Apple's "Killer" iPhones, Killing Phone Company Margins

Verizon, now down 6% for 2012, reported slightly disappointing results as a result of big sales of 1.2 million Apple iPhones in the  4^th quarter of 2011.  Reportedly, analyst expectations had been in a range from 980,000  to 1.3 million units with the blended estimate at 1 million iPhones for the quarter. 

While this is good for Apple, it seems clear that selling iPhones is not really a short term winner for the phone companies. The operators push consumers toward smart phones because they use far more bandwidth which is what they sell. The problem is that Apple charges so much for the devices that the phone companies have to substantially subsidize the price of the phones to us, the users to incent us to buy them. The justification is short term pain for long term gain. 

Verizon reported earnings that disappointed analysts because of the high uptake by customers of smart phones and particularly iPhones in the quarter.  Verizon Wireless’  EBITDA (earnings before interest, tax, depreciation and amortization) dropped to 42.2% of service revenues from the corresponding number of 47.8% at the end of the third quarter. They hope, of course, and it is how the phone companies justify paying Apple so much for their phones, is that iPhone buyers will use their phones far more than before and generate future profits.

Apple maximizes its profits by gouging for its phones. Demand at the moment is very high (maybe peaking?) so Apple is riding that wave of popularity all the way to the bank, for now.  Fifteen years ago, it was the Motorola flip phone that everyone wanted. Then it was the super slim Motorola RAZR.  Nokia was busy garnering share after the RAZR peaked and Motorola collapsed. Next was the Blackberry which business users loved for its ease of emailing even if the phone feature wasn’t the best.  RIMM diminished interest in higher end Nokia phones.  Motorola, Nokia and Blackberry are now in the junk heap.  Eventually, Apple will be succeeded with an even better phone.  Who will invent it and when is anybody’s guess?  It’s not this quarter, it seems.  Just remember that we have more than a decade proving that nobody in this business stays on top for long. Chronologically, Apple is long in the tooth at the top of the heap. Of course, the iPad has helped Apple, too, and it's another device that promotes extensive bandwidth use so the phone companies love it as well.

Rather than devices, phone companies sell bandwidth. Anything that drives higher usage is good for them.  AT&T was first into the iPhone space followed by VZ. Phone usage was so high for T that it crashed its network even as it garnered increased market share.  In the end, it made people so angry they couldn’t wait to bolt to Verizon when they had the chance. Initially, Verizon was bragging that its network was better and faster in TV ads. Eventually, it learned that it, too, had to limit the bandwidth hogs.

Sprint watched its market share collapse as it was unable to offer the iPhone until recently.  Apple extracted a high price from Sprint but S management felt they had to pay through the nose to have the phone just to be able to stay in the game. If Apple’s pricing hurt strong Verizon’s margins, what is it likely to do to Sprint?   

Joan E. Lappin CFA       Gramercy Capital Management

Mrs. Lappin, Gramercy Capital and its customers own shares in Nokia at this time.

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