What to expect from a low-cost, prepaid iPhone

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Mike Dano
A number of reports have indicated Apple (NASDAQ:AAPL) could be planning a low-cost iPhone. Such a device could vastly widen Apple's addressable market and open up the iPhone to more prepaid service plans. But what are the obstacles Apple faces in offering a less expensive iPhone?

Before we get into the details, let's start at the beginning: The 16 GB iPhone 4 currently costs around $649. The reason AT&T Mobility (NYSE:T) sells the device for $200 is because the carrier subsidizes the cost of the device, and recoups that expense through the two years of service iPhone buyers are required to sign up for. Thus, prepaid carriers would have to sell the iPhone at full price ($649) because they couldn't reliably recapture a subsidy.

A $649 iPhone does sound like a pretty steep price, but some customers apparently are paying it. Toni Sacconaghi of Sanford Bernstein recently said that China Mobile counted 5.6 million iPhones on its network at the end of May, and since China Mobile doesn't sell the iPhone, most of those devices probably are unlocked iPhones that users likely paid full price for and paired with a China Mobile prepaid service contract.

But most iPhones across the world are sold in a postpaid scenario, because most users aren't comfortable shelling out $649 for a phone just to have the flexibility of a prepaid service contract.

This means Apple is foregoing a major part of the wireless market: prepaid. Research from New Millennium Research Council shows that about three out of five new U.S. wireless subscriptions in 2010 were for prepaid cell phone service vs. contract-based postpaid service.

And Apple knows the prepaid market is important in wireless. "We know that we need to play there [in prepaid] in order to have the kind of volumes that we'd like to have," Tim Cook said during Apple's most recent quarterly conference call, according to a Morningstar transcript.

"If you step ... out into [the] prepaid market ... it's clearly in a distinctly different price than the iPhone 4 is," Cook said. "We will only make products that we're proud of, that are the best in the world, and if we can do that and the price is lower then we're great with that. An example of that that happened some time ago is the iPod shuffle. It started at a different price point, but it's now at $49 and that's because it's a product we're very proud of. It's very innovative. A lot of people love that product."

Can Apple make a cheap iPhone like it did with the iPod shuffle?

"It just might not be financially reasonable or feasible ... to create a cheaper device," cautioned ABI Research's Michael Morgan. "Why compromise brand and image for lower margins?"

Morgan explained that Apple's bill of materials for an iPhone 4 is around $450. He said the company records iPhone revenue of around $630 per device, a figure that includes revenue from hardware, software, accessories and other items. Thus, he said Apple enjoys iPhone margins of around 30 to 40 percent.

The most expensive prepaid smartphones in the U.S. market today cost shoppers between $250 and $300. Morgan said Apple could sell a prepaid iPhone for around $350, given the company's brand recognition and ability to charge a premium for its products.

But in order to bring down the cost of the iPhone to around $350 and maintain its margins, Apple would have to make significant compromises on one or more of its main iPhone components.  Morgan said Apple's iPhone bill of materials consists of four key components: the baseband chipset, the application processor, the internal memory and the screen. He said a compromise on any of these specific components could affect the iPhone user experience:

  • A less expensive baseband processor would help, but Apple may have already squeezed all the profit it can from this component.
  • If Apple reduces the expense of the applications processor with a less powerful one, the resulting iPhone might not be able to run high-end applications like games.
  • If Apple reduced the size of its iPhone internal memory (currently the smallest available configuration is 16 GB) users might not be able to store as much data (music, movies or applications) as they would like. Apple's forthcoming iCloud service could alleviate this concern, however, by streaming content to the device instead of storing it locally. Reuters reported in August Apple is working on an 8 GB version of the iPhone 4.
  • Finally, Apple could offer a lower-quality screen, but that could affect the company's brand and reputation as providing high-quality merchandise.

Nonetheless, Morgan said Apple has in the past several years shown a surgical ability to cut expenses throughout its supply chain, in some cases forming business partnerships with suppliers instead of just purchasing space on their manufacturing lines. He said the company could slim down some of its existing iPhone products--the iPhone 4 or the iPhone 3GS--and offer them as low-cost alternatives to the iPhone 5.

While Apple may well be able to build a less expensive iPhone, the challenges posed by such a device don't end there. Prepaid carriers would also have to support the gadget (though existing iPhone carriers like AT&T Mobility and Verizon Wireless (NYSE:VZ) could offer the iPhone through their own prepaid divisions). If the iPhone found its way to prepaid, flat-rate carriers like MetroPCS (NYSE:PCS) or Leap Wireless (NASDAQ:LEAP), those carriers might have to fortify their networks further to support users' data demands. And both Metro and Leap are already struggling to support the smartphone customers they already have. For example, Metro said it will increase capital expenses this year from a previous estimate of $700 million to $900 million to a new target of $900 million to $1 billion to support extra smartphone data traffic. A MetroPCS iPhone could exacerbate that spending.

But it's likely that prepaid carriers across the board would be clamoring to offer the iPhone. As Sprint Nextel's (NYSE:S) CFO Joe Euteneuer recently explained: "The benefits of having such an iconic device are really huge."

Perhaps the most interesting aspect of a low-cost, prepaid iPhone--aside from what it means for Apple and prepaid carriers--is the potential effects the gadget would have on existing, low-cost smartphone suppliers like Huawei, LG and Kyocera. Further, a low-cost iPhone also could cut into the market share of Android, which along with Research In Motion's (NASDAQ:RIMM) BlackBerry is working its way down to the $200 to $300 level among prepaid wireless carriers. +Mike Dano

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