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Mid-market consumers, women will "trade up" to luxury of iPhone - report

Apple Inc. and its iPhone are set to ride a growing wave of middle-market Americans who are defining a new market segment through their willingness to pay a premium for "new luxury" goods, says a new report from Credit Suisse.

According to the 21-page briefing, a "new luxury" product is one that demonstrates technical superiority, improved functionality, and compels an emotional attachment by its owner. It possess higher levels of quality, taste, and aspiration than other goods in its category, but is not so expensive as to be out of reach.

"We believe the iPhone addresses all three of these characteristics as it enters the market harnessing the world’s best operating system (Mac OS) which will drive a step function increase in both functionality and simplicity relative to other products in the market," analyst Robert Semple wrote in the report. "And while these features can stand on their own, we believe there will be a certain 'cachet' associated with owning the iPhone, much like the Motorola RAZR phone when it was launched in 2005."

Semple said middle market consumers most likely to adopt the iPhone include empty nesters, single twenty-something professionals, and dual income couples with reduced financial commitments and more disposable income. Divorced women also rank high on the list, according to the analyst, given the increase of women generating income combined with higher divorce rates.

"In fact, we believe the greatest surprise around iPhone is that women may surpass gadget geeks as the largest customer segment to adopt the iPhone," he wrote.

In defending his thesis, Semple cited a "precedent" or trend in the market where consumers continue to show a willingness to "trade up" to premium products, such as the Apple iPod, Under Armour, Coach handbags and Tiffany jewelry. "At Coach, the mix of $400+ handbags has increased 100 basis points as a percentage of total sales," he explained. "And at jeweler Tiffany, 'statement' jewelry has seen average selling prices increase from $81,000 to $91,000 over the past year while less-than $500 silver products have decreased as a percent of total."

Fueling the trend, according to the analyst, is the rise in discretionary wealth, the introduction of an influential female consumer, changing family structures, and evolving consumer behavior, along with encouragement from media influences to acknowledge and respond to personal needs.

"Why will consumers Trade Up to the iPhone?," asked Semple. "The real value and differentiation in the iPhone lies not its sleek design (this is certainly helpful though), but rather, the innovative qualities and resulting capabilities delivered by the Mac OS X, which remains the best operating system in the PC world today in our opinion, and an OS that easily exceeds the capabilities of the scaled down OS’s that dominate the mobile phone market today."

While the Apple device was conceived to act as a phone, web browser and iPod, its potential to excel in other areas of digital media may also exist. The Credit Suisse analyst said it's products of the iPhone's nature that typically develop popular utilities unforeseen by the product designers. "With the host of capabilities that the iPhone enables, users will inevitably find their own uses for the product," he wrote. "For example, with a 2 mega-pixel camera and an OS designed to handle photo management (iPhoto), we believe the Apple will be able to deliver in one product what camera phones have been trying to accomplish for several years, immediate and quality photo sharing."

Semple also predicts that iPhone will become a go-to weather tracker along with a pseudo GPS device — two utilities which he claims consumers have needed since the inception of the mobile phone. At the same time, however, he acknowledged that concerns around the device are many and the stakes high. While Apple has a great track record with its products, it has from time to time, had issues with new releases, primarily due its decision to surprise the market and avoid real beta testing. In the case of iPhone, the analyst believes this particular concern is exacerbated by the fact that Apple is entering an entirely new product category, one which is very complicated.

"From our perspective, this is where Apple can do the most harm to the iPhone brand if it is early to market with a product that is not ready for prime time," he wrote. "Battery life and screen quality are other concerns that warrant discussion."

With the global handset market expected to grow 14.7 percent to 1.1 billion units in 2007 followed by growth of 9.7 percent to 1.2 billion units in 2008, Semple estimates that Apple will capture "a very small segment" with sales of 5 million units in 2007 (share of 0.4 percent) and 15 million in 2008 (share of 1.2 percent).

"Our expectations are being viewed as overly optimistic, especially in light of the fact that only 3 percent of handsets sold in US retail locations actually sell for over $300," the analyst continued. "The majority of which are categorized as smart phones. If we are correct, Apple would take over 100 percent share of the smart phone market, but importantly, we do not believe the iPhone is aimed at smart phones, rather, it is designed to expand the high end of the traditional mobile phone market."

While iPhone's features certainly qualify it as a smart phone, the device will resonate most predominantly with mainstream users owing to its innovative design, superior functionality and 'hype' associated with new product releases from Apple, he added.

In light of his analysis, Semple is convinced the iPhone will generate a gross margin of 40-46 percent before payments from Cingular (which could potentially amount to $100-150 per unit), making the device significantly more profitable than he originally anticipated.

As a result, the analyst raised his fiscal year 2007 and 2008 earnings-per-share estimates on Apple from $3.56 and $4.30 to $3.59 and $4.43, respectively. He also increased his price target on shares of the Cupertino-based company by $20 to $140.

Shares of Apple reacted favorably to the report and were trading at an all-time high on the Nasdaq stock market, up $1.17 (or nearly 1 percent) to $122.50.