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Apple, AT&T Try to Plug iPhone Revenue Gap

Priya Ganapati

SAN FRANCISCO -- Unlocked iPhones may soon become a thing of the past.

That's because Apple(AAPL) and service provider AT&T(T) have made new 3G iPhone customers pay a premium to opt out of a two-year contract with the carrier's network.

Coupled with the increased availability of the 3G iPhones worldwide and an impending deal with one of China's mobile service providers, the demand for unlocked iPhones could shrink, analysts say.

"All this will significantly reduce the unlocked iPhone market, says Ezra Gottheil, an analyst with Technology Business Research, "though it may not entirely disappear."

When Apple first launched the iPhone about a year ago, the company inked an agreement with AT&T that allowed the carrier to be the exclusive service provider for the iPhone. Instead of following the industry standard of taking a carrier subsidy on the sale of each iPhone, Apple struck a deal for a slice of the subscription fee for every new AT&T subscriber.

As it has turned out, both AT&T and Apple apparently underestimated the extent of subscribers and fees they lost from unlocked phones.

At its Worldwide Developer Conference last month, Apple said it has sold about 6 million iPhones. In May, AT&T revealed it had about 2.5 million iPhone subscribers.

Including subscribers in countries outside the U.S., the percentage of unlocked iPhones could range from 30% to 40% of all iPhones sold, analysts estimate.

That startling high percentage could have been the main reason behind Apple's decision to shift to the phone-subsidy model, offer more choices and build a wider set of carrier partners.

As a result, the percentage of unlocked 3G iPhones could drop to single digits, says Charles Wolf, an analyst with Needham & Co. Wolf owns shares of Apple but Needham does not have an investment banking relationship with the company.

By offering a no-contract iPhone, AT&T has essentially legitimized the philosophy of having an unlocked iPhone, says Gottheil.

"AT&T and Apple have accepted unlocking as a fact of doing business," agrees Gottheil. "With this if people want the equivalent of an unlocked phone and are willing to pay a premium for it, they have an option."

AT&T has said it will offer a no-contract-required iPhone at $599 for the 8GB version and $699 for the 16GB model.

AT&T's no-contract phone is not exactly an unlocked iPhone, says Ken Dulaney, mobile and wireless analyst with industry research firm Gartner. Buyers will still be bound to AT&T's network, he says.

"An unlocked iPhone is one that you buy at the store and can activate on any non-AT&T account," says Dulaney. "The no-contract iPhone still locks into AT&T."

In other words, that gives iPhone buyers three options. They can buy a iPhone with the standard two-year contract from AT&T, or they can get a no-contract phone that can still be used only on an AT&T network but will allow them to avoid early termination fees and give them the option to get another phone or a different network whenever they would like to.

Or users could hack their iPhones to unlock it and use it on any other network such as T-Mobile.

The no-contract option, albeit expensive, will allow users to avoid penalties that come with hacking and unlocking the iPhone, while retaining some freedom and flexibility, say analysts. Unlocked iPhones are left out of security and software updates and the unlocking process voids the warranty on the phone.

The 3G iPhone will be available in more than 70 countries later this year, beginning with sales in 22 countries on July 11. By contrast, the original iPhone was available in only six countries.

"Given the number of countries it is going to be sold in, my strong opinion is that it will effectively get rid of the grey market in iPhones," says Wolf.

The two countries of note that Apple's missing are South Korea and China, both major cell phone markets. The duo are also among the biggest markets for unlocked iPhones, industry experts say.

Online chatter has it that Apple is close to inking a deal with one of the major Chinese mobile service providers, China Mobile.

"The attraction of an unlocked iPhone will diminish if Apple has a carrier partnership in China," says Gottheil as many users are likely to buy a phone with warranties and service updates rather than a hacked model.

Shares of Apple were up $1.68 to $173.06 Wednesday. Apple's stock is up about 16.7 % in the last three months.

Rival Research In Motion(RIMM) has stayed mostly flat during the same period while smart phone makers Palm(PALM) and Motorola(MOT) have been down about 12% and 25% respectively. The Nasdaq Composite Index was down about 3% during the same period.

To be sure, unlocked iPhones may not completely disappear, say analysts. Even in countries where the 3G iPhone is available through Apple authorized carriers, some users may want to get an unlocked phone for use on another carrier of their choice.

"There will always be a market for unlocked phones," says Dulaney, "but it is going to be trickier than in the past."