Random Thoughts

I was watching an episode of Cranky Geeks on my iPod a few days ago, and John C. Dvorak and his crew were talking about the iPhone. Dvorak is pretty open with his opinion that the iPhone will be a “flop”, and realistically, he could be right.

The question, though, is how successful does the iPhone really have to be for it to be worth Apple’s (and AT&T’s) while?

The iPhone is definitely different than other cellular phones on the market. It not only packs a completely uniqueThe iPhone user-interface (and really, would you expect anything less from Apple?) it also is the first time that a phone has been designed from the ground up with the user experience in mind.

Every cellular phone I’ve ever used has been compromised in one area or another, and most of the time those compromises are related entirely to cost. The iPhone is the first cellular phone where the cost issue seems to have been ignored. As a result (and due in large part to Apple’s desire to maintain the high margins they have on pretty much all their products), it’s one of the most expensive consumer-oriented phones on the planet.

Most of the time, when an expensive phone is brought to market, the carriers subsidize the cost of that phone. Sign up for a two or three year deal, and they’ll knock a lot of money off the price of the phone. The phone manufacturers also bring the cost of the device down fairly quickly because they can leverage multiple carriers. No such luck in the case of the iPhone. When the iPhone was announced, Steve Jobs declared the price would be $499 for the 4GB model and $599 for the 8GB model. Both prices are with a two-year term (although, rumor has it, that may change). The phones will also be available only through AT&T Wireless (Cingular at the time the deal was initially struck).

The deal Apple made with AT&T also specified that the iPhone would not be subsidized by the carrier. When Jobs was shopping the iPhone around to carriers, at least one other carrier balked at this requirement. The reality, though, is that this is the best thing that could happen for AT&T. AT&T gets all the hype around being the exclusive carrier for the iPhone, and they don’t even have to subsidize the cost of the phone. All it costs them is selling their soul to Steve Jobs, and who really believes AT&T had a soul left to sell?

Analysts expect about 8 million iPhones to be available in 2007. Let’s conservatively assume that Apple has manufacturing issues and/or demand issues and only 3 million iPhones are ready between their launch on June 29 and the end of the year. Let’s also assume that half of those are 4GB models and the other half are 8GB models (although I expect in reality the ratio is more in favor of the 8GB, probably about 70/30, let’s keep the estimates modest). Let’s also assume that the margin on these products is 25% when sold through an Apple store, 20% when sold through an AT&T store (which would be low margins for an Apple product – their overall gross margin in 2006 was 29%).

Let’s assume the Apple fanboys are not going to line up at the Apple stores, but instead opt to go to the AT&T stores in overwhelming numbers. We’ll say 80% of the phones will be sold at AT&T stores and 20% will be sold at Apple stores. All of this represents a sort of “worst case scenario” for the iPhone (aside from all the analysts being wrong, and nobody showing up to buy them at all – but the numbers in that scenario are pretty easy to work out).

Scenario ABased on these assumptions, $1,647,000,000 would be the gross retail sales total for this product. If that’s too many zeros for your eyes to handle, that’s $1.647 BILLION dollars. This is the US alone, never mind when this product launches overseas. Profits off the device would be $345,870,000, which translates into roughly $0.40 of profit per share.

As far as the impact to Apple’s bottom line goes, it would represent an increase of 8.53% in total revenues and 6.18% in gross profits. Not bad for a “flop”.

If we crank up the numbers to the levels analysts expect (conservatively, 6 million units in 2007), split the ratio to 70% 8GB models and 30% 4GB models (ignoring the fact that the 8GB model likely has a higher margin) and assume 70% of these phones will be sold through Apple stores, the picture is even rosier.

At those levels, the iPhone’s gross revenues translate into $3.4 Billion dollars, with gross profit equaling $802 Million. ThisScenario B represents a 17.69% increase in gross revenues and a 14.33% increase in gross profits for Apple, excluding all other revenues. Even if the iPhone impacts iPod sales (which is likely to a degree), it won’t be enough to hurt these numbers significantly. These higher-end estimates represent $3.95 in gross revenue per share and $0.93 in profit per share. On looking at these numbers, it’s pretty easy to see why Apple plans on booking this revenue across several quarters. It’s the easiest way to keep shareholders’ expectations realistic.

Finally, let’s look at a “best case” scenario for Apple. Let’s say they can sell 10 million of these things before the end of the year. Let’s also say that the margins on this device are more iPod than Apple TV; 35% at the Apple stores, 30% at AT&T stores. Let’s also assume that 80% of the units are sold at Apple stores, and 20% are sold at AT&T stores. We’ll also assume 70% of the units are the higher end 8GB model, with the remaining 30% being 4GB units.

Scenario CIn this third scenario, the gross revenues brought in by the iPhone are a whopping $5.7 Billion dollars. Gross profits are $1.935 Billion dollars. This translates into a 29.48% increase in gross revenues, and a 34.56% increase in gross profit. On a per share basis, this is $6.58 per share in gross revenue and $2.24 per share in gross profit. This scenario is VERY optimistic, but not unrealistic.

Up to this point, we’ve also ignored the impact to AT&T’s revenues. Let’s assume our most conservative scenario, 3 million units sold. Let’s also assume that the average plan for the iPhone costs $40 (AT&T’s average revenue per wireless subscriber is about $50 currently). We’ll say that 30% of the iPhones are being sold to existing subscribers, and that those upgrades do not affect the revenues of AT&T (meaning nobody upgrading their phone to an iPhone upgrades their plan at the same time). That leaves 2.1M new subscribers, at $40 per month. Over the two year term, this equals about $2B in new revenue for AT&T.

If we look at the impact to AT&T with 4.2M new subscribers (70% of 6 million), then that is $4B in new revenue. If we take the “best case” scenario of 10 million handsets, with 7 million being new subscribers, and increase the average revenue per user to AT&T’s average of $50, then they are looking at $8.4B in new revenue over the course of two years. We’re not even considering the fact that AT&T would likely suffer less user churn as a result of the iPhone being exclusive to them. What’s the incentive of moving to Verizon if you can’t get the same spiffy phone?

So, does it matter if the iPhone flops? Yes, but not in the way that many people think. If the iPhone “flops”, it’ll equal large amounts of revenue for Apple and AT&T. If the iPhone succeeds, then it’ll equal massive revenues for Apple and AT&T, and likely a massive shift in how cellular phones are designed and marketed. Given the dollar values involved, I’d bet on the latter, and in that scenario, whether we want an iPhone or not, we all win.

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