Can Apple Keep a Shine on the iPhone?

On Mar. 17, Apple (AAPL) unveiled upgrades to the software for its best-selling iPhone. But the consumer electronics maker may need more than software to stay ahead of rivals introducing their own feature-rich smartphones.

Now, Apple needs to home in on hardware and handset pricing. A new version of the iPhone is due to be released at midyear. While Apple is mum on what the new device will look like before its introduction, analysts, consumers, and iPhone enthusiasts have a long list of features they'd like the next iteration to include. "What they ought to be doing is a smaller, lighter, and less expensive iPhone," says Mike Mace, a principal at consumer electronics researcher Rubicon Consulting.

It's important that Apple keep improving hardware quality as rivals introduce their own smartphones amid an economic slump that's forcing consumers to reduce spending. Since the iPhone's introduction, manufacturers have released several comparable devices, some of them at lower prices than the Apple device, which starts at $200. T-Mobile's G1 phone sells for less than $100 on (AMZN). Research In Motion's (RIMM) BlackBerry Storm, which costs $200 through Verizon Wireless, has sold more than 2 million units in the three months through February, according to estimates by Matt Thornton, a senior research analyst at Avian Securities.

Cheaper Rivals Circle

Sprint Nextel (S) will soon introduce the Palm Pre, a smartphone that, like the iPhone, offers a touchscreen. It also includes a physical keyboard that the iPhone lacks. Sprint and Palm (PALM) plan to advertise the device with a comprehensive, expensive campaign. "We'll spend heavily, and we will be aggressive," says Trevor Van Norman, a senior manager at Sprint. "We certainly think the device is a switcher device, we'll go after AT&T (T) and Verizon Wireless." The Pre, whose design was overseen by iPod creator Jon Rubenstein, could sell 3 million units in its first year, both to existing Sprint customers and users who switch from other carriers, Thornton says. Some of these gadgets also include their own online stores, akin to Apple's App Store, that let customers download a host of software applications; others will open their own app sites soon.

The growing list of iPhone alternatives makes it less certain that existing iPhone owners will upgrade to a new iPhone model unless it offers clear hardware improvements or is offered at a better price. In the first few months of 2008, when the new iPhone 3G became available, about 20% of sales came from existing iPhone users who wanted access to AT&T's speedier 3G network, Thornton estimates. People who already had an iPhone were locked into two-year contracts and would have had to pay a penalty if they tried to get out of the deal.

But the first iPhone contracts will be ending by midsummer, and rival providers are certain to try to lure iPhone users who may be looking for an alternative. Instead of upgrading, some 6% of the iPhone users could switch to save cash, Thornton estimates. Sprint's $70-a-month plan for Palm Pre includes text messaging. AT&T's comparably priced plan, its cheapest, doesn't include texts.

Of course, some consumers who already own an iPhone could choose to keep that device and switch carriers instead of upgrading to save costs. One option is Zer01 Mobile, a carrier that will introduce its mobile service in early April and will be sold through large electronics retailers. The company offers an unlimited voice and data plan for $70 a month, including taxes—with no contract. Unlike AT&T, Zer01 doesn't cap monthly downloading at 5 gigabytes, roughly equivalent to two standard-definition movies. The company encourages users to use their smartphones as modems for laptops and to download as much music and video as they like. While Zer01 will start out supporting only Windows Mobile-based devices, the iPhone will be added within several months as the company strives to grow to 1 million users in its first year. Because iPhone owners are heavy multimedia and Web users, "we feel that a lot of the iPhone users more than anyone else might migrate over," says Zer01's CEO Ben Piilani.

Could An iPhone Nano Be Next?

As a result, Apple and AT&T may need to get more aggressive on price. Today an 8-gigabyte iPhone sells at Wal-Mart (WMT) for $197 with a two-year contract. To appeal to a broad swath of consumers, a phone may need to cost $50 with a two-year service plan, says Mace. Hitting that price target may be tricky, since according to researchers at iSuppli, the iPhone cost $172 to make as recently as a year ago—though component prices have since plunged.

Alternatively, a smaller, lighter iPhone model—an iPhone nano, if you will—would cost less and mirror the evolution of another best-selling Apple hardware product, the iPod music player. The original iPod Classic was launched in 2001. Three years later the company launched offshoots called iPod Mini and iPod Photo. A year later the iPod nano was born, followed by iPod Touch in 2007. Sooner or later, Apple is bound to splinter the iPhone into a slew of wireless products with varied capabilities offered at different price points. Perhaps a new, cheaper iPhone could have a smaller screen and be operated via voice. Or it could be a multimedia-focused cell phone, designed especially for listening to music, snapping videos and photos, and for social networking.

Another option: AT&T may need to reduce the price of its iPhone service plan. To sign up users in this economy, carriers need to figure out a way to charge people $10 to $15 a month instead of as much as $30 for Web access, says Charlie Wolf, an analyst with Needham & Co..

Wolf believes the lead Apple currently enjoys in software and the popularity of its App Store may allow the company to hold off on introducing cheaper iPhone models for a while longer. As the number of applications found in the App Store continues to balloon to the tune of 500 new applications added weekly, Apple could gain even more traction by starting to recommend applications to users, similar to the way Amazon's recommendation engine can suggest books you might like based on your past purchases.

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