Minority Report: Will the iPhone save the iPod?

While some worry the iPod will go the way of the Tamagotchi, Seb Janacek believes the iconic device may merely be in transition - and could prosper in its next iteration, the iPhone. Here is the second instalment of a two-part series. (Read part one.)

Rumour-mongering is a beloved pastime of the Apple faithful and currently the talk is all about the next generation of the iPod - a mobile phone/MP3 player hybrid speculatively referred to as the iPhone.

A fall in iPod sales for two consecutive quarters led some to predict the death of the ubiquitous digital music player. This is certainly a premature prediction, though the product does need to evolve, and the iPhone is seen by many as the answer to sustaining sales.

It's not just forum posters, bloggers and journalists who are excited about the iPhone. Industry analysts have increasingly become as guilty of contributing to the speculation. Piper Jaffray analyst Gene Munster earlier this year predicted there was a "75 per cent chance of an iPhone in the next 12 months".

And American Technology Research analyst Shaw Wu was just as bullish in his views on the totally unconfirmed product, stating in September that the device was ready for production.

There's no hard evidence Apple will release the iPhone, though for such a secretive company, which almost never comments on future products, that's no surprise.

Rumour sites point to the following evidence as proof the iPhone's release is imminent: the company's application for the iPhone trademark; the iphone.org URL redirecting users to Apple's home page; references to GPS and mobile phone technology in Apple software code; various Apple patent filings for touch-screen media devices; and a job posting on the company's website advertising a role for a mobile marketing manager.

Even Apple CFO Peter Oppenheimer hinted the company was working on the device in July when he said: "As regards cell phones, we don't think that the phones that are available today make the best music players. We think the iPod is. But over time, that is likely to change. And we're not sitting around doing nothing."

It's clear why Apple would consider such a move - it recognises the challenge today's MP3-enabled mobiles, such as Sony Ericsson's Walkman phone, represent for the iPod.

All about the iPhone

♦ Minority Report: The death of the iPod (part 1)

♦ Upwardly Mobile: Why I won't buy an iPhone

Still, even if it's a good idea, morphing the iPod into a phone would be a major undertaking beset by challenges. For instance, an iPhone would almost certainly be accompanied by a move to make iTunes content available for direct download to the device - and the distribution of music and other media over mobiles hasn't exactly boomed. But the company clearly would have no qualms about taking a step into nascent markets, particularly when the projections for take-up are vast.

As I wrote in part one of this column, the true challenge of convergence isn't so much being able to pack a lot of features into a small device, it's about making sure it works without diminishing the user experience.

This is Apple's trump card. Irrespective of the (possibly diminishing) cool factor, iPods are a triumph of user interface design - from the easy-to-navigate iTunes software to the single click-wheel.

But despite its strengths, Apple won't be resting on its laurels. Microsoft has pledged that a future version of its so-called 'iPod killer', the Zune, will feature phone functionality.

There are several possible barriers to the iPhone's success. First, would it deliver the profit margins Apple has come to expect from its devices? Recent figures show profit margins for handset makers Nokia and Samsung coming in around 12 or 13 per cent. At the low end, for the likes of LG, they can be as low as one per cent.

According to some reports, the iPod nano has a margin of around 20 per cent, while some claim the Shuffle's margins are as high as 40 per cent. Apple would need to position the iPhone as part of the iPod product family in such a way that doesn't affect its bottom line by cannibalising sales of higher-profit devices.

A second obstacle for the iPhone to overcome relates to Apple's likely demand for complete control over handset design and features. This would no doubt be a sticking point for some network operators, who see content and other services as key revenue drivers and pack devices with high-profile links to content.

Apple has a religious approach to delivering purity in its design. When it chose to use Intel chips in Macs, it was willing to forego the chip giant's marketing millions to avoid adding an Intel-inside sticker to the front of its computers. It would be unlikely to tolerate any operator-dictated links to relatively WAP-type features if it meant compromising the quality of its aesthetic.

On the other hand, operators could earn money from the data transfer of iTunes content - which we can presume the iPhone would link to. And they could be willing to forego links to affiliated services in return for being the operator offering the iPhone, a product which could no doubt be used to tie customers into long-term contracts and cut churn - the bane of mobile operators.

A third, related obstacle is Apple's penchant for owning the whole vertical solution, from hardware to software to content to distribution, as it does with the iPod and iTunes. Apple could simply sell the iPhone as a network-independent device through its existing sales channels, but it doesn't quite satisfy the Apple iTunes formula for providing an end-to-end solution for content distribution, device and software.

Another possibility is Apple launching a mobile virtual network operator (MVNO), thereby controlling the hardware, content and distribution as it currently does with the iTunes Store. MVNOs driven purely by content distribution have struggled, however. In fact, it's hard to think of a single one that's succeeded. A recent high-profile casualty in this arena was a Disney-operated MVNO featuring sports content from the ESPN channel.

So what are the prospects for the Apple iPhone?

It's unlikely the company won't enter the mobile arena, given the opportunities. It already has a toe in the water through the risible Motorola ROKR phone and the mobile handset market has clearly been part of its long-term vision for music sales.

That it hasn't done so before probably has as much to do with the ongoing demand for iPods as it does with any wrangling over having complete control over the product feature set or an exclusive network deal that removes all question marks over content distribution.

All the rumours point to a January release for the iPhone at the San Francisco Macworld event. Will it be a successful iPod spin-off or a wrong number? Surely so many forum posters, bloggers, journalists and analysts couldn't be wrong, could they?