How Apple could sell 77 million iPhones in 2013 by Philip Elmer-DeWitt @FortuneMagazine January 14, 2009, 2:55 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons Two very different iPhone reports — with very different perspectives — were published this week. One, from Citigroup’s Richard Gardner, focused on the short-term. He looked at inventory levels in Apple’s supplier channels, saw levels coming down, concluded that iPhone sales over the holidays were soft, and lowered his Apple AAPL price targets for the next three years. The other, from Generator Research’s Andrew Sheehy, took the long view. He reviewed Apple’s performance over the last eight years, saw what it had done to the music industry with the iPod and iTunes, compared the services offered by the iPhone/App Store with those offered by traditional cellphone manufacturers, and concluded that Apple could dominate the smartphone market within four years with a 40% share, shipping as many as 77 million units a year. Sheehy’s report is more ambitious — and a lot more interesting — than Gardner’s, so we take closer look at it below the fold: Sheehy’s premise is that the mobile services industry boils down to three ingredients — devices, networks and services. After 20 years and billions of dollars, the industry has done a good job delivering the first two, devices and networks, and a terrible job delivering the third ingredient: the services themselves. That, he says, is better done by companies with experience in computers, software and the Internet. Companies, he writes, like Apple: From a starting position as a rank outsider, Apple is already beginning to have a transformational impact on the mobile industry. Even taking into account the highly uncertain economic outlook, the company is on a roll and with cash reserves of $25 billion, 33% gross margins, no debt and a strong product portfolio. He sees three reasons Apple is particularly well positioned to dominate the smartphone business: In the future it won’t be good enough to deliver devices with more and more features, which has been the industry’s playbook so far. “Instead, would-be market leaders will either have to offer or enable a total service experience that encompasses the device, device software, network software and the associated services, most of which will be delivered by third parties. It is this ability to combine hardware and software, in a way that is simple for users, that is Apple’s core competence.” Apple is the past master of the vertical platform — having proved itself with the combination of the iPod and the iTunes Store. The case for a vertical platform is even stronger in mobile industry, which has become hugely complex and fragmented. “It is Apple,” he writes, “that currently has the best platform, even though the service aspect—the App Store—is currently at an early stage.” Smartphones have the potential to substantially increase Apple’s revenues at a corporate level, which is not the case for a company like Nokia NOK , currently the market leader. The iPhone and its derivatives, he writes, are Apple’s core business and command the majority of attention in the Apple board room.”For Nokia, smartphones are one of many important market segments, but the most important of all involves churning out lower-end phones in markets that are still some way from saturation.” For Apple to achieve the kind of growth Sheehy anticipates, however, several things have to happen. Apple has to broaden its offerings, selling not just iPhones but a range of devices — tablet PCs, portable book readers, portable movie players and, presumably, low-cost entry-level phones — that all have access to the App Store. It must open up the iPhone’s application programming interface (API) to allow developers access not just to the device, but to the whole network — vastly expanding the kinds of services available to the user and freeing Apple from its dependence on network providers. The carriers are likely to resist this. Finally, it has to find ways to broaden the market, selling not just better smartphones to existing smartphone customers, but services compelling enough to reach critical mass — that point “where average users can clearly see that there are enough high-quality services on offer to justify spending $30 per month [for a] mobile broadband subscription.” If all goes according to plan, Sheehy says, the market four years from now could look something like the chart at right. Of course, Apple is not the only company pursuing a strategy along the lines Sheehy envisions. Google’s GOOG Android initiative comes immediately to mind. But the current economic downturn, combined with Apple’s enviable cash position, could work to its advantage. As Sheehy sees it: We think that Apple will use the current spending freeze that is currently paralyzing many markets and many companies to get one or two design cycles ahead of the competition. While Apple will not be immune from the effects of the downturn, we think that the company will still be able to afford to keep investing and it will be highly motivated to do so. When rivals start spending again, they may discover that Apple has built an unassailable lead. Below, Generator Research’s chart of projected unit sales. The full report is available here for £190 ($277).