AT&T Will Focus On Profitability As iPhone 5 Is Here

With Apple (NASDAQ:AAPL) announcing its iPhone 5 Wednesday, wireless carriers in the U.S. are preparing themselves for what could be one of the biggest device upgrade cycles in the history of electronic devices. AT&T (NYSE:T), in particular, will be looking to make the most of this considering it has had the iPhone for the longest time and has also been outselling its peers even after losing exclusive access to the device in early 2011. In preparation for the iPhone launch, the carrier has started offering early bird discounts on the device to select iPhone customers who want to upgrade before the end of their two-year contract period. ^[1] However, those choosing to avail the early upgrade discount will have to pay $250 over the subsidized iPhone 5 price and sign a new two-year contract.

What this means is that someone choosing to upgrade to an entry-level iPhone 5 before the end of their contract period will need to pay $449 only, instead of the unsubsidized $649 price, assuming Apple maintains status quo on iPhone pricing. Since these customers will be locking themselves for an additional year, this is a good move by AT&T as it has to subsidize the device by only $200 for the extra year. AT&T usually pays a subsidy of $450 for every new iPhone purchase in exchange for a two-year contract – implying a subsidy of $225 for each year of the contract.

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Subsidies have served their purpose

The offer is however nothing new. AT&T had changed its early upgrade policy in April last year, increasing the fee from $200 to $250 and thereby decreasing its subsidy from $250 to $200. The policy change was part of a broad organizational plan to gradually improve margins and reduce the impact of burgeoning subsidy costs. The subsidies, that were initially seen as driving up the demand for smartphones and data services, have started becoming more of a liability now that the purpose of subsidies has largely been met. Data demand is exploding and spectrum resources are not enough to meet that demand. Thus, it makes sense at this point to roll back the subsidies gradually while taking care to not impact smartphone demand too much.

More than 60% of AT&T’s value comes from the wireless division, by our estimates. Most of this value comes from the constantly growing demand for mobile data and a diligent management of subsidies could help AT&T extract more value from this division as data demand continues to spike.

Focus back on profitability

It is therefore a good sign that the carrier is slowly seeing discipline in meting out handset subsidies and operational efficiency return to its ranks. Last quarter saw AT&T’s wireless EBITDA margins come in at a strong 45% and operating margins at its best-ever 30.3%. The focus on profitability is being driven not only by lowering subsidies but also an attempt to lengthen the handset replacement cycle by levying additional upgrade fees. Recently, AT&T doubled the upgrade fees it charges subscribers for smartphone upgrades to $36, a ploy that we believe has not only had a positive impact on margins but also lowered the number of handset upgrades. (see AT&T Doubles Smartphone Upgrade Fee; Looking for iPhone Subsidy Relief) AT&T sold only about 5.1 million smartphones last quarter, down from the 5.6 million it sold during the same period last year.

However, with the holiday quarter coming up and the iPhone expected to see very strong sales, AT&T could be seeing margins come again under pressure, as it generally does at the back end of the year. Last year’s holiday quarter had seen AT&T’s operating margins drop by almost a half y-o-y. It should therefore come as a welcome relief to investors that AT&T has some of these cost-reducing policies in place to mitigate the upcoming subsidy impact to an extent.

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1. AT&T Offering Early iPhone Upgrades to Potential iPhone 5 Buyers, Gottabemobile, September 4th, 2012 [↩]