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Missing iPhones conundrum puts Apple in a pickle

Where oh where are those iPhones?

Bernstein Research analyst Toni Sacconaghi touched off a frenzy of fretting at the end of last week when he issued a report saying that as many as 1.4 million iPhones are either being used unlocked or are sitting in inventory.

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You can read all the details of how Sacconaghi arrived at this conclusion here, but essentially he subtracted the number of iPhones AT&T says it has activated by the number of iPhones Apple says it has sold.

Sacconaghi also estimated that Apple derives as much as 75 percent of its profit from the iPhone from the shared fees it collects from service providers. That means an annual loss of $500 million and 37 cents a share in annual profits.

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Another analyst, Gene Munster of Piper Jaffray, came up with somewhat lower numbers but still figured 25 percent of the iPhones sold in the U.S. have been unlocked. He projected a loss of $362 million in revenue over two years.

Commentary from the media has tended toward the dire, with one piece on Australia's ITWire Web site declaring the missing iPhones "bad news for Apple" and making the preposterous assertion that Apple actually loses money on each $399 sale. Yeah, right.

If Apple has a lot of unsold iPhones sitting around, that would indicate slowing demand, which would be the worst of all scenarios. I doubt this is the problem. During the earnings conference call last week, Apple Chief Financial Officer Peter Oppenheimer made it a point to repeat the company's confidence in meeting its goal of selling 10 million iPhones in 2008. If sales had shown signs of slowing in the December quarter, Oppenheimer would have avoided the topic.

It strikes me as far more likely Apple has sold a ton of unlocked iPhones. Many of the people in the U.S. who crave the iPhone are well-heeled and technically minded. Plenty of them are willing to take their chances with an unlocked iPhone to avoid a contract with AT&T.

In the three European countries where the iPhone is officially available, customers prefer having a choice of cellular carrier. Third parties are happy to meet the even greater demand for unlocked iPhones there.

Elsewhere in the world, unlocked iPhones are the only kind you can get. People have them in dozens of nations, including China, India and Brazil. Since Apple isn't shipping iPhones to those countries, they had to be purchased somewhere else.

Two things need to be determined: how much will the proliferation of unlocked iPhones hurt Apple, and what will the company do about it?

The loss in revenue and profits sounds awful, but remember that Apple raked in $24 billion in profit in fiscal 2007. If you figure Apple's prospects for growth across its various product lines (Mac, iPod, iPhone) will offset a potential recession this year, the company should end up with at least the same revenue for 2008.

With the $9.6 billion head start it got in the December quarter, Apple only needs to average $4.8 billion for the next three to hit $24 billion. Last year it made in the $5 billion to $6 billion range in quarters two through four.

If Apple does lose $500 million to unlocked iPhones in 2008, that's only 2 percent -- or less -- of its total annual revenue. So it's not the end of the world.

Of course, every business strives to avoid hits on their revenue whenever possible. What are Apple's options for retrieving the revenue it stands to lose to unlocked iPhones?

It could continue its hard-line approach, going after those selling unlocked iPhones and "bricking" them with software updates. But that strategy hasn't worked so well, enraging customers while failing to deter the grey market in unlocked iPhones.

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Given this latest difficulty, I am more convinced than ever that Apple's best path is to sell an unlocked version of the iPhone for $599, the original sales price, while continuing to offer the $399 version as part of a service package with its partner carriers in each country.

Munster has estimated that Apple makes about $432 in shared service fees for each iPhone sold with a two-year contract. The extra $200 Apple would get from an unlocked iPhone only would make up less than half of that profit, but it's better than losing all of it. Moreover, by offering a legitimately unlocked iPhone, Apple probably would sell more of them, further helping restore otherwise lost revenue.

Demand for unlocked iPhone will keep growing. Rather than fight it, Apple needs to figure out how to meet it and still make a profit.

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