Apple 2.0

Covering the business that Steve Jobs built

Apple and AT&T: Who's Exploiting Whom?

October 24, 2007: 9:01 AM ET

picture-9.jpgAlthough it was never actually mentioned by name in AT&T's (T) quarterly earnings report yesterday, Apple's (AAPL) iPhone was clearly a factor in the phone company's net gain of 2 million wireless subscribers -- the third largest (and highest third-quarter) increase in its history. But how long AT&T can continue to bask in the iPhone's glow is not so clear.

One day after Apple trumpeted its quarterly sales of 1.12 million iPhones -- for a total of 1.4 million sold so far -- AT&T reported that it has activated 1.1 million of the devices. Most of the 300,000 gap between those two numbers, according to Apple, can be accounted for by iPhones purchased to be unlocked and used with another wireless service. (See One in Six iPhones Bought With "Intention to Unlock.)

picture-8.jpgMeanwhile, Todd Sullivan at Seeking Alpha points to a recent poll that suggests that the bulk of the users who might have switched to AT&T to buy the iPhone have already done so. The chart at right shows the percentage of would-be AT&T switchers peaked in July, just after the iPhone hit the market.

Still, as long as AT&T remains the iPhone's exclusive U.S. carrier, it will continue to ride profitably on Cupertino's coattails.

Not that Apple doesn't also profit from the deal. Buried in Apple's Q4 report yesterday was a $118 million line item called "iPhone and Related Products And Services," which is where the company tucked the proceeds from its revenue sharing deal with AT&T. Piper Jaffray's Gene Munster, who's been trying to unravel the terms of that deal ever since it was announced, estimates from the Q4 report that AT&T is sending Apple $18 per month per subscriber.

Dan Frommer at Silicon Valley Insider takes those numbers and runs with them, concluding that the AT&T deal has allowed Apple to reverse its razor-and-blade iTunes model, where it sells songs cheap to move high-margin iPods. With the iPhone, he says, Apple stands to make more money on the blade than it does on the razor. His thinking:

Assuming a $400 iPhone and a $18 monthly contribution from AT&T, Apple would record $832 in revenue over two years per phone. Research firm iSuppli estimated in July that it costs Apple $265 to build an 8-gig iPhone. So Apple's gross profit looks more like $565 per phone over two years, up 125% from our previous estimate of $250 per phone. At Apple's current U.S. run rate of about 1.8 million iPhones per quarter, that's about $1 billion in gross profit per quarter (which will be recorded over two years).

If these numbers hold up, it means that Apple has inverted the business model it has used with iTunes and the iPod, where it makes a small amount on the software/service and a huge profit on hardware. Now Apple stands to make much much more on service than it ever will on the machines themselves. And that would certainly explain why Jobs was so quick to slash his prices this summer. (link)

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Philip Elmer-Dewitt
Philip Elmer-DeWitt
Editor, Apple 2.0, Fortune

Philip Elmer-DeWitt has been following Apple since 1982, first for Time Magazine, and now on the Web for Fortune.com.

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