2010 Will Be the Year of the iPod touch

In the last analyst's conference call, Peter Oppenheimer said that iPod touch sales were up over 130% year-on-year (YOY). This in a quarter when YOY iPod unit sales were down for the first time.

iPod revenue has been trending down for over a year, but this is about to change.

Why did Oppenheimer talk down the iPod numbers? The FY 3Q numbers were so good that he could deal with the drop in the classic/nano/shuffle numbers and avoid headlines like "Apple in denial over iPod numbers". Another company would have emphasised more the internal research showing that 50% of iPods are being bought by new users, would have suggested the recession was to blame, and would have pointed to the Zune's catastrophic sales (down over 50% YOY).

Talking about managing the decline of a major business is also much easier when it has been replaced in the analysts' eyes by something much more profitable - the iPhone.

Migrating the iPod User Base

Talking down the numbers also set the stage for the cannibalisation of the iPod user base. For Apple, the day of the classic and the nano is largely over. In the same way that the nano replaced the much loved mini when it was still selling well, it is time for the iPod touch and iPhone to take over.

More than 100 million iPods have been sold over the last two years, but the future is in mobile computing, not in playback devices for music and video. Apple needs iPod buyers to move to the new platform, and the more that move, the more developers will cluster around the iPhone and iPod touch. As another Steve, Mr. Ballmer, said "Developers, Developers, Developers." A strong user base and rising sales with free development tools will keep them happy as Apple works through hiccups with the App Store.

The iPod classic is obviously on its last legs. The last major reason for buying it is capacity. As Apple has not taken advantage of newer 256 GB hard drives in a redesign, the classic is effectively at the end of its life. All Apple needs to do is offer a 128 GB iPod touch. It will be more expensive, but it will allow Apple and the retailers to sell off their stocks of classics without heavy discounting. Even if this high capacity iPod touch is $499, it will sell: four times 32 GB for less than twice the price. The only reason for not launching it in September and offering a 64 GB model instead would be if flash memory is too expensive.

The nano currently occupies the $199/$149 price points that the bottom of range iPod touches need to take over. Last year nano memory doubled for the same money, and a new range of colors came out. If Apple is still following the car manufacturers marketing plan, this means it is time for a new model design. Cost and manufacturing capacity of the capacitive screens used in the iPod touch and iPhone may mean that $149 is unreachable this time around, leaving a place for the 8 GB nano and a cheaper 4 GB version to better fill the gap between the $79 shuffle and the lowest price iPod touch.

Apple Needs a 'Cheap' iPod touch

A cheap iPod touch is needed for the games market. At $169, the iPod touch would cost the same as Nintendo's DSi and Sony's PSP 3000, so when parents look at handhelds, they don't think of the iPod touch as "expensive and fragile" but as "costs the same and with much cheaper games and more of them". Many will be willing to pay the extra for more memory and upgrade to the $199 model. This low cost model will do much to kill the PSP market in North America and Europe, adding 5+ million iPod touch sales a year.

The DSi will also look expensive, but with over 100 million sold, there is a strong DS replacement market. Sales of over 6 million since the November launch in Japan should have paid for the R&D, so Nintendo could cut the price and start bundling a game or two to add value.

There have been many rumors about Apple adding a 3.2 megapixel camera to the touch as they already have to the iPhone. This makes a lot of sense in higher end 16, 32, 64, or 128 GB models. Then iPod touch owners won't need a camera in their cellphone, and they can buy cheaper models. This effectively moves value from other cellphone makers and further cuts their already thin margins. Adding a camera will also drive down unit costs. Apple will be able to buy 40+ million cameras a year, and by using its cash pile, put in place long term contracts similar to those in the flash memory market. The more Apple buys, the more it drives the pricing, and the more it forces competitors to react instead of setting the prices and defining the market.

iPod touch vs. Zune

A look at Microsoft's Zune HD shows some of the issues. People buy ecosystems. As people migrated from the Walkman era, a digital music player was enough. For some, that is still enough, but the value has dropped from hundreds of dollars for a 5 GB player to less than a hundred.

Better video for films, TV, and YouTube was the way to add value two years ago. Now it's games and apps, and most buyers who only really want to listen to music would like an app or two. The Zune HD would have been competitive two years ago, but the App Store changed the market.

An 8 GB iPod touch at $199 will undercut the lowest price Zune HD ($220) and have enough memory for many music collections and apps. The best Microsoft can hope for, even though Apple will charge higher prices for its 16 and 32 GB models, is that Zune users will buy the HD. I can predict with near certainty that sales of the HD will be disappointing and add to the Zune losses.

Impact on Apple

How will these changes to the iPod touch affect Apple's figures? I expect sales of 10 million iPhones and iPod touches this quarter without taking into account any new models. Apple sold over 50 million iPods last year. With these changes, the touch will be the only high-end iPod and thus the only compelling upgrade for iPod owners - and it will be competitive with the PSP and DSi, so at least 25 million sales looks reasonable. Upgrade sales will increase the iPod average selling price (last quarter $146) and, combined with new sales into the handheld games market, revenue could easily be up a billion dollars.

The main gain, however, will be in doubling the number of users of the iPhone/iPod touch platform to over 100 million when the 2010 iPhone sales are added in. Then OS X will be seen as the major mobile platform. This will drive more developers to work on OS X, which will increase App Store revenue. By the end of the year, the App Store should be nicely profitable and a new billion dollar business for Apple.

If Apple decides to add an ARM-based netbook or an iPhone HD or enter new iPod markets like hearing aids or to change the face of digital music the gains will be even larger.

We will see during the annual iPod refresh in September how much of this will start happening in time for Christmas. Before then, the iPhone shortages need to be sorted out, as recently the carriers in Australia, Ireland, and Canada have reported being out while AT&T quotes a 14 day delivery period. The launch in China may be delayed for the same reason, and selling a more profitable iPhone will always take priority.

If it isn't the year of the iPod touch, 2010 will be the year of the iPhone.