Analysis – Calling the iPhone a cellphone isn’t fair. We here at TG Daily actually believe that it is the prototype of Intel’s mobile Internet device (MID) category that happens to be about 3 years ahead of its time. And, if you think about it, pricing this MID at $199 means that the iPhone 3G is a real bargain – in any way you look at it. In fact, it is such a bargain that some were wondering how Apple could make money on this device. But look a bit closer and you notice strategic tweaks that are likely to turn the iPhone into a gold mine for Apple, much more than it was the case with the first-gen iPhone. Here’s why.

It is an obvious thought that Apple is cutting into its profit margin by reducing the price for the iPhone by 50%. Considering the fact that Apple's profit margin on the first $400 iPhone was somewhere between 30% - 50% (which, by the way, is the usual profit margin for most Apple products), the reduced price of the new handset, which arrives in combination with upgraded features (3G, GPS), could mean that Apple is making dramatically less money on the $200 iPhone 3G, even if the production cost of the device went down (Apple typically finds ways to reduce the production cost in successive product designs).
 
But then, we know that Apple isn’t in the money-losing business. As it turns out, Apple is likely to make quite a bit of make money on the 3G device, probably more than with the first-gen device (AT&T makes more money as well.)  

In short, it all comes down to the fact that the 50% price cut is designed simply to get you through the door. Once you are in the store and you have fallen in love with the iPhone, you will have to commit to a two-year contract with AT&T (realistically, you are likely to stay much longer with AT&T, at least if you don’t jailbreak your iPhone.) By the time the contract expires you will have paid a $240 premium (compared to the first-gen data plan) for services due to the fact that AT&T has put a $10 per month premium on its unlimited data plan - justified through the 3G network upgrade. This data plan price increase isn't iPhone-specific, most carriers now charge $30 a month for unlimited 3G data access for PDAs and mobile phones in the U.S.

It is generally assumed that the iPhone price remains at $399 (as mentioned by TG Daily before), with AT&T covering a $200 subsidy (AT&T told its investors that this subsidy will actually mean that it will take a hit on its profit margin initially). Count in potential production and cost efficiency gains and you have a device that delivers higher margins than the first-gen device. The estimated bill of materials for the iPhone 3G is $100. If that is true, there could be a profit margin even Apple should be celebrating.

AT&T: Between $240 and $360 premium in services revenue

Since AT&T does not share service revenue with Apple anymore, the carrier takes in an estimated additional $240 over the time frame of the two-year contract. It also collects $240 more as a result of the $10 premium for the unlimited 3G data plan (we assume at this point that every iPhone buyer will subscribe to a data plan.) So, the $240 over two-years for not sharing revenue with Apple plus $240 more for $10 a month premium over data service adds up to a remarkable $480 premium (minus the $200 Apple has to come up with for each iPhone 3G) over what AT&T was making with the first iPhone and its entry-level $60 service plan over the two-year contract.

So, even if AT&T pays Apple $400 upfront, the company collects $199 (+$36 activation) from buyers and subsidizes the remaining $200 – which means that AT&T still ends up with a $240 premium after the two-year contract expires, plus a portion left over from the fact that it is not sharing its service revenue anymore. If you are picky, then you could claim that fronting Apple $200 and cutting into the profit margin carries extra cost (interest!), but we have a good feeling that this cost is covered by the service premium and the additional service revenue.  So, we don’t feel sorry for AT&T.

These numbers, by the way, assume that a customer signs up for a basic voice and data plan. If a customer wants 200 text messages (previously included in the entry-level $60 plan for the first iPhone), he has to upgrade to a service that is priced at an additional $5 per month, adding an additional $120 over the two-year period, raising AT&T's service premium to at least $360 when the contract expires. You might argue that text messaging should be part of an unlimited data plan, especially when the complete package is priced at $70 per month (and could cost close to $100 per month in some areas, if taxes are included.) In that view, the $5 price increase is actually sneaky AT&T’s part, but you always can use the iPhone’s email service instead.

Of course, the $200 subsidy is not officially confirmed. But even if we assume that $200 is what Apple charges AT&T for each iPhone 3G, a recent EETimes report suggests that even at $199, Apple's price includes about 50% gross margin over its parts cost, putting the handset in line with traditional iPods.

Read on the next page: iPhone tear-down, Apple's most profitable product ever

iPhone 3G tear-down: $100 bill of materials

Before we dive into the bill of material analysis, we need to mention that these numbers only cover the cost of physical components that make up the device. The bill of materials does not capture other important factors such as research and development, licenses, assembly, packaging and shipping and marketing. According to Portelligent, the raw cost of the material to build the iPhone 3G is nearly half of the cost of the original iPhone. The firm estimated the first iPhone's bill of materials at $170 at launch. Now we are looking at a number closer to $100, Portelligent claims.

EETimes said that Infineon and Samsung are still the two primary chip suppliers for the iPhone 3G. Will Strauss, principal of Forward Concepts, thinks that the iPhone 3G uses Infineon's baseband and RF transceiver and Samsung's applications processor. As for the GPS module, Strauss believes that Apple integrated Infineon's global positioning system chip, which is said to be based on technology Infineon licensed from the startup Global that was recently acquired by Broadcom. Strauss' assumptions echo recent textual string discoveries in the iPhone 2.0 beta firmware relating to Infineon hardware.

It is generally believed that Infineon chips are significantly cheaper than similar offerings from rival Qualcomm. For example, Samsung launched a handset last month that uses the same Infineon baseband and RF chip as the iPhone 3G. At that time, Samsung went on record to justify Infineon's choice with a 20% lower price than Qualcomm offering. Portelligent's president David Carey said the iPhone 3G's HSDPA chip added only about $15 and the GPS module just $5 to the bottom line. Carey also estimated that advances in display engineering may have cut the $60 cost of the first iPhone's touch screen into half - down to about $30. The company may have shaved an additional $25 off the bill of materials costs based on changes Carey noticed in the iPod Touch tear-down.

Apple probably achieved a longer battery life by using a larger battery. The additional weight due to the additional 3G/GPS components and a larger battery could have been offset by using lighter materials for the casing. It seems that the back of the handset is now made of plastic: If this is true, the use of plastic could have easily offset the weight gain, while improving the phone’s reception capability as well.

Flash memory prices

The flash memory market is a buyer’s market these days. Analysts suggested that Apple has been aggressively buying devices to get the best deal possible and achieve a market advantage. The company reportedly paid $1.25 billion in 2005 to guarantee flash memory supplies and prices for iPods through 2008. This move not only secured a potentially great deal, it also made it next to impossible for its competitors to secure flash memory supplies at the same prices Apple is likely to have in place. However, it is unclear how the dwindling flash prices are affecting Apple’s pricing as well as its competitive position with companies that are not locked into deals.

David Carey estimated that an 8 GB MLC NAND chip goes for about $20 today, which means that Apple may be getting it for less than that. Rumor has it that the company negotiated a new flash memory deal in 2007, similar to the $1.25 billion deal in 2005. To put flash prices into perspective, the same 16 GB NAND chip was priced at $50 a year ago. Reduced flash memory prices have an even greater impact on the 16 GB iPhone profit margin since the additional memory module costs Apple about $20, but the handset costs $100 more.

iPhone 3G is Apple's most profitable product ever

If we assume scenario echoed by many analysts - that AT&T is subsidizing the handset with $200, paying Apple at least $400 for the iPhone 3G, put it against the estimated bill of materials of $100 and add about 20% of secondary cost, Apple’s profit per device could be as much as $280. If that estimate in fact is close, the iPhone 3G could become the most profitable product Apple has ever sold. Not bad for the company’s second-gen phone.

The iPhone 3G will start selling in 22 markets on July 11, expanding to a total of 70 markets worldwide by the end of 2008 (not including Russia and China). Analysts estimate this expansion will increase addressable iPhone market from 150 million to potentially 500 million customers, making it much easier for Apple to meet self-imposed 10 million units target by the end of the year. At WWDC, Steve Jobs said at the WWDC earlier in June that Apple has sold 6 million iPhones since the handset went on sale June 29, 2007.

In some markets, carriers are completely absorbing the cost of the handset, but customers will have to commit to higher contract volumes, enabling a carrier to get a decent on its investment. For example, T-Mobile announced it will sell the 8 GB iPhone 3G for 1 Euro in Germany, Austria and the Netherlands to customers who sign a two-year contract and choose plans for either 69 (about $90) or 89 Euro (about $116) per month. The 16 GB iPhone 3G will be available for 19.95 Euro under the same terms. Such price reductions are not unusual in Europe where customers tend to me more price-sensitive than in the U.S. And apparently, these announcements are showing already some effect, as UK consumers are showing four times more interest in the iPhone 3G than they did with the first-gen phone. At least in the UK, the average iPhone user spends 30% more money than with any other cellphone, according to the Daily Telegraph.

The bottom line of all this is simple: iPhone 3G is far from being a product that needs subsidies to survive. It sure does not generate losses for Apple. Even at $199, it still has a margin near 50% and room for even more price reductions. The new business model works well for both AT&T and Apple. The carrier makes at least $240 more over the two-years contract compared to the first iPhone.

Of course, Apple has much more to offer, for example the $99 per year MobileMe service, adding to an already substantial phone bill. Everything looks great for Apple and AT&T, with the potential to increase revenues substantially. Of course, someone will have to pay more money for these new services. Guess who that will be.