Millions of iPhones Go AWOL

It's been dubbed the Mystery of the Missing iPhones. On Jan. 22, Apple reported that it sold 3.7 million units of its smartphones worldwide through the end of 2007. But AT&T, the exclusive U.S. iPhone reseller and by far the largest buyer of the devices, reported that its subscribers activated 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 (AAPL) stock price to $130 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 over concerns about how weakening consumer spending would affect the company's shipments of iPod music players and notebook computers. Now the worries about iPhone sales have entered the mix. "In the past week the stock has fallen further because of potentially lower iPhone shipments," says Shebly Seyrafi, an analyst at Caris & Co.. A story that recently surfaced in a Chinese newspaper claimed that Apple's iPhone component suppliers are cutting back on production in anticipation of lower U.S. demand.

A January falloff isn't unusual in the cell-phone industry; the holidays are typically when sales peak. But investors who examined the discrepancy between Apple's and AT&T's (T) numbers figured that, with handset sales to European carriers Orange, O2, and T-Mobile Germany (DT) just ramping up, many of the missing iPhones may be languishing in inventory. And an inventory buildup is always dangerous, particularly amid slowing demand. Toni Sacconaghi, an analyst at Sanford C. Bernstein, figures Apple's first-quarter iPhone sales could be down as much as 30% compared with daily sales rates last year.

So where are the missing phones? Two industry insiders confirm what is only now becoming apparent to analysts: that Apple is selling far more "unlocked" iPhones than previously expected. Those phones are adapted by the user with unauthorized software and phone cards so they run on nonapproved wireless networks.
A Swarm of Do-It-Yourselfers

Some 800,000 to 1 million iPhones had been unlocked by the end of 2007, the sources say. The high end of that range far outpaces most analysts' assumptions of 750,000 unlocked phones. The vast majority of those phones are trickling into nations around the world where Apple has yet to sign up a local carrier—especially China, say industry sources (BusinessWeek.com, 12/4/07). "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 consultant Envisioneering Group. "In China, nine out of 10 phones are hacked."

Financially, unlocked iPhones are bad news for Apple. While its revenue-sharing agreement with AT&T is kept under wraps, Charles Wolf, an analyst with Needham & Co., believes the carrier pays Apple $10 per iPhone-brandishing subscriber per month of the two-year contract. While Apple still earns admirable margins on each iPhone it sells, missing out on this cut of monthly phone bills would cost Apple $300 million to $400 million in revenue and profits for every million unlocked phones sold. 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. This year consultant Technology Business Research expects Apple to sell 7 million units, booking $1.7 billion in revenues and $340 million in operating income.

But are unlocked phone sales really so bad for Apple? In countries where the iPhone isn't yet legally available, unlocked devices may function as part of the company's hype machine. Every time someone flies home with an armful of iPhones purchased at a local shop or online, it revs up awareness of Apple's brand. That, in turn, could make it easier for Apple to strike more carrier distribution deals and make a case for better revenue-sharing terms. After all, unlocked devices sell for as much as a 70% premium to Apple's retail price on foreign gray markets.

Indeed, it's possible that Apple has 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. Piper Jaffray analyst Gene Munster notes that Apple could simply up the price of the device for anyone who didn't sign up with an authorized carrier—say, to $800 instead of the regular $400. "That would put the nail in the coffin on all of this [unlocking]." But he figures that Apple realizes it's a smart trade to give up incremental near-term profits to get a leg up in vast new markets it hasn't even officially entered. "The best thing for Apple to do is to get as many of them out there as possible," says Munster.

Factoring out the unlocked phones leaves 700,000 to 900,000 iPhones unaccounted for. About 350,000 of those—and possibly more—were sold in France, Britain, and Germany over the holiday season, analysts estimate. Another hundred thousand 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 contracts with other carriers to expire before jumping on board.

That leaves as many as 480,000 iPhones in inventory, according to various estimates. Chris Whitmore, an analyst at Deutsche Bank Equity Research (DB), which may own equity in Apple and may have advised the company in the past, figures that Jobs & Co. typically sell 20,000 iPhones a day. That means the company has 2½ to 3½ weeks of inventory. But if sales slow, that same inventory may take eight weeks to move, Sacconaghi says. That's not overly much by AT&T's standards, since it typically carries four to six weeks of cell-phone inventory, though it's sky high by Apple's lean standards.
Chasing a Big Target

The real concern is what this says about overall demand for the iPhone. At this point, Sacconaghi and others feel it's unclear if Apple can reach its target of 10 million iPhones sold by yearend. That's "achievable, but not a sure thing," says Bill Shope, an analyst at JPMorgan Chase (JPM). The economy is slowing, after all. And with a next-generation iPhone rumored to be in the works and due for release this summer, some consumers may hold back on buying an iPhone just yet.

Perhaps Apple will need to cut prices to revive sales—a painful move if the percentage of unlocked iPhones continues to rise. Selling a cheaper iPhone while also losing the cut of a carrier's monthly take could bring the iPhone's lofty profit margins closer to earth.

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