Is Chasing the iPhone Too Costly for Carriers?

Profits at the three largest U.S. phone carriers are being squeezed by steep discounts on advanced mobile phones, triggered by AT&T’s hefty subsidy for the iPhone.

AT&T, Verizon Communications and Sprint Nextel are expected to show a drop in wireless profit margins when they report third-quarter results in coming weeks, also feeling the pinch from consumers holding off on buying add-on services like data to lower their phone bills in the weak economy.

Wireless carriers have always shouldered part of a phone’s cost to persuade customers to sign longer-term contracts, but U.S. market leader AT&T (NYSE: T) lowered the bar when it helped Apple (NASDAQ: AAPL) launch the latest iPhone for only $200 on July 11.

This forced Verizon Wireless (NYSE: VZ), AT&T’s biggest rival, and Sprint (NYSE: S), the No. 3 U.S. mobile service, to follow suit with higher subsidies on their advanced phones, analysts said. While that helps boost service revenue in the longer term, it hurts near-term profits.

“The derivative effect is lower profitability in wireless for all the carriers,” said UBS analyst John Hodulik, adding that the iPhone is selling faster than he expected, which is actually bad for AT&T’s profitability in the short term.

“Subsidies have been creeping up anyway but the new iPhone and the efforts to defend against it have likely brought it to a new level,” he said.

AT&T, which reports results on Wednesday, is seen as the worst hit, with JPMorgan analyst Michael McCormack forecasting what he called a “shocking” drop in its mobile profit margin to 36.1 percent in the third quarter from 41.2 percent in the second quarter. He estimates that AT&T will depend on wireless for about 45 percent of 2008 operating income.

Bad sign

McCormack forecast the margin at Verizon Wireless, owned by Verizon Communications and Vodafone Group, to fall to 43.8 percent from 45 percent. He says 40 percent of Verizon Communications’ 2008 operating income comes from wireless.

“We expect the success of AT&T’s 3G iPhone to pressure results at Verizon Wireless,” said McCormack, who added that any pressure at Verizon was a bad sign as it typically reports the most consistent results in the industry.

Verizon is scheduled to report quarterly earnings on October 27 and Sprint on November 7.

McCormack forecast Sprint’s margins falling to 24.7 percent from 25.7 percent in the second quarter. Sprint is also seen struggling to stop customers from leaving due to its reputation for weak customer service and network problems.

Analysts said Sprint’s retail price of $130 for the Instinct phone from Samsung Electronics was a good example of an industry-wide increase in subsidies.

“A touch-screen feature phone like Instinct a year ago would likely have sold for as much as $299,” said Current Analysis analyst Avi Greengart. He also cited a recent offer from Verizon for its Voyager phone, made by LG Electronics for $99, compared with $299 last year.

Analysts also expect Storm, a much-anticipated advanced touchscreen phone from Research in Motion (NASDAQ: RIMM) that Verizon has said it would price competitively, to come with a hefty subsidy.

No relief

According to Reuters Estimates, AT&T’s third-quarter earnings per share before unusual items are expected to remain flat with a year ago at 71 cents. Verizon’s profit before items is forecast to rise to 66 cents a share from 63 cents a year ago while Sprint’s profit is expected to plunge to 3 cents a share from 23 cents in the same quarter last year.

If the economy worsens, UK-based analyst Ben Wood of CCS Insight said carriers may prefer to cut service fees instead of boosting subsidies to keep customers and attract new ones, citing examples in the United Kingdom.

“I’ve no doubt you’ll start to see some of that in the States as well,” he said.

Some U.S. analysts disagreed, saying carriers will continue to offer smartphone subsidies because they tend to come with an obligation to pay monthly service fees for data services, such as Web surfing, on top of voice service fees.

Whatever the strategy, analysts are forecasting phone companies will earn less per user as the economy worsens.

“I think we’ll see average revenue per user (ARPU) decline but the real question will be to what degree,” said Stanford Group analyst Michael Nelson, adding that as voice call prices have fallen, carriers have depended on data for ARPU growth.

“The industry has been supported to some degree by increased data revenue. That may be limited in a slowing economy,” Nelson said.

McCormack now expects third-quarter ARPU for U.S. mobile providers to be flat with the same quarter a year ago. His expectation coming into the quarter was for 1 percent growth.

He believes smartphone sales showed signs of slowing in the last few weeks. “We think it’s going to hurt the third quarter but clearly the fourth quarter could be under much more significant pressure in what’s typically the strongest quarter,” he said.

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