Why AT&T actually doesn't mind when smartphone sales drop

You'd think AT&T would be more upset that the number of smartphones it sold in the second quarter fell nearly 8 percent. You'd be wrong.

The Dallas telecommunications giant is probably thrilled that smartphone sales fell, resulting in better wireless margins and driving better-than-expected second-quarter results.

It's the contradictory dynamic that all carriers find themselves in: smartphone sales are vital to keeping a healthy flow of revenue and profit growth but come at a more immediate cost in the form of subsidies that are paid to the handset manufacturers. The subsidy issue is most dramatically seen from Apple, which takes a much larger toll for each iPhone that is sold.

The smartphone subsidy dilemma is a classic struggle between near-term forces seeking the best quarterly results now and a longer term perspective that sets the company for growth several quarters down the line. This quarter was a win for those looking for an immediate payoff.

Given the millions of dollars carriers pour into advertising for the latest and greatest device, it's easy to forget that they making money off the service, not the device. But that's why AT&T and Verizon Wireless are moving into shared data plans and insisting that individuals bundle data, voice, and text message service into a single plan.

Carriers take an initial financial hit when a customer buys a phone and make it up on the back end of the two-year contract. That's why phones purchased without a contract or in the middle of an existing contract don't come with subsidies are usually several hundred dollars more expensive.

The standout statistic for AT&T this quarter was its strong wireless service margins. They rose to 45 percent in the second quarter, up significantly from the 41.1 percent margin it posted a year ago. As a result, the company posted per-share earnings that exceeded Wall Street expectations of 66 cents by 3 cents a share.

At the same time, smartphone sales fell to 5.1 million units from 5.6 million a year ago.

"AT&T is enjoying a still-rapid migration of feature phones to smartphones, driving steady [average revenue per user] gains, and better yet, the customers who already have smartphones are sitting on their hands," said Craig Moffett, an analyst for Sanford C. Bernstein.

AT&T's recent policies underscore their reluctance to really push smartphone sales. The company recently increased the fee to upgrade a smartphone, and also eliminated the option to upgrade early.

"Our new upgrade policy works," CFO John Stephens said during a conference call today.

By lengthening the time that customers keep their smartphones, AT&T is able to generate more revenue without going through the expense of another subsidy, translating into more profits. Of course, that means customers will have to wait longer before they are eligible to switch to a new phone at the subsidized price, as well as pay a higher fee (the other carriers have implemented similar policies).

As a result, AT&T had a record low amount of phone upgrades with a rate of about 6 percent in the second quarter.

"All of these results are a consequence of more disciplined behavior, in our view," said Jonathan Chaplin, an analyst for Credit Suisse.

Despite these policies, AT&T still stuck to its forecast of selling 25 million smartphones this year, even though it's on pace to fall below that figure. Stephens said he was reluctant to change the forecast given the uncertain impact of new devices. In other words, he doesn't know how big the next iPhone will be.

With the next iPhone believed to launching in the fourth quarter, analysts expect the third quarter to yield further weak smartphone sales.

AT&T has also been managing network costs by pushing customers toward tiered plans of capped data. The company said that 27 million, or nearly two-thirds of all smartphone customers, are on tiered plans, with many of them opting for the higher-end 3GB or 5GB plans.

The shared data plans, which the company announced last week but won't make available until August, will slowly improve its revenue over time as people trickle in, Stephens said.

AT&T, like the other carriers, has been working to move itself away from high-subsidy smartphones such as the iPhone with mixed success. The company activated 3.7 million iPhones in the period, a lion's share of the total smartphones sold.

"We need to focus on managing cost of those subsidies," Stephens said.

Still, as the popularity of the iPhone continues to endure, and its availability so widespread, don't expect AT&T to make any drastic moves on subsidies.