Apple's iPhone 3G: who needs carrier subsidies?

[This post also appears on the Yankee Group Blog at http://blogs.yankeegroup.com] With Apple's iPhone launching on July 11 for $199 in the US with a 2-year AT&T contract, everyone (including me) is assuming that there's a roughly $200 AT&T subsidy baked into that price. That assumption seems especially reasonable since AT&T is raising its unlimited data service subscription price by $10 per month and will no longer share subscription revenue with Apple. Those two factors means that AT&T is accruing about $480 more ($240 from the higher data service price and $240 from not sharing subscription revenue with Apple) per 3G subscriber over the two-year contract, leaving them plenty of room to pay Apple roughly $399 up front for 3G iPhones and still sell them to consumers for $199. But there's an intriguing twist to this story that may surprise people. According to Porteligent and as reported by EETimes, the parts cost of the 3G iPhone may be as low as $100. That means that even at $199, Apple's price includes a roughly 50% gross margin over its parts cost, which is in the ballpark of the gross margins on traditional iPods. If AT&T is adding in a $200 subsidy, then the iPhone 3G is anything but a a phone requiring a carrier subsidy. In fact, if these numbers are true and the carriers are subsidizing the phone, the iPhone 3G could end up being the most profitable product Apple makes. But more likely, this means that Apple has a lot more pricing flexibility than analysts have given them credit for. Now as one of those analysts, I have to apply a caveat here. It's highly unlikely that Portelligent actually has an iPhone 3G to tear down, so their parts cost analysis is probably just an educated guess informed by current cost data from parts suppliers. But that said, Apple has a history of aggressively buying parts to achieve a market advantage. For example, Apple paid $1.25 billion in 2005 to guarantee flash memory for iPods through 2008; that purchase made it nearly impossible for other flash music players to have competitive supplies and profit margins. Apple reportedly negotiated another similar deal in 2007. In my opinion, the Portelligent's cost is probably closer to right than wrong, simply because Apple never sells loss-leader products. And given Apple's intent to sell this phone in more than 70 countries this year, it undoubtedly worked hard to ensure low parts costs regardless of significant currency fluctuations too. So what's the takeaway here? It's simple: Apple's 3G phone isn't a loss-leader product needing subsidies to survivie. It's designed to be an Anywhere phone that puts your online life, media, and connections in your pocket, yet be simple enough for your grandma to use. But for Apple, it's a business platform designed to make money -- and the details of that business design may surprise more analysts than the product itself.

Seven Overlooked iPhone 3G Details

The blogging world is abuzz at Apple's new $199 iPhone 3G, with most writers (including Yankee Group) bemoaning the lack of surprises in Steve Jobs Keynote. But my analysis of the press releases that came out after the event actually produced more surprises than I would have expected, including:

1. More upfront payments to Apple in exchange for no subscription payments. Based on data released by ATT, Apple will no longer receive a cut in carrier subscription revenue for iPhone 3Gs. For first generation iPhones, that amounted to $10 per iPhone per month, or about $240 over the 2-year contract. Instead, ATT is subsidizing iPhone purchases, presumably paying Apple about the same amount on the day of purchase. So who cares? Well, Apple and ATT investors do: despite charging $10 more per month for the iPhone 3G data service, ATT will take a hit of about $600 million annually over the next two years, all of which presumably will show up on Apple's balance sheet due to subsidies. Note carefully: this does NOT mean that Apple is discontinuing its accounting for iPhone sales prices over 24 months -- it simply means that it isn't getting monthly payments from the carriers for iPhone 3Gs. By the way, the original iPhone subscription payments will continue for the full two years.
2. In-store activation required in the US. Apple pioneered do-it-yourself phone provisioning through iTunes last year. Sadly, ATT has forced Apple to drop this unique feature, now requiring in-store activation of the phone, presumably to ensure that it earns back its iPhone subsidies from subscriptions. This has two significant implications: 1) Apple can no longer sell its phone online through the Apple Store, and 2) anyone waiting in line on July 11 for a phone should expect to wait hours longer as people buying phones each wait 10-12 minutes for in-store activation. This is one of the rare circumstance where Apple has decided to degrade the customer experience to please its carrier partners.
3. Multiple carriers in some countries. As Apple pushes forward to deliver the iPhone is 72 countries, it seems to have gotten overly enthusiastic in countries like Portugal, Austria, Switzerland, Italy, and Australia, each of which has gotten not one, but two carriers offering the iPhone. So much for exclusive carrier deals.
4. iPod touch is poised for a price cut. With the iPhone cut to $199, iPod touches selling for $299, $399, and $499 seem out of place. While there's no similar carrier subsidy to reduce these prices, Apple's not dumb enough to leave them there. Expect a $100 price cut on these products before the back-to-school season.
5. Apple's toe dip into running an iPhone NOC. This was a real sleeper, but an important one for developers. Apple has refused to allow developers to run background applications on the iPhone (understandable given power and stability requirements). Instead, Apple is providing a centralized push application service that can present badges, sounds, and text alerts on any number of phones at the same time. What Apple has actually created here is a poor man's Blackberry Enterprise Server and Network Operations Center, complete with the associated single point of failure too. It's too early to know how much developers will embrace this service, but it in essence makes the iPhone a cloud computing client.
6. Multi-mode location-based services. Yes, Virginia, the iPhone does support both GPS and photo geotagging. But the dirty secret of GPS is that it doesn't work in the most common places you use your phone -- inside and in the shadows of buildings in cities. But just as the navigations systems built into cars do, the iPhone integrates multiple sources of location information -- cell tower triangulation, WiFi network triangulation, and GPS -- into its location service. The result: the iPhone's location services may actually be better and more reliable than those you get from your average Garmin or Tom-Tom personal navigation system, simply because it will work in more places.

The seventh and final observation I'll make is one that was hiding in plain site during the keynote. Steve Jobs dedicated nearly 40 minutes to third-party software demonstrations during the two-hour keynote. That's more time than any other topic received. If there's one thing we know about Jobs' keynotes is that he doesn't waste time on things that are unimportant to users. By dedicating nearly 1/3 of the keynote to third-party applications, Jobs served notice that the Apple iPhone is not just a consumer device, but is Apple's third big developer platform, following the Mac and the iPod. And while it isn't yet a third of Apple's revenue, just wait. It will be -- and sooner than you think.