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For carriers, the iPhone is a bittersweet drug

Yes, the iPhone brings in new customers, increases revenue, and lets the carrier bask in Apple's halo effect, but all of that comes at a cost. One analyst calls the iPhone a habit the carriers just can't kick.

Roger Cheng Former Executive Editor / Head of News
Roger Cheng (he/him/his) was the executive editor in charge of CNET News, managing everything from daily breaking news to in-depth investigative packages. Prior to this, he was on the telecommunications beat and wrote for Dow Jones Newswires and The Wall Street Journal for nearly a decade and got his start writing and laying out pages at a local paper in Southern California. He's a devoted Trojan alum and thinks sleep is the perfect -- if unattainable -- hobby for a parent.
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Roger Cheng
7 min read
The iPhone has done wonders for the carriers, but has it all been good? Apple

Could the wireless carriers actually be addicted to the iPhone?

By now, it's well understood that the iPhone is a double-edged sword for the wireless carriers. On one side, Apple's smartphone is a pricey device to carry, requiring an unusually high subsidy that carriers must pay to keep it affordable enough for the masses. On the other, it leads to more loyal customers who pay more each month.

Furthermore, the telecom companies get to wrap themselves in the hip vibe that Apple brings to its products and partners, and can you put a price on being cool?

Apparently, you can, and it's a steep one. The dilemma for the carriers is that with each successful quarter of iPhone sales, there is a corresponding hit to their profit as a result of the extra subsidies paid out, as illustrated by Verizon and AT&T's fourth-quarter results. (Sprint Nextel hasn't reported yet, but will likely see a similar impact.)

While the carriers have argued that the short-term hit will lead to longer-term gains, the desire for constant upgrades--and the subsidies that go with it--blunt any benefit they get in the long term. Customers who own iPhones aren't just content with their current model; they will re-up as soon as possible. There lies the problem: a never-ending loop of subsidy payments that the carriers can't get out of, largely because the iPhone has become so key to their growth.

"At this point, the iPhone is like a drug, and the carriers are hooked," said Craig Moffett, an analyst at research firm Sanford C. Bernstein. "The question isn't whether it's worth it. It's whether they can get by without it. "

The 'new normal'
Moffett said he is concerned that while more people will use smartphones, there will really never be a any real rebound in profit from iPhone customers because of the constant upgrade cycle.

"Is the iPhone margin effect transitory, or is it a 'new normal'?" Moffett said. "The fallacy is the idea that the iPhone upgrade cycle is a one-time event."

The demand for the iPhone is staggering. Verizon, for instance, said on Tuesday it activated 4.3 million iPhones, or more than half of the smartphones sold in the period. Most of those activations came from existing customers; Verizon added 1.2 million net new contract customers.

All of that came at a cost. After taking out one-time items such as pension-related costs, the company earned 52 cents a share, two cents shy of Wall Street expectations. Excluding income tax, depreciation and amortization, earnings fell 1.1 percent from its year-earlier period. A year ago, when Verizon didn't have the iPhone, it saw 5.5 percent growth.

Verizon, however, was upbeat about the customer growth driven by the iPhone, acknowledging that margins would fluctuate in the next few quarters.

"The sales volumes in the fourth quarter exceeded our expectations, but obviously will create more opportunity for growth in 2012," Chief Financial Officer Fran Shammo said during a conference call on Tuesday.

AT&T, meanwhile, said today it activated 7.6 million iPhones--a vast majority of customers choosing the iPhone 4S--but only added 717,000 net new contract subscribers. AT&T's results over the past few years illustrate Moffett's concerns. Since getting the iPhone and moving to a subsidy model, the company has seen lower margins, he said. Its fourth-quarter wireless margins dropped by a third from a year ago.

Like Verizon, AT&T remains bullish on its ability to derive more longer term value out of its iPhone customers.

"All in, I continue to be a big-time bull on the smartphone category and the iPhone in general," AT&T CEO Randall Stephenson said during a conference call today. "I'm not shying away from this market."

While acknowledging some of the margin pressure, Stephenson said he sees the smartphone as a platform to sell more services, including tablets and other connected devices.

Others aren't so optimistic. Morgan Stanley analyst Simon Flannery said he expects average revenue per user growth to slow for the wireless carriers. Beyond data, the companies face pressure from shrinking revenue on the voice and text message side of the business.

Sprint, meanwhile, has more at stake than anyone else. The company has basically bet its financial future on the success of the iPhone, reportedly committing to pay Apple $20 billion for 30 million iPhones for the next four years.

Sprint CEO Dan Hesse and his leadership team have been nothing but ecstatic over getting the iPhone, with one executive likening it to getting a seat at the cool kids' table.

But with three national carriers (and one regional one) carrying the iPhone, how exclusive is this club?

"Sprint decided to mortgage its entire future just to make sure it has the me-too status of saying they had the iPhone for sale," Moffett said.

Factoring in capex
Further complicating the actual cost of the iPhone is the amount of capital expenditures needed to ensure the network is up to par when it comes to handling iPhone and other smartphone traffic. Carriers tend not to break out their network expenses in regards to specific devices, but there's no question the companies have spent a significant amount bolstering their infrastructure.

AT&T said it is still working on boosting coverage and improving the quality of service in major markets such as New York and San Francisco. The company said it made 150,000 improvements to its network last year.

Before it got the iPhone, Sprint executives coyly said they were prepping to handle any major influx of traffic from such a marquee device.

While Android devices have been shown to be major bandwidth hogs in recent years, the introduction of the iPhone 4S and the voice-command feature Siri has proven to be a data hog of its own. Because Siri constantly pings Apple's servers for information, the iPhone 4S has been shown to use twice as much data as the iPhone 4.

Remember, the iPhone runs on the carriers' 3G service, necessitating further investment there even as the carriers turn their attention and most of their resources to the faster, more efficient 4G networks.

Consumers are already seeing some of the steps the carriers have taken to offset the impact of the iPhone. AT&T was the first to move to a tiered pricing, and recently raised the price of its smartphone data plans, although it also lifted its limits too. Sprint, meanwhile, eliminated a slew of customer-friendly perks such as early upgrades, while enacting higher early termination fees and a shorter window for product returns.

Tangible and intangible benefits
Of course, the iPhone brings its share of advantages to a carrier.

Sprint's flagship Manhattan store prepping for the launch of the iPhone 4S back in October. CNET/Marguerite Reardon

Some are obvious. The device's ability to win over new customers and retain existing ones has been proven over and over. That has remained the case even after AT&T lost its exclusive hold over the iPhone. AT&T's answer has been to offer up the older models for a heavily discounted price, expanding the potential base of iPhone customers.

Without the iPhone, neither Verizon or AT&T would have been able to show the impressive customer growth that they did.

Perhaps the biggest benefit is in reduced customer turnover, known in industry parlance as churn. Sprint's Hesse has long complained that the availability of the iPhone at its two bigger rivals was a primary contributor to why he couldn't keep his subscribers. His belief is that by getting customers to stay on longer, he'll be able to eventually turn a profit on them.

It's a risky tightrope Hesse is walking on. In addition to the hefty iPhone subsidies Sprint has committed to paying, the company is building out its 4G LTE network, two moves that are expected to depress margins for the company over the next two years.

Because the iPhone was only available on one carrier for so long, there was an air of exclusivity about it that aided both Apple and AT&T. Verizon and Sprint, however, won't be reaping those benefits, since the iPhone no longer has the cachet of a hard-to-get device.

Still, some analysts maintain the iPhone will pay dividends in the long run. Robert W. Baird analyst William Power said Verizon could be poised for further earnings growth this year. Verizon on Tuesday backed its per-share earnings forecast for 2012.

And with all of its potential drawbacks, T-Mobile USA, the only national carrier not to get the iPhone, desperately wants to have it. At a press conference during the Consumer Electronics Show, T-Mobile CEO Philipp Humm acknowledged the lack of the iPhone had hurt the company's ability to keep subscribers. But the carrier is hoping to get the phone soon; Chief Technology Officer Neville Ray told CNET that the next version could technically support T-Mobile's unique spectrum.

The only undisputed winner here is Apple. On Tuesday, the company reported a massive gain in profit, with quarterly earnings more than doubling to $13.06 billion, thanks to strong sales led by the iPhone 4S. Unlike the carriers, its margin only increased, rising to 44.7 percent from 38.5 percent a year ago.

The carriers, meanwhile, are falling over themselves paying for the privilege of selling the iPhone. While everyone is lauding Apple for its blowout quarter, no one's getting excited for the carriers' financial performance.

Updated at 8:32 a.m. PT: to include an additional comment from AT&T CEO Randall Stephenson.