Broadband Cable Association of Pennsylvania

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January 22, 2013

In the world of U.S. wireless, Verizon Communications and AT&T sit at the head of the table. Neither is likely to give up its seat any time soon. But the No. 1 and No. 2 wireless carriers by subscribers may have to accept that they can't fatten their margins, and may even face some downward pressure, if they want to keep a reinvigorated Sprint Nextel from closing in.

Verizon, which posts fourth-quarter earnings Tuesday, has said its wireless-service margin, in terms of earnings before interest, taxes, depreciation and amortization, will be below that of the fourth quarter of 2011. AT&T, set to report on Thursday, has also said it expects pressure on wireless-service margins, which exclude equipment sales. Both cite high device subsidies. The main culprit: Apple's iPhone. Carriers subsidize new phones to keep subscribers signing up for-and staying with-their services. For the iPhone, such subsidies are 30% to 40% higher than for high-end Android phones, according to UBS . Carriers have paid that price because they have also benefited. The iPhone has pushed users to more expensive plans and has cut the rate at which subscribers quit.

But as more users have smartphones-53% at Verizon and 64% at AT&T at the end of the third quarter-the incremental revenue gained from selling them has fallen. The impact of the subsidies is most evident in the fourth quarter, when many customers upgrade to get newly released iPhones, as well as new Android and Windows models. Given this, it would seem logical for Verizon and AT&T to begin pushing back against Apple by refusing to subsidize iPhones at the same level. Such moves, however, carry new risks. Sprint, bolstered by an investment from Softbank, could use any drop in subsidies to take market share. Softbank Chief Executive Masayoshi Son has a history of pricing aggressively and has expressed a willingness to endure short-term pain to gain scale.

Verizon's wireless-service margins climbed, year over year, in each of the first three quarters of 2012. AT&T also had higher margins in the first and second quarters, although margins fell in the third. But margins have become more volatile and seasonal, as phone sales increasingly occur in the fourth quarter, according to Sanford C. Bernstein. Verizon's full-year service margins will be around 46.8% in 2012, the research firm estimates, in line with 2010.

AT&T's fourth-quarter margins may not suffer quite as much as Verizon's. AT&T has always had a significantly higher percentage of users on the iPhone than Verizon, meaning it felt the iPhone impact last year as well. But AT&T also likely had fewer net new subscribers: around 750,000, UBS estimates, compared with Verizon's already announced figure of 2.1 million. That suggests most of AT&T's record quarterly smartphone sales of 10.2 million went to existing subscribers, meaning the company bore a high subsidy bill without seeing much additional revenue to offset it.

The two companies have had some success combating margin volatility by lengthening the time before subscribers can upgrade. In 2012, UBS estimates 30.7% and 30.9% of customers upgraded at Verizon and AT&T, respectively, compared with 36% and 35.6% in 2011. But upgrades should rise again in 2013, as the lengthened cycles come to an end. If Verizon and AT&T don't push back against the likes of Apple, they risk further margin pressure at the end of each year. Telecom investors used to a clear signal on margins may need to get used to the odd dropped quarter. Wall Street Journal

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