iPhone buoys AT&T subscriptions--but hurts profit

AT&T has been sacrificing short-term profits for long-term gains with its exclusive deal to sell the Apple iPhone. But will the strategy pay off?

The exclusive iPhone deal has helped AT&T lure coveted subscribers from competitors such as Verizon Wireless and Sprint Nextel. And the device, which requires a $30 a month data service, has helped boost the amount of money its customers spend per month on services.

However, the estimated $300 subsidy that AT&T pays each time an iPhone is sold is eating into the company's profits. And the more successful AT&T is with the iPhone, the greater the short-term pressure on the company.

AT&T, which reported second-quarter earnings on Thursday, said it activated more than 2.4 million iPhones during the quarter. Roughly, a third of these activations were for new AT&T subscribers. And of the existing AT&T customers who upgraded to the iPhone, more than half increased their average monthly spend on wireless services by signing up for the required $30 a month data service.

Despite the new iPhone subscribers and added data revenue, AT&T's profits still dipped about 15 percent compared with the same quarter last year. The company reported a profit of $3.2 billion, which is down from $3.77 billion during the same quarter a year ago. The company also reported that its revenue fell slightly to $30.73 billion from $30.87 billion a year ago. Analysts had expected revenue of about $30.64 billion, according to Reuters.

AT&T executives have admitted that the iPhone subsidy has been a drag on profits and will continue to be in the short term, but they apparently are confident that the company's iPhone investment today will pay big dividends tomorrow.

"The iPhone has proven to be a terrific investment for us," Richard Lindner, AT&T's chief financial officer, said during a conference call with analysts and investors. "It offers us better customer churn and stronger ARPU." That stands for average revenue per user.

When AT&T first began selling the iPhone in 2007, it did not subsidize the phone at all. Thousands of die-hard Apple fans stood in line for hours to be the first to get the iPhone, and AT&T and Apple sold a good number of the devices. But AT&T recognized that the phone wouldn't appeal to the average consumer at the cost of $500 or more.

Thus, in the effort to bring the iPhone to the masses, AT&T began subsidizing the iPhone 3G in 2008. This is a more traditional model for carriers, which typically subsidize phones to attract customers and keep them tied to service contracts.

The reason AT&T pays this high subsidy is because it hopes to make back that money and add profits over the two-year service contract it sells with each phone. And it expects the profits to start pouring in by 2010 as the subsidies get paid off.

As that starts to happen and as AT&T cuts more costs, Lindner said that operating margins could begin to approach 40 percent. In the meantime, the money that AT&T is spending to subsidize the phones hurts its operating margins. AT&T's operating margin in wireless declined to 23.8 percent from 25.5 percent a year ago.

The iPhone 3GS upgrade question
But now AT&T is facing another unexpected hurdle. When the iPhone 3GS went on sale, some existing iPhone customers were upset that they couldn't get the $199 and $299 prices offered to new AT&T customers or AT&T customers whose two-year contracts had already ended. So AT&T altered its upgrade policy to allow some customers to get the new iPhone at a reduced price depending on how much time they have left on their contract.

It's difficult to say whether this policy hurt the company's profits--and if so, by how much. But if AT&T is willing to discount new iPhones for existing users every time a new iPhone comes out before it has paid off the subsidy on the previous phone, it seems like the company could be eating into its anticipated profits.

The good news for AT&T is that with the new iPhone subscriptions, the company is again driving up the average revenue it generates per customer. In fact, the company reported that its ARPU increased 37.2 percent in its wireless data revenue to $3.4 billion during the quarter. This is more than double the total for the second quarter two years earlier.

And the iPhone is also helping the company add new subscribers. In total AT&T added 1.4 million net subscribers during the quarter, including 1.2 million customers with monthly subscription plans. Analysts had expected the company to add about 1.08 million new subscribers, according to Reuters.

These new additions, coupled with the increase in revenue, have made analysts optimistic about AT&T's future.

"Their wireless results were nothing short of spectacular," Craig Moffett, an analyst with Sanford Bernstein, wrote in a research note Thursday. "The result was their best second quarter wireless result ever."

But what happens when the iPhone exclusivity deal runs out? There is already talk that Verizon Wireless is working with Apple to sell a new device on its 4G wireless network.

Lindner of AT&T wouldn't say how long the exclusive deal with Apple lasts or whether or not it will be renewed. But he explained that the groundwork that has been laid today with sales of the iPhone will continue to pay off years from now, even when the iPhone is eventually offered by other carriers in the U.S.

Specifically, he said that more than 60 percent of the nearly 9 million current iPhone subscribers were AT&T subscribers before they bought the iPhone. He also said that a large number of iPhone and other "integrated device" customers, or customers buying devices that use AT&T's wireless network to connect to the Internet, are on family plans. This is an important distinction because people with family plans are much less likely to switch carriers than consumers who have just one phone line with a provider.

"When we start putting these things together, it gives us some comfort as to the stickiness of the base and our ability to maintain that base going forward," Lindner said. "Obviously, we will always strive to have a top-of-the-line device lineup. And as our network performance and quality improves, we think that will also help retain this base."

Lindner also explained that the company is in the early stages of upgrading the network to the latest generation of HSPA technology. This network upgrade will double the capacity that AT&T has on its 3G wireless network to serve its growing iPhone base, but will also allow the carrier to offer more 3G wireless service at faster speeds to subscribers using other devices to connect to its wireless network, such as Netbooks. Lindner said the upgrade will happen quickly since it's primarily a software upgrade. He also said that the upgrade will help the carrier transition more elegantly to fourth generation technology, LTE, when the time comes for even more bandwidth.

Verizon Wireless plans to begin its network upgrade to 4G wireless technology using LTE starting in 2010.

Landline business hurting
The profit and revenue dip AT&T experienced in the second quarter can't be blamed entirely on the iPhone subsidy. AT&T is also still losing traditional telephone customers, which has hurt the company's bottom line. These customers, who are using a network that has been paid for many times over, have traditionally been a cash cow for the company.

During the second quarter the company said it lost 921,000 residential phone lines. The loss of landline phone customers is a trend that has been happening for the last few years as customers sign up for less expensive phone service from cable TV providers and rely more on cell phones for phone service. The trend seems to be speeding up in the last couple quarters as customers hit by the recession try to trim household costs.

AT&T also said that earnings were affected by pension and retiree benefit expenses that were $400 million higher, or 5 cents per share more, than they were in the same period a year ago.

But AT&T is optimistic that it will see an eventual return on its investments in its wireless business through its relationship with Apple and in upgrades to offer new services with its landline phone network.

"We think we have excuted pretty well through the first half of 2009 in a pretty challenging environment," Lindner said. "And we will continue to be focused on things that will make AT&T stronger operationally and financially."

The iPhone has certainly helped AT&T add new customers. In fact, the company said it added a net 1.2 million new wireless customers who are monthly subscribers (as opposed to prepaid). This is crucial, especially in a market that's nearly saturated. This figure is up 29 percent compared with the second quarter of 2008. AT&T now has a total of 79.6 million wireless subscribers.

The company has also reduced its churn rate, or the rate at which customers dump its wireless service for another carrier's service. During the quarter, AT&T reported that its churn rate for post-paid wireless subscribers was 1.09 percent, which was down compared from 1.2 percent in the first quarter. Overall, AT&T's churn rate was 1.49 percent, down from 1.64 percent a year ago.

AT&T's broadband and U-verse TV businesses also did well during the second quarter. AT&T added a total of 248,000 new U-verse customers to reach 1.6 million. More than three-fourths of AT&T U-verse TV subscribers also subscribe to broadband and voice services from AT&T, and many also have wireless service with AT&T.