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Tuesday, January 29, 2008, 05:00 am PT (08:00 am ET)

Needham says Apple letting iPod touch cannibalize iPhone sales

Apple knowingly gave up as many as 1.5 million iPhone sales during the holiday quarter to establish the future of the iPod as a mobile device, according to investment note issued on Monday by Needham & Co.

Analyst Charlie Wolf bases his observations around statements made by Apple chief operating officer Tim Cook during the iPod maker's latest quarterly results conference call; the executive referred to the iPod touch as becoming a "mainstream Wi-Fi mobile platform" rather than just a touchscreen version of the iPod. The company's willingness to reduce the feature and price gaps between the iPhone and iPod touch indicates that it's ready to trade short-term losses for long-term growth of the iPod as a general device, especially among existing iPod owners trading up from older players.

"If the company is successful in this endeavor, it would provide a compelling upgrade path for the estimated 85 million people who already own iPods," Wolf says. "And it could attract new users to both the iPhone and the iPod platform as well. The company appears willing to risk the cannibalization of a significant number of iPhones to accomplish this."

Apple's decision also costs the firm a significant amount of long-term profits, the Needham researcher says, as it meant losing as much as $250 in subscriber revenue shared from AT&T over two years.

Without the iPod touch, Apple may have sold as many as 4 million iPhones in the last quarter alone, according to the research note. During observations at Apple's Fifth Avenue store, many customers were said to have considered both the iPhone and the touch on an equal footing. Some Europeans may have felt pushed into buying the iPod touch after the iPhone's 1.1.2 update made it harder to unlock the device for unsanctioned carriers, Wolf argues.

The increased support for the iPod touch may also be a calculated risk that future iPhone updates will negate any immediate hits to the current product's success. Needham predicts that Apple will release an upgraded, 3G-capable iPhone at the same price in the summer and will drop the price of the current model to $299 at the same time, also dumping current iPod touch prices to $199 and $299.

Altering prices this way would maintain the price difference between iPod and iPhone but would provide stronger incentives to buy the higher-end — and importantly, more lucrative — handheld device.