On the Trail of the Missing iPhones

About 1.7 million more have been sold than are being used by AT&T customers. The bad and good news for Apple

It has been dubbed the Mystery of the Missing iPhones. On Jan. 22, Apple Inc. (AAPL) reported that it sold 3.7 million of its smartphones worldwide in 2007. But AT&T (T), the only authorized wireless service provider for the iPhone in the U.S., reported that its subscribers activated just fewer than 2 million units last year. The big question on the minds of Apple watchers is: Where have the other 1.7 million iPhones gone?

The uncertainty has helped sink Apple's stock to 132 a share, down 34% since the beginning of the year. That is far worse than the 13% drop for the tech-heavy Nasdaq index. Apple shares were already under pressure because of concerns that weakening consumer spending could affect sales of iPod music players, Mac Books, and other Apple gear. Now worries about iPhone sales have entered the mix.

One investor concern is that many of the missing iPhones may be languishing in inventory, on the shelves of Apple's distributors and suppliers. But inventory isn't the only issue. Two sources close to Apple say that far more of the iPhones the company is selling are being "unlocked" than previously expected. Those phones are adapted by customers or gray-market distributors, using unauthorized software and phone cards, to run on the wireless networks of companies with which Apple has no service agreement.

Some 800,000 to 1 million iPhones had been unlocked by the end of 2007, the sources say. The high end of that range outpaces most analysts' assumptions of 750,000 unlocked phones. Most of those phones are trickling into nations around the world where Apple has yet to sign up a local carrier—especially China. "In my travels around the world, two out of three iPhones I've seen outside of the U.S. have been unlocked," says Richard Doherty, director at consultancy Envisioneering Group.

Unlocked iPhones are bad news for Apple's earnings, at least in the short term. While the company's revenue-sharing agreement with AT&T is kept under wraps, there's no question it's lucrative. Charles R. Wolf, an analyst with Needham & Co., believes the carrier pays Apple $10 per month for every iPhone subscriber over the course of a typical two-year contract, for a total of $240. Toni Sacconaghi, an analyst at Sanford C. Bernstein (AB), thinks each subscriber is worth $300 to $400.

Do the math, and for every million iPhones that are unlocked, Apple misses out on $240 million to $400 million, which is pretty much all profit. Although Apple posted sales of $24 billion in 2007, such lost revenues could become more significant as the iPhone becomes a bigger part of Apple's overall business. Piper Jaffray (PJC) analyst Gene Munster expects Apple to pull in $4.6 billion in iPhone sales in 2008, up from $1.4 billion in 2007.

Still, unlocked phones aren't all bad for Apple. The company makes an estimated $120 in gross profit on every phone sold. What's more, in countries where the iPhone isn't yet legally available, the devices may function as part of the Apple's hype machine, revving up awareness of the brand. That, in turn, could make it easier for Apple to strike more carrier distribution deals. Analyst Ingrid Ebeling of JMP Securities says the short-term hit is well worth it. "The No.1 concern for them should be to sell iPhones," she says.

How do people get unlocked phones in the first place? Apple's unusual deal with AT&T in the U.S. creates a window of opportunity. Most phones from Nokia (NOK), Motorola (MOT), and others are sold through the wireless carriers themselves or authorized dealers, and you sign up for a service contract at the same time you buy the phone. Apple cut a different arrangement. Customers buy the iPhone from AT&T or Apple directly, for the same price of $399.

The idea was that customers would turn around and activate a service plan with AT&T over the Internet.

But they can also choose to install bootleg software, easily available on the Net, and tinker with the guts of the phone so it can be used on other wireless networks. Some customers in the U.S. unlock phones because they don't like AT&T's service, but the vast majority are Apple enthusiasts abroad who can't get authorized service in their home markets.

INVENTORY ESTIMATES

There's evidence that Apple may have had a change of heart about the unlocking question. Soon after the iPhone was released last June, Apple issued an update to its iTunes software that rendered some unlocked iPhones useless. While the company has continued to add similar code into recent releases of iTunes, it clearly isn't looking too hard for ways to foil the efforts of its million or so unlocked customers. "Almost every iPhone you see on eBay is unlocked, so I don't think Apple is that concerned," says Ebeling.

Factoring out the unlocked phones still leaves 700,000 to 900,000 iPhones unaccounted for. About 315,000 of those—and possibly more—were sold through Apple's authorized carriers in France, Britain, and Germany over the holiday season, analysts estimate. An additional 100,000 or more customers may not have activated their phones yet with authorized carriers, either because they haven't gotten around to it or because they're waiting for their current wireless contracts to expire.

That leaves 300,000 to 500,000 iPhones in inventory, according to various estimates. Chris Whitmore, an analyst at Deutsche Bank (DB), figures Jobs & Co. typically sell 20,000 iPhones a day. That means Apple has 2 1/2 to 3 1/2 weeks of inventory. Sacconaghi cautions that if sales slow, that same inventory may take eight weeks to move. That's not overly much by AT&T's standards, since it typically carries four to six weeks of cell-phone inventory, but it's sky-high by Apple's lean standards.

AWAITING THE NEXT MODEL

The real question is what all of this means for overall iPhone demand. Sacconaghi figures Apple's first-quarter iPhone sales could be down as much as 40% compared with sales rates during the holidays, and he thinks the company will struggle to reach its target of 10 million iPhones sold by yearend. The economy is slowing, after all. And with a next-generation iPhone rumored for release this summer, some consumers may delay buying.

Perhaps Apple will need to cut prices to boost sales, a painful move if the percentage of unlocked iPhones continues to rise. A cheaper price tag and the loss of Apple's monthly take from carriers would bring the iPhone's lofty profit margins closer to earth.

The best resolution for Apple may be to pick up the pace of its overseas expansion. That would give unlocked iPhone owners an opportunity to sign up with the company's chosen wireless partners. And it would help Apple tap into all those other potential customers who haven't wanted to deal with the hassles of unlocking a phone. Indeed, some experts expect the company to announce more carrier deals by the Mobile World Congress 2008 conference in Barcelona in mid-February.

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