battery life." An Apple spokesperson refused to comment on rumors and speculation.

But the fact is the iPhone looks less like a slam dunk than it's been made out to be. Most financial analysts aren't expecting a huge uptake, at least initially. "In my opinion, it's not going to be a huge market," says Charlie Wolf, an analyst with Needham & Co., who believes the next big seller for Apple will be a Mac computer preinstalled with Windows operating software. Other analysts instead point to iTV as Apple's next big thing (see, 9/14/06, "iTV: Here's Our 2¢").

Many analysts are skeptical on the appeal of an iPhone. Wolf believes an iPhone would first find buyers among today's 50 million or so iPod users. But even if all those people bought an iPhone right at its release, that would still trail the 78.1 million cell phones handset market leader Nokia (NOK) shipped in its most recent quarter. And, of course, initial iPhone sales will be far lower: After years of touting the iPod, Apple shipped only 8.7 million iPods in its latest fiscal quarter, according to results released on Oct. 18 (see, 10/19/06, "Apple's Big Mac").

Inadequate Margins and Demand

In the handset market, that's a drop in the bucket. And like other low-share players trying to muscle their way in, Apple is sure to feel margin pressure. Even today, most handset makers reap only single-digit margins—a radical, unusual business position for Apple, which reported 12.6% overall operating margins in its latest quarter.

Meanwhile, even iPod aficionados might turn their nose up at the new device. Today, more than half of Americans with music-capable phones also carry MP3 players. That's an indication that "it's a nice feature to have, but people aren't that interested in it," says Bill Hughes, an analyst with consultancy In-Stat. That's a disquieting prospect for any new Apple phone, given that much of the iPod's user base is in North America.

Room for Improvement

But these statistics also indicate a market opening for Apple. While phones from the likes of Motorola (MOT) already work with Apple's iTunes, Jobs & Co. could still make their product unique by offering increased ease of use and feature richness. Consumers today complain that existing music phones make it difficult to synchronize their music collections and download music. If Apple were to introduce a phone that makes these functions as easy and seamless as the iPod, that could induce some iPod fans to pull out their wallets, says Neil Strother, an analyst with NPD Group.

Another powerful incentive: a phone with more memory. When In-Stat surveyed 1,700 people in August, it found that two-thirds of people who owned music phones and downloaded music onto them were dissatisfied with the number of songs they could store on the phone. And no wonder: The infamous ROKR phone, co-developed by Motorola and Apple, could store only up to 100 songs; it's still hailed as one of the greatest market failures of the past year. Other, newer phones have limited storage as well or use SD memory cards, offering no more than 2 GB of storage. Compare that to the iPod, which is able to store as much as 80 GB of content—or 20,000 songs, plus video and photos—and weep. Problem is, such a high-capacity phone may require heavy battery power use.

Even if Apple's iPhone offers all these features, reaching consumers who don't currently own MP3 players could take years. As of the second quarter of this year, some 19% of all new phones sold in the country could play music files, compared with only 7% in the same period of 2005. Only about 3% of buyers actually used the phones to play music, according to various surveys by NPD Group. And studies by In-Stat show that the increase in usage will be slow. So not many people will be willing to plunk down $250 or more for an iPhone, Strother says.

Carrier Worries

This potentially limited appeal is bound to have wireless service providers scratching their heads about whether to embrace an Apple telephone. While Cingular, which has an established relationship with Apple, is likely to offer the phone (the company wouldn't comment for this story), it stumbled with ROKR. Other carriers might also hesitate because Apple has yet to prove itself in the handset market, and making quality cell phones isn't easy.

The device's limited appeal might make carriers hesitant to spend the big bucks on their distribution and promotion—particularly if existing handset makers jockey to elbow Apple out with cool new products. Already, LG's (LPL) Chocolate music phone is a runaway success worldwide (see, 9/5/06, "Easy Listening on LG's Chocolate"). And Apple isn't even the largest new player eyeing the handset market. Software giant Microsoft (MSFT) will soon introduce its Zune device, a music player with Wi-Fi capabilities. It's also said to have a Zune-based cell phone in the works. And the Redmond (Wash.) giant can afford deeper marketing incentives for carriers than the much-smaller Apple.

Perhaps most important, carriers might not wish to work with a company that has a long history of setting its own path, instead of accepting influence from service provider customers, the custom in the wireless world. "Jobs is known for going his own way," says Strother. "There's this whole corporate ego thing. Does Apple have a shot at success? Sure. But they are stepping outside their ecosystem."

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