Unlocking the Case of the Missing iPhones

Monday morning, the saga of the missing Apple (AAPL) iPhones continues, but with a new focus. First, a quick review. At MacWorld on January 15, Apple CEO Steve Jobs announced that had sold 4 million iPhones to date. Through December 31, the total was 3.75 million. Then on Thursday, in a post-earnings conference call, AT&T (T) CFO Rick Lindner said Ma Bell had registered about 2 million iPhones through December 31. That raised an obvious question: what happened to the other 2 million iPhones?

In a research note that got huge amounts of attention, Bernstein Research analyst Toni Sacconaghi last week concluded that there were large numbers of iPhones in inventory at AT&T and the company’s European carriers. Other analysts, notably Piper’s Gene Munster, were less concerned.

This morning, there are some additional tidbits to add to the story, including a modified theory from Sacconaghi. Here are the key points in Sacconaghi’s latest report:

• Sacconaghi says his original estimate on total European iPhones sales was a bit too high; he says the total through December 31 was likely 315,000, rather than the 350,000 he previously estimated.
• He says investor suggestions that there may a large number of iPhones purchased as Christmas presents but not yet connected are not likely accurate. He notes that carrier experience is that people almost always activate phones within a few days; he also notes that there is a 14-day return period for the iPhone.
• He now thinks that about 1 million phones have been sold and unlocked to be used on carriers other than those authorized by Apple, or about 27% of units sold through year end. He had previously been estimating 15%-20% of all units were “unlocked.”
• Sacconaghi says that leaves about 480,000 units in inventory. Given that he sees first quarter units down about 40% in the U.S. and about 30% in Europe, he says that comes to about 8 weeks of inventory in the U.S., and over 8 weeks in Europe. He notes that AT&T typically carriers about 4-6 weeks of channel inventory, including 10 days worth in its stores and the rest in warehouses.
• He says the unlocked phones are being used in countries where the device is not officially sold. I would note that if you read the comments on my previous postings, you will see many people noting that they have seen iPhones in use in many places where there are no official carriers, including throughout Asia.
• Sacconaghi notes that unlocked iPhones are a problem for Apple, since the company gets no carrier payments for their use. He estimates that unlocked iPhones generate 50% less revenue and 75% less profits for Apple than phones registered with authorized carriers. He estimates that if the company reached its 10 million iPhone goal for 2008, but 30% are unlocked, it will cost the company over $500 million in revenue - 37 cents a share in profits - in each of the next two years. But he notes that if Apple somehow can stop the use of unlocked iPhones, unit sales will be lower, and “Apple would forego even more revenues and profits.”
• Sacconaghi adds that the unlocked phones issue may make it difficult for Apple to sign additional carriers to revenue sharing deals - and he says it will make it hard for Apple to lower the price of the iPhone to boost volume. A lower price, he says, could drop the margins on unlocked iPhones to “unacceptable levels.”
• Meanwhile, he also says the company’s 10 million unit target “is aggressive without major price cuts of new models, especially if Apple hopes to maintain the rick economics of the current iPhone business model.”

One last note here: Sacconaghi also noted, as he has previously, that he has become incrementally more positive on the stock given the pullback in the shares. He maintains a $165 price target.

Also this morning, RBC Capital’s Mike Abramsky weighed in on the situation, and came with up with similar data on where the iPhones are: he estimates 25%-30% of phones sold have been unlocked. But he contends unlocked iPhones “are financially positive for Apple,” in that they “bode well for global iPhone demand.”

And one more: Needham’s Charlie Wolf suggests Apple could have sold a lot more iPhones had it not introduced the iPod Touch. “What investors are missing is the role Apple’s iPod Touch played in siphoning off iPhone sales in December,” Wolf writes. “The iPhone and the iPod Touch are close substitutes.” Well, I’m not sure that is quite true, given that the Touch lacks both a phone and a camera. Wolf, however, thinks the company would have sold 1.5 million more iPhones in the December quarter had it not introduced the Touch.

Apple is up $2.35, or 1.8%, to $132.26.

Comments

[Tom B:]

"And one more: Needham’s Charlie Wolf suggests Apple could have sold a lot more iPhones had it not introduced the iPod Touch."

Not clear. My next iPod will be a Touch. I'd love to buy an iPhone, but my wife insists on the much-despised Verizon. Moreover, I'm not a road warrior; the iPhone, in truth, would be overkill for me. My current phone is an antique MOT V60 which has the virtue on not minding crashing to the asphalt occasionally when I get clumsy while jogging.

I suppose one can Skype on the Touch? I haven't researched that point. You'd need a microphone, of course.

2008 Jan 28 01:02 PM

[ThinkFirst:]

Some observations. 1) there is a huge worldwide demand for the iPhone. Just look at the prices they go for on Ebay to foreign buyers. Sometimes as much as $200 over U.S. prices. 2) Apple must realize that it's deals with carriers is throttling demand. One thing they have done is make the iPod touch as close to the iPhone as possible. But, you cannot make calls, take pictures, send messages, and browse the internet unless you have Wi-Fi. So, the iPod touch may satisfy some of this worldwide demand, but not all of it. 3) They will have to introduce an unlocked phone to meet this demand, and this may require renegotiating their deal with carriers. My guess is that they will introduce a phone with less features but which is unlocked.

2008 Jan 28 02:32 PM

[peter02l:]

I suppose, in retrospect, Apple should have charged $799 for the iPhone, but with a $400 rebate if you sign with the preferred carrier.

2008 Jan 28 08:36 PM

[johnacw29:]

People are not factoring the way christmas gift giving of iphones may play out in activations. I gave my mom an iphone for christmas and she wanted to wait until the new year to activate it. I think about 10% of all iphones sold in Q1 were christmas gifts (which I think is a conservative number) and you will see a spike in new year's activations with AT&T on January 1. I think there isn't as many unlocked phones in the US as in Europe. Consider the alternative - T-Mobile not very attractive.

2008 Jan 29 02:19 AM

[David Lentz:]

Does any of this "analysis" pass the sniff test for reasonablility? Does anyone really believe that there are a MILLION people, mostly in the US, that are willing to risk bricking a $500 gadget?

A show of hands, please?

How many of YOU would be willing to go through a hacking procedure on your new expensive gadgets to avoid an AT&T contract?

In my own case, I despise AT&T's EDGE network sufficiently to put me off purchasing an iPhone -- so I bought an iPod Touch, and am very happy with it. If Apple ever ships an iPhone that works with a true broadband cellular network, I'll get right in line (depending on the price of the service contract). But I'm not about to put a $500 gadget at risk to use it on another carrier (WITHOUT the network-resident features, and still limited to the glacial EDGE network). And I regularly work with hacking procedures and open source software that is not quite polished and still has some rough (if not sharp) edges.

If these were the only explanations for the difference between the AT&T activation and Apple sales numbers, it would be one thing -- but we also have Gene Munster's analysis that places things squarely in the realm of the believable.

I really don't understand how this stuff gets chucked about masquerading as analysis. Slow news day, I guess.

2008 Jan 29 09:58 AM

[Tom B:]

"But I'm not about to put a $500 gadget at risk to use it on another carrier"

Normally, I'd agree with you. I wouldn't do it. But didn't Apple say they were seeing a pretty big number of unlocks in their conference call? Maybe I'm misremembering. Also, I wouldn't assume it's INDIVIDUALS doing the hack; I think it's mostly "entrepeneurs". It seems to me that foreigners shopping in the US could make a killing re-selling with the iPhone so cheap and the dollar so weak.

2008 Jan 29 10:31 AM

[David Lentz:]

Hmmm. You might have something there. If so, they do it at their peril -- while Apple might hesitate to brick customers' iPhones with a software update, they wouldn't hesitate a second to do so to iPhones being bought, unlocked and resold. Aren't their limits on how many are sold to an individual? I thought that was how they are trying to thwart this activity.

Even if a 100 person company sends out every person in the company to buy iPhones, if there's a 5 or 10 or N-unit limit on what a person can buy, that kind of limits the total number of phones they can resell. Unless there are a whole lot of small companies doing this, I can't see it having much of an impact.

But in the case of foreign tourists buying them here to leverage both the exchange rate AND the high prices Apple charges outside the US, that's a definite possibility, and makes all kinds of sense. People could pay for a US shopping vacation just with the profits from a few iPhones.

So maybe a large number of iPhones being unlocked is possible.

Hmph. I can only see a few ways for Apple to deal with this -- and I think it's pretty clear that they must deal with it, the sooner the better. Although it's not all lost revenue, as they still get the up-front money from the sale -- but unlocking certainly cuts into what is in my opinion the more lucrative aspects of the iPhone business, that being the post-sale revenue stream.

1) send out an update that adds some more desirable apps, and bricks unlocked iPhones. But that's a losing battle, as they will be in an arms race with iPhone hackers, and OS X on the iPhone is pretty much an open book by now.

2) change their pricing structure to eliminate the disparity between domestic and foreign iPhones. They may be able to negotiate some of the loss back from the carrier fees, or perhaps there is a sliding scale based on activation volumes built into those arrangements. But lowering the pricing differential would remove a lot of the incentive to unlock a US iPhone for foreign use.

3) bring out editions of the iPhone more specifically tailored to the cellular networks in foreign countries, and only sold there. That would remove a lot of the attractiveness of unlocked US iPhones that are stuck with EDGE.

4) bring out a low-end iPhone, that is not sold in conjunction with a cellular lock-in, and lacks many of the features. Cripple it with a weak processor and limited memory. Call it the "global iPhone" (I'm sure that Apple can come up with a better name) and cannibalize the unlocked iPhone sales with a cheaper product (plastic case, plastic display (instead of glass)) that looks like an iPhone, but sells for a lot less. It would not only compete with unlocked iPhones, but also with the horde of iPhone lookalikes that is hitting the markets. Think of it as an iPod nano (or shuffle) for iPhones.

2008 Jan 29 03:30 PM

[David Lentz:]

The above assumes that the actual number of unlocked iPhones (which is something I am certain Apple knows quite precisely) is becoming a problem, and that Munster's analysis is not closer to the truth.

2008 Jan 29 03:35 PM

[David Lentz:]

And I suppose I should (with no small amount of embarrassment) mention that I went back and revisited Minster's analysis, and it also indicates a substantial number of unlocked iPhones (falling a bit under a million, but close enough at 838,000). My inclination is to believe that Apple will deal with this situation via one of the above listed methods, to the extent that they are not prohibited by their agreement with AT&T.

I would expect AT&T to be even more eager than Apple to see the unlocking reduced, perhaps it will even spur them to better serve their customers. (I know, such thinking is most unlike Ma Bell, but maybe it is possible) A rapid push to expand their HSDPA cellular network and include it in their existing contracts at no increase in cost would help them a lot. But in gazing upon a flyer for their U-Verse DSL service, it sure looks like their pricing is concocted in some alternate universe, one without out capacity and populated by consumers with unlimited ability to pay. So any hopes of AT&T contributing to reducing the pressures to unlock are pretty faint.

2008 Jan 30 09:34 AM

[User 169663:]

Not sure why this is a "mystery"...well, there is the whole PR angle and wanted to make it seem as if the iPhone launch is really controlled to make a sustainable product launch at the global level. Anyway, it's a matter of stepping outside the U.S. and seeing that the iPhone is being used in other countries. Friends of mine in Colombia and Dominican Republic had the iPhone waaaay before most of my friends in the U.S.

- Ed

2008 Mar 28 02:41 PM