How the iPhone Zapped Carriers

Tuesday, December 20th 2011. | Gadget News

Americans are glued to their mobile devices, obsessively calling, texting, emailing and downloading applications. So why is the U.S. wireless industry in such straits, as shown by AT&T Inc.’s crucial but failed plan to buy T-Mobile USA?

How the iPhone Zapped CarriersA big reason is that carriers are losing power to the device and software makers riding the smartphone boom.

They’re saddled with rising capital costs while much of the profit growth continues to accrue to Apple Inc., manufacturers using Google Inc.’s Android software, and companies making popular wireless apps. And carries haven’t figured out the most profitable way to charge consumers for their greater use of data.

In short: Device makers and app developers are having the fun, while the carriers are doing the grunt work.

The wireless industry has always been capital intensive, but the recent move to build faster and more reliable networks to support a deluge of data has weighed on these carriers.

Now that AT&T’s pursuit of T-Mobile is over, those two companies are expected to join the rest of the industry in mulling expensive deals for rights to the airwaves—a game that’s become a lot more difficult in recent weeks after Verizon Wireless spent nearly $4 billion purchasing spectrum rights from four different cable companies.

The U.S. wireless industry spent $24.9 billion on capital investments like networks and infrastructure in 2010, the highest annual total since 2005, according to industry trade organization CTIA.

But in 2010, AT&T and Verizon Wireless were the only companies to earn a return on their wireless network investments greater than their cost of capital, according to Bernstein Research.

At the same time, the rapid rise of Apple’s iPhone franchise reflects many of the challenges the telecom industry faces even as Americans’ reliance on their phones grows.

Wall Street analysts have projected AT&T’s wireless profit margins in the fourth quarter will be the worst in at least four years, despite AT&T saying it would sell more smartphones—including the iPhone 4S—than any other quarter.

That’s because every time a new iPhone model comes out, it’s the carriers—not consumers—that shell out the biggest bucks. Analysts estimate that carriers pay Apple a subsidy of about $400 each time a consumer buys an iPhone with a two-year contract.

AT&T and other wireless carriers say that subsidizing the iPhone heavily amounts to an investment that will make their customers more likely to stay and increase the amount of money they’re willing to spend for the carrier’s services. But some analysts say those benefits have yet to materialize.

At AT&T, Nomura Securities analyst Michael McCormack says, the profit margins on wireless service haven’t meaningfully improved since the company started carrying the iPhone in 2007.

“For the most part, it’s really been a wealth transfer from AT&T shareholders to Apple shareholders,” said Mr. McCormack, who predicts AT&T’s fourth-quarter profit margin will fall to 30% from 44% in the third quarter.

Apple missed financial expectations in its latest quarter due to a delay in the iPhone 4S launch, but sales of iPhones and iPads continue to surge, driving earnings up 54% over a year ago to $6.62 billion.

For the wireless carriers, average revenue per user has been falling in recent years despite increased smartphone adoption as the companies added more connections for lower-revenue devices like e-readers and tablet computers. In the third quarter, wireless carriers were being paid $46.09 a year by the average user, $2 less than a year before, according to UBS AG.

While carriers have to pay higher subsidies for smartphones such as the iPhone, such devices allow carriers to charge customers for data plans. Google’s free Android software for smartphones also helped drive smartphone sales and boosted demand for wireless bandwidth even more.

Just in the last year, the amount of wireless data consumed monthly more than tripled among teens and doubled for just about every other age group, according to Nielsen.

Meanwhile, revenue from voice calls, which take up far less bandwidth than, say, watching a YouTube clip, has been declining for years. And even extremely profitable text messaging is threatened by new applications, like Apple’s iMessage, that allow smartphone users to interact without racking up texting charges.

Now, carriers are seeking to forge a new pricing model that allows them to monetize surging data usage. Before the smartphone boom, many carriers sold data access on an unlimited basis, making it hard for them to profit.

Earlier this year, Verizon followed AT&T in implementing a tiered data plan, in which heavier users of data pay more.

In trying to buy T-Mobile, AT&T bet that government officials would see the wireless industry’s difficulties amid the smartphone boom as a justification for allowing the second-largest industry player to buy the No. 4 player. Regulators didn’t see it that way.

Now, analysts say AT&T will have to pull out its checkbook and spend billions more to acquire spectrum rights and invest in building capacity on its network.

For AT&T’s smaller competitors, things are even tougher. AT&T and Verizon Wireless earn roughly 80% of the industry’s profits and have fared better in adjusting to the smartphone boom than smaller competitors.

The giants are able to use their scale to provide broader coverage and land access, sometimes exclusive, to the hottest devices, such as the iPhone and choice Android phones from device makers like HTC Corp.

The third-largest carrier, Sprint Nextel Corp., decided this year that it needed to carry the iPhone as well. But to do it, Sprint had to commit to paying Apple $15.5 billion for the devices, whether or not it could find buyers for them. The company acknowledged that subsidizing a customer buying an iPhone would cost 40%, or about $200, more than another kind of phone, on average.

T-Mobile, meanwhile, is the only one of the top four carriers that isn’t selling the iPhone, one reason for its customer losses. In the first nine months of the year, T-Mobile lost 850,000 contract customers.

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