iPhone News Updated

A global network is thriving by selling up to 1 million iPhones that bypass Apple's restrictions

Encamped along the aisles of the massive Zhongguancun Kemao Electronics Market in Beijing are many people like Li Zhongxin, of the Beijing Xinyu Lianhe Telecom Equipment Co. Li sits atop a plastic stool in front of his open-air stall on the third floor, scanning the throngs of shoppers for would-be customers. There's no sign of Apple's iPhone among the thicket of cell phones, handset covers, and other accessories hung on shelves and inside the waist-high glass display case, but he'll be glad to show you one. In exchange for an up-front payment, "you can buy as many as you'd like," Li says.

The assertion may seem misplaced in a country where Apple (AAPL) has yet to introduce the iPhone. The device is officially on sale only in the U.S., Britain, France, and Germany, where Apple has signed exclusive contracts with cellular carriers including AT&T (T). Yet Li's booming business is the very real byproduct of pent-up demand for a much-hyped device made by a company that places strict limits on where and how it's sold.

And Li represents only a sliver of the intricate, widening global iPhone gray market that encompasses no-name importer-exporters in China, a semiconductor maker in Eastern Europe, businessmen in the Midwest and Australia, and "runners" enlisted to buy as many iPhones as they can from stores run by Apple and its partners in the U.S. and Western Europe. And, of course, there are countless small retailers willing to buy and then sell iPhones at jacked-up prices to consumers worldwide.

Prague at the Epicenter

BusinessWeek sources confirm analyst reports that 800,000 to 1 million iPhones, or about one-fourth of the total sold, are "unlocked"—that is, altered to be able to run on networks other than those of Apple's exclusive partners (BusinessWeek.com, 1/28/08).

This iPhone aftermarket didn't take long to develop. By the time the device went on sale on June 29, 2007, software hackers and companies that specialize in unlocking cell phones were already searching for ways to make the iPhone work on nonsanctioned networks. Within weeks, online forums were buzzing with an answer that emanated from a tiny company based in Prague, Czech Republic.

Pavel Zaboj is a 36-year-old former math student who together with friends developed an electronic device called Turbo SIM that was designed to turn cell phones into mobile payment systems. Turns out Turbo SIM could also be used to trick the iPhone into thinking it's operating on AT&T's network. By mid-August, Zaboj's 10-person firm, Bladox, was being flooded with orders, particularly from Canada and Mexico, where Apple addicts didn't have to venture far to get an iPhone. Bladox was totally unprepared, and couldn't fill the orders that rolled in. "We just sat their open-mouthed," Zaboj says.

Little Interference from Apple

Bladox has sold devices used to unlock phones in roughly 100 countries, including French Polynesia and Afghanistan, Zaboj says. BusinessWeek readers report iPhone sales in Brazil, Canada, the Dominican Republic, Indonesia, Israel, Nigeria, Peru, Poland, Russia, and the United Arab Emirates.

The boom is being fueled not just by short supply of a hot product, but also by scant evidence of interference from Apple or its partners. Apple-authorized partners—AT&T, O2, Orange, and Deutsche Telekom's (DT) T-Mobile—lose hundreds of dollars in monthly fees when subscribers forgo a two-year contract in favor of unlocking. But the bulk of the unlocking seems to be occurring in places where customers have no authorized carrier to choose from.

While Apple takes in hundreds of dollars per iPhone sale when customers activate service with one of its partners, most analysts say the unlocking craze helps spread Apple's brand awareness. The greatest risk might be a lawsuit seeking to shut down the illegal purchase of iPhones. Apple and AT&T restrict the number of iPhones a person can buy. In recent weeks, AT&T Mobility filed suit against resellers of its GoPhone, alleging the businesses hack the cheap handset and then sell it for higher prices. AT&T spokesperson Mark Siegel wouldn't comment whether the company will sue people who improperly buy iPhones, though he adds the iPhone is "meant for use by the person who buys it" and not to be resold for commercial purposes.

Leak from Chinese Factories?

The gray market has also gotten a push forward from exchange rates. With the dollar falling, consumers from Europe and elsewhere can get a better deal on an iPhone during a trip to the U.S. than buying it at home. Gray marketers saw the same opportunity and began recruiting a range of people to secure iPhones.

Sometimes, it is as simple as asking friends and family members to tap out their limit, which for individuals is five phones at Apple and three at AT&T. One reseller admits he got a friend to print business cards and pose as a small business owner so as to dupe an Apple Store manager into letting him buy 100 iPhones for his "employees." Deng Aijun, sitting in an unnamed stall elsewhere in Beijing's Zhongguancun Kemao Electronics Market, admits that "We get people like airline stewardesses to bring the iPhones over for us."

Some of the iPhones on the gray market may be leaking out from points closer to the source: the big Chinese factories where they are assembled. One distributor says he believes his China-based source gets iPhones from factory workers. One of this distributor's suppliers recently gave him an internal Apple document showing the schematics of the original iPhone, as well as repair instructions. The most likely explanation is an Apple employee or contractor stole the documents, possibly to sell to would-be unlockers.

Risk of Fraud

Returned phones also find their way into the aftermarket. Hilliard (Ohio)-based Cellucom Group, a cell-phone refurbisher, gets 400 to 500 iPhones a month from retailers and phone recycling outlets, says Charlie Taylor, Cellucom's director of carrier relations. Like most refurbishers, Cellucom won't tinker with phones that appear to have been altered already. Instead, the company sends the devices to wholesalers in Miami and New York who in turn repair and then unlock the phones.

Like many gray markets, the iPhone aftermarket is fraught with risk. For starters, many iPhone buyers are fraudsters, says Shawn Zade, a senior sales associate at WirelessImports.com, which sells unlocked phones. In the case of non-iPhone handsets, fewer than 1 in 100 purchasers try to use stolen credit cards, he says. With the iPhone, the rate is about 1 in 5. To control fraud, Zade requires buyers to submit copies of credit cards and driver's licenses.

Playing Cat and Mouse

The biggest risk is the inherent unpredictability of the market—an artifact of the cat-and-mouse game between Apple and the software hackers who make unlocking possible. Last September, an Apple iTunes software update rendered unlocked phones useless, but it was quickly followed by a software hack that made it simple to unlock iPhones. Demand for so-called Franken-SIM cards sold by Prague-based Bladox and other more involved services to unlock iPhones plummeted. A glut of more than 100,000 unlocked iPhones ensued. One example: VOTech, a small outfit in Australia, saw more than 1,500 out of its 2,000 outstanding orders evaporate, leaving it with heaps of inventory and a fraud investigation by eBay's (EBAY) PayPal, which locked its account, says owner Alex Voevodin. Only after another Apple software update shut down the so-called "software unlock" did demand growth resume for these electronically altered gray-market phones.

None of that is stopping other players from entering the market. One of them is PDA Cable, a one-man operation owned by 29-year-old Nathan Walberg. Five years ago, Walberg said good-bye to his job as a cell-phone salesman and set up shop in a 30-foot-by-30-foot office in his backyard. Using the Web and other sources, Walberg scoured the globe for cheap parts and accessories for a range of cell phones and iPods, which he resells from his Web site, pdacable.com. That's earned him a six-figure salary in recent years, and he's only getting ramped up with the iPhone.

In January, Walberg found a cheap Turbo SIM knockoff sold by a Chinese supplier. He packages the device to create an altered SIM card and sells them for $44. His customers include London businessmen and retailers in Mexico, Brazil, and other locales. He's even getting calls from carriers that don't want to share their profits with Apple, as AT&T and others have agreed to do. That way, customers can come in with their iPhone, buy Walberg's device, and skirt Apple's exclusive provider. "I don't know if [these carriers] can legally encourage unlocking, but they're not going to discourage it," says Walberg. "This market will go on forever, because I don't think there's a way for Apple to stop us."