Millions of iPhones Go AWOL

The huge gap between units sold and iPhone buyers signed to AT&T may mean there are a lot more hacked iPhones out there than anyone expected

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by Olga Kharif and Peter Burrows

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.