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iPhone 3GS steals some Pre thunder, but Apple has big challenges

In marketing terms, Palm was left looking like the enthusiastic school cheerleader next to Apple's super slick professional - as usual, the iPhone maker created a great balance of anticipation and last minute nerves ahead of its new handset launch, and got its timing just right, leaving the Palm Pre only a couple of days in the sun. But in reality, the relief that Apple actually had announced some hardware at its Worldwide Developer Conference (WWDC) quickly gave way to a measure of disappointment that the iPhone 3GS was not more radical - and to anger at restrictions imposed by some of its operators. Which led to another comparison - between the carrier exclusives of the two phones. While Palm can take advantage of huge efforts by Sprint during the Pre's first months - given that this is almost as critical for the cellco as the device maker - and then jump off onto the bigger networks of Verizon Wireless and others, once it sorts out its supply shortages. By comparison, Apple's agreement with AT&T is looking increasingly exhausted - still important to the operator, but holding the iPhone back in terms of market share and user satisfaction, at a time when it is facing a rising surge of competitors.

In marketing terms, Palm was left looking like the enthusiastic school cheerleader next to Apple’s super slick professional – as usual, the iPhone maker created a great balance of anticipation and last minute nerves ahead of its new handset launch, and got its timing just right, leaving the Palm Pre only a couple of days in the sun. But in reality, the relief that Apple actually had announced some hardware at its Worldwide Developer Conference (WWDC) quickly gave way to a measure of disappointment that the iPhone 3GS was not more radical – and to anger at restrictions imposed by some of its operators. Which led to another comparison – between the carrier exclusives of the two phones. While Palm can take advantage of huge efforts by Sprint during the Pre’s first months – given that this is almost as critical for the cellco as the device maker – and then jump off onto the bigger networks of Verizon Wireless and others, once it sorts out its supply shortages. By comparison, Apple’s agreement with AT&T is looking increasingly exhausted – still important to the operator, but holding the iPhone back in terms of market share and user satisfaction, at a time when it is facing a rising surge of competitors.

Apple’s challenges:

Apple’s challenges were there for all to see in the iPhone 3GS, which it unveiled at WWDC (calming last minute analyst nerves that there would be no new handset, but without the rallying presence of ailing CEO Steve Jobs). These are squeezed margins (the lower end iPhone 3G drops to $99 and there is no premium for the new features, although the carrier will bear the brunt of the keener pricing in subsidies); a narrowing gap in features terms between the iPhone and its rivals (for all the chatter, the 3GS is interesting but not a game changer); and arguably being stuck with the wrong US carrier, and having difficulties attracting strong sales in emerging or business markets. These last issues may be partly addressed by the new product line-up. For the enterprise, there is a heavier focus on RIM’s home sector in the software enhancements, while lower cost hardware models could work better in markets like India and Russia where carrier subsidies are rare (though Apple will still have to be prepared to take a hit on its margins to penetrate these markets in full – see separate item on Nokia).

New iPhone features:

The iPhone 3GS (‘S’ stands for ‘Speed’), will be priced at $199 for the 16Gb version and $299 for the 32Gb. It claims to be up to three times faster than the existing 3G iPhone. The better performance and new software features from the iPhone 3.0 OS – already detailed – are the main leaps. In terms of actual phone capabilities, the iPhone remains short of the super phone league – its camera does have autofocus and video capture/edit now, but is only 3.2-megapixels, a far cry from the 12-megapixels boasted by the Korean vendors and Sony Ericsson. In form factor terms, the 3GS looks pretty much like the current 3G device.

Software features introduced with iPhone 3.0 OS include voice control and the long awaited MMS and cut-copy-paste (users can shake the phone to undo this). Also added is the ability to track and wipe lost handsets via the MobileMe service, while Apple has introduced the ability to rent and buy movies from iTunes on the handset and is partnering with Scroll Motion on digital books for App Store.

The tracking service will appeal to businesses, and other features show Apple chasing the enterprise sector more aggressively, most importantly by introducing support for Exchange in the Mac’s native email and address book (which sync with the iPhone); and with hardware encryption in iPhone 3.0, which will extend to the Mac or PC when the data is backed up. Another feature much demanded by businesses – tethering – requires carrier support and while Apple said it would be offered by 22 cellcos, these may not include AT&T, at least for now.

Other important software enhancements include HTTP-based streaming audio and video that will pick the right bit rate depending on the phone’s data connection quality; autofill for Mobile Safari; and turn-by-turn GPS directions (plus an iPhone version of the TomTom navigation app).

Palm Pre ships:

Whatever the strengths and weaknesses of the new iPhone, the buzz around its launch puts pressure on Palm and Sprint, just when they could do with a clear run at the market. Sales in the Pre’s first weekend appear to have been very respectable, with estimates ranging from 50,000 to 100,000 units, but the partners need to sustain the momentum, even amid component shortages. Sprint also needs to reach out to new customers more effectively, as AT&T has done with successive iPhones. Estimates by analysts at Soleil/Nelson Alpha Research point to sales of 75,000 to 80,000 over the weekend, but with 80% of these going to existing Sprint users. This is not all bad – Sprint’s greatest issue recently has been hanging on to its higher end customers – but shareholders will also be looking for new sign-ups. Neither Sprint nor Palm released official figures on how many devices they hoped to sell on the Pre’s first day. Most observers reported only short lines outside stores compared to those for the iPhone. Crowds were larger at Best Buy outlets, which were offering the phone for $199 upfront, rather than customers having to pay $299 and then get a $100 mail-in rebate.

Sifting through the vast amount of web chat about the Palm launch in US stores at the weekend, the overall conclusion seems to be a ‘B+’ – strong launch, some good early reviews, but lacking the first day volumes or wow factor of the iPhone, and with the jury out on how many applications its webOS will attract (not to mention component shortages and the elusive European carrier deals).

Early reviews of the Pre praised its touchscreen/keyboard combination, its ease of use and the general webOS experience, while the main downsides were poor battery life (though battery is more easily replaceable than the iPhone’s) and shortage of apps. Sprint told The Wall Street Journal it was not concerned by this last point. “You’re not going to get a critical mass of developers coding for the new platform until you give them devices,” said VP of product and technology development Kevin Packingham. “There are only so many things you can control in the initial delivery.”

The latest prediction for Palm Pre sales volumes comes from iSuppli, which is forecasting 1.1m units this year. It thinks this figure could go to 1.3m if the firm announces an HSPA version before year end, but this would, of course, mean it would have to sort out a deal with at least one GSM carrier (not a US one, since Sprint’s exclusive lasts at least until year end). This would be less than the 2.4m 3G iPhones that AT&T sold in the handset’s first quarter, and similar to the one million BlackBerry Bold sold by the same operator in its first three months. Verizon Wireless sold about 2m BlackBerry Storms in the first quarter.

iSuppli’s research note also calls on Palm to open up its webOS Linux-based software platform to third parties, to spread its software reach beyond its own devices. This, however, would break the tight integration of device and OS – which is still working well for Apple and RIM – and put Palm up against Google Android and Symbian, with their massive resources and market headstart.

Sprint versus AT&T:

Sprint Nextel has pinned almost as many turnaround hopes on the Pre as Palm, and the operator’s CEO Dan Hesse said, at the official launch party, that the Pre’s debut would be “a coming-out party for the new Sprint”, claiming dramatic improvements in customer service and other areas where Sprint has been weak in recent years. “We’re a very, very different company than we were 12 months ago,” he said, claiming Sprint’s networks are performing at their best ever levels, even on iDEN.

Consumers will need more convincing that Sprint really has turned a corner in customer service and network coverage, but in general the sentiment is less negative than for AT&T. The crowd at WWDC howled when it was revealed AT&T would not support tethering – using the phone as the PC’s internet gateway – until late in the year, and then at high additional prices. This was just one of a series of criticisms of the carrier by the audience, increasing the sense that Apple is being held back in its native market by its operator’s patchy network, which could give the lie to the ‘S’ label of the new phone, despite AT&T’s ongoing program to upgrade its system. Such pressure may encourage Apple to make a CDMA-based deal with Verizon Wireless, which is also reported to be getting the Pre as early as January, when Sprint’s exclusive should end, and which has a more spectrally efficient 3G network with EV-DO.

In an increasingly competitive market, Apple cannot afford to have the reputation of its iPhone tarnished by frustration with its carriers. Rather than capitalizing significantly on the new iPhone, as it usually does, AT&T saw the event just highlighting growing discontent with the restrictions that users believe it puts on the performance of its favorite handset.

For instance, AT&T will only introduce MMS later in the summer, saying it has to remove ‘opt out MMS’ codes manually from each iPhone account first. More controversially, AT&T will block data tethering at launch, and even when it does support this key feature, it will charge $70 a month (with unlimited data, but no SMS or MMS).

Time to call time on operator exclusives?

Other operators are nervous about the strain that tethering can put on their networks and are looking to charge high prices for the option. O2 UK users will have to buy a ‘Bolt On’ to use the service, paying an extra £14.68 ($24) a month on top of their regular iPhone tariff to get 3Gb of tethering data, or £29.36 per month for 10Gb. An extra 1Gbb on top costs a further £4.89. This has aroused fury in the UK market, with consumer petitions floating round the web, and calls for the freedom to choose a carrier and plan. They are also angry that O2 will apparently insist that customers buy themselves out of their existing contracts to sign a new one for the 3GS. This would entail a massive £210 for a user with six months left to run on a £35 monthly deal – and is all in line with O2’s recent attempts to discourage subscribers from upgrading early, even offering incentives for users to stay with their phones beyond their contract expiry date, and so save O2 on subsidy bills.

Such discontent suggests that it may be time for Apple to haggle its way out of its hugely long exclusive deals in key markets like the US and UK (it may be looking wistfully at Palm’s six-month lock-in with Sprint) and open up consumer choice to maintain iPhone momentum and grow market share. But AT&T is desperate to hang on to its exclusive for another year at least, as its margins start to pick up. Although it will sell off the older iPhone models cheaply – $99 for the 8Gb version and $149 for 16Gb – it is not expecting a heavier hit on margins than iPhone subsidies already entail. The operator said it expected 2009 wireless service operating income to be in the low 40% range, and insisted that the cost of customer acquisition for the 3GS and the new low cost iPhone 3G will be similar to those of the existing devices. In addition, it expects the 3GS to drive ARPU increases, attract new users and reduce churn – a balance that has so far paid off for the cellco, despite the impact of high subsidies on its profits. Margins fell to 33.5% after the iPhone launch but were back to 41% last summer and analysts think that, as AT&T gains scale (it has over 4.5m iPhone subscribers paying at least $70 a month) margins could go up further.

Meanwhile, Sprint CEO Dan Hesse is trying to dampen the most unrealistic expectations for the make-or-break first weeks of its Pre deal, saying it will take three months for the carrier to know how well the handset is doing. “It will probably take about three months before we know,” he told the Atlanta Journal-Constitution. “Early on, it will sell like crazy. The real issue is what kind of legs it will have after the initial euphoria.”