Apple Inc. is expected to cut iPhone 3GS price to $0 on contract, or $399 unsubsidized, in conjunction with iPhone 5 launch, which is expected in September, says an analyst.

This approach is intended to target mid-market smartphone buyers and counter Android’s mid-market expansion. We expect iPhone 5 to launch at $199/$299 ($599/$699 unsubsidized), and Apple to drop iPhone 4 pricing to $99 ($499 unsubsidized), said Mike Abramsky, an analyst at RBC Capital Markets.

While a $49 iPhone is already available (AT&T), psychologically a $0 iPhone provides a compelling offer, Abramsky said.

RBC Capital proprietary survey data (1,500 respondents) suggests 14 percent are very/somewhat likely to buy the iPhone 3GS for free with 2-year contract, exceeding buying interest for the iPad (13 percent) and original iPhone (9 percent).

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Our Scenario analysis shows $7 billion revenue and $1.82 EPS contribution (assuming 10 percent cannibalization from $0 iPhone). We are maintaining our 95 million fiscal 2012 iPhone estimate, assuming economies of scale should help Apple to preserve blended fiscal 2012 iPhone margins at 47 percent to 48 percent, said Abramsky.

Abramsky expects Apple to ship 15.5 million iPhone in third quarter (down 17 percent quarter-over-quarter), on slowing sell-through ahead of the iPhone 5.

Abramsky still expects Apple to launch a smaller, prepay iPhone -- but more likely in 2012, both to avoid iPhone 5 cannibalization, and as its design may deeply leverage iCloud services for convenience and affordability.

Abramsky views valuation as compelling, and foresee higher valuation on upcoming catalysts (iCloud, iOS5, iPhone5, PC share gains, iPad3), financial outperformance, and comfort with management transition. Risks to his view include: intensifying succession concerns; slowing growth; rising competitive pressures (e.g. Android); margin erosion; and 'law of large numbers'.

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