Ken Kam's Best Ideas Blog

More than a music player or a phone, the key to Apple's success is an ever-improving gadget that is changing the entertainment industry.
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ChangeWave Investor Tobin Smith came out this week with a new Strategy Lab journal declaring "I'm here to tell you why Apple (AAPL, news, msgs) is headed to $225."

In my recent journal on Apple, I took a look at whether Apple, which has doubled over the last year, has the potential to double again. To me, in the end, it came down to this question: Is the iPhone a cell phone that is also an iPod, or is it an iPod that is also a cell phone?

There are many smart, competitive cell phones, but the iPod is, hands down, the dominant music player.

Well, you can tell a lot more about what people are thinking by observing what they do, rather than listening to what they say.

The phone companies clearly don't think the iPhone should be compared with other smart phones. They have done deals with Apple that they would not have done with any other smart phone manufacturer.

Neither do the buyers. They are passing on the Motorola, Nokia and Palm smart phones, even though they are, because of wireless-carrier subsidies, much cheaper -- and sometimes even free.

Conclusion: The answer to the question I posed in the last article is that the iPhone is more properly thought of as an iPod that just happens to make calls.

Unlimited potential

When you think of it as a member of the iPod family, it changes your perspective about what the iPhone could do for Apple. And with the announcement Wednesday that Apple plans to start allowing third-party iPhone applications to be built and installed, a whole new level of flexibility has opened up for users.

Jeff Kalnitz, blogging as one of our Strategy Lab Open competitors, recently wrote about how valuable he has found the iPhone so far, saying "After using my iPhone for several months now and experiencing the reactions of others to my using it -- I think the implications of what Apple is doing here go way beyond the current crunching of data analysis, in order to comprehend just how revolutionary and disruptive this company's forays will be to early 21st century communications."

Later in the post he writes, "In the meantime, you will see more iPhones popping up in consumers' hands and pockets in an escalating sliding scale of consumer purchases, and the numbers will impress, not only in the U.S., but increasingly around the world. And they will improve with every version, selling in larger and larger numbers. They get fashionable, they get sexy and consumers won't be able to resist splurging.

"And there is a good chance that business-oriented people the world over will increasingly snap up the next few versions of the iPhone, which will continue sporting more and more essential new features necessary to the business class of buyers. "

Let's not forget about the new iPod Touch, which is essentially an iPhone without the cell phone component.

Look, ma, no wires

Both the iPod Touch and the iPhone are designed to leverage Apple's iTunes music store. Sprint and Verizon also have online music stores, but neither of them is selling billions of songs, as Apple has done.

Amazon has started a competing store selling songs without digital rights management at 89 cents each, a 10-cent discount to the iTunes store.

It is a measure of the music industry's fear of Apple's domination of retail music sales that they are willing to remove digital rights management restrictions, and cut their price, in order to give Amazon a chance to be a real competitor to Apple.

Both the iPod Touch and the iPhone are going to solidify Apple's lead in selling music online by making it unnecessary to use a computer to buy digital music. Already, you can get a free song with the purchase of a cup of coffee at Starbucks, and it will be delivered to your iPhone or iPod Touch while you are drinking the coffee. It will be a long time before Amazon can match that!

Looking down the road, there is still plenty of room for Apple to gain market share, even though it already controls a whopping percentage of the digital-music-player market. Piper Jaffray did a survey and estimated that 3% of teenagers already own an iPhone. I think that number is high, because, if true, it would mean that most iPhones already sold are in the hands of teenagers.

The iPod Touch will be even more popular with this group, meaning it should be a great Christmas for Apple.

That's the entertainment industry

One final fact to keep in mind when evaluating Apple is that these devices are not just pieces of hardware. They are the keys to Apple becoming dominant in a huge new business -- the retail distribution of entertainment (not just music, but video as well).

The entertainment industry is fighting this. The record labels are desperately hoping that Amazon succeeds. The TV industry is trying to establish its own Internet distribution channels.

But if Apple keeps making it easier and more convenient for consumers to find, buy and enjoy its content, the music and TV industries eventually will see the light.

Clearly this business should not be valued using the same price-to-earnings stock multiples that Nokia, Samsung, Motorola or Palm sell for. This is a very different business, one in which there are no comparable products. So it is easy for Wall Street to get this one wrong.

In fact, we have differences of opinion on this company even within the Strategy Lab Open among savvy investors vying for a spot in the next round of Strategy Lab.

For every Jeff Kalnitz, we have an equal and opposing position, like blogger Ahknaten -- who likes the iPod but remains unconvinced that Apple is a good buy: "Who knows, maybe I'm wrong, but I'll stay away from this stock for now." You can see all of his reasons on his blog post.

An iGift for Christmas?

Of course, whether you are in the "buy AAPL for a double from here" camp or the "get out now" corner, one question remains worth asking and answering:

Are your kids (or you) getting an iPhone or iPod Touch for Christmas?

click on the "comment" button above to share your answer.