Tech Check

Unlocking Apple's iPhone Profit Stream?

Apple shares continue to take off, thanks to news nuggets here and there about the better-than-expected iPhone sales success. In fact, shares are so high that rumblings of an impending stock split are coming back, even though CEO Steve Jobs was pretty clear at his shareholders meeting earlier this year, offering up props to the Google no-split stock-price strategy (Eric Schmidt sits on Apple's board) and steering investors away from the idea of any kind of split.

But let's take a look at one of the key reasons why Apple shares continue to swell: I've spent a lot of time looking into the whole "unlocking" trend and what it means for sales. The conventional wisdom goes that consumers are buying the phones three or four at a time (I've checked around at Apple and AT&T stores and everyone I've talked to say they've seen customers buy multiple phones at once). Initially, investors might have been squeamish about the exclusive deal with AT&T and what many complained was a sub-standard network.

Then, the unlocking thing began to gain momentum: first, a complicated hardware approach; then, a far easier software download. The thinking is that Apple wins no matter what since the phones are obviously in demand, and can now run on any network if you download the right programs. So consumers will buy them no matter what.

Apple iPhone
Manuel Balce Ceneta

Whoopee for Apple! A collective sob for AT&T.

Then, Apple steps up and says new software from the company, once it's downloaded onto an unlocked phone, could disable that phone, so consumers need to be warned. There was lots of skepticism that this was indeed the case. (I'm still skeptical, though the web is rife with angry iPhoners who have seen their unlocked phones turn into a snazzy desktop paperweight.)

But the profit potential from buying these phones, unlocking them, and then selling them overseas for a tidy profit because the dollar remains so weak, is apparently an irresistible proposition.

So much so that Piper Jaffray now estimates that one in ten iPhones purchased this past quarter was done so for precisely that: unlocking and then re-selling overseas. That's a big number. And on its surface, it would appear to bolster the idea that the iPhone is enormously popular, and that Apple sits in the catbird seat -- until you also remember that an important part of the Apple revenue and profit model isn't merely selling the iPhone, but collecting a nice chunk of the monthly service revenue it was supposed to share with AT&T.

This isn't merely about the phone, but about the recurring monthly fees Apple was supposed to enjoy as well. When unlocking was a difficult, complex, hardware solution, it seemed so esoteric that it wouldn't affect any meaningful number of Apple handsets. But now that it has gotten so easy, and, according to Piper Jaffray, affects up to 10% of iPhone handsets sold, this becomes something much more insidious.

In fact, right now, Piper estimates that of Apple's whopping $4.3 billion in operating income, only a paltry $28 million comes from revenue sharing with AT&T. Next year, the number swells to $200 million, or 3% of operating income. By 2009, we're talking real money: $800 million, or 13% of Apple's projected $6.2 billion in operating income.

It's certainly worth watching for investors giddy about the Apple stock story. I'm not suggesting that this torpedoes Apple and its shares. No way. The company, thankfully, is much more diversified than a single product: the new iPods seem to be selling briskly; and Mac sales are nothing short of amazing.

But if iPhone is so critical to the company's future, and a key revenue stream disappears because Apple customers are more innovative than the company itself, investors would be well-advised to keep this developing news top of mind -- and to see how the company addresses all this on its conference call after earnings Oct. 22.

Questions?  Comments?