Apple 's iPhone Subsidy 'iPain' May Be Over for Verizon, AT&T

TheStreet.com

Updated to reflect Gimmie Credit comments starting in 14th paragraph.

NEW YORK (TheStreet) -- Heading into first quarter earnings, investors appear to be worried Apple AAPL is losing its ability to sell premium priced iPhones amid competition from cheaper Google GOOG -Android powered devices and new product launches from Microsoft MSFT and Research In Motion RIMM .

Fundamentals are also in question as Apple faces its first potential quarterly profit drop in a decade and a sharp slowdown from the near 25% growth rate the world's largest tech giant posted at this time last year.

But the real story to Apple's earnings may hinge on a potential change to the company's relationship with wireless carriers Verizon VZ and AT&T T in 2013 and less with its battle against Google's Android ecosystem.

The key for investors to consider is whether a long standing relationship between Apple and wireless carriers is about to turn from an earnings windfall for the iPhone maker to a growth drag starting in the New Year.

Already, some expect fourth quarter earnings to be a turning point.

As seen in Verizon's VZ weaker than expected earnings - which were cut multiple times into the report - Apple's iPhone 5 launch and millions of subsidized quarterly handset sales by the carrier proved to be a significant profit and margin drain.

But some, notably Evercore Partners telecoms analyst Jonathan Schildkraut, expected earnings to be light and recommended buying Verizon's shares were they to fall on the weak report. After falling over 2% in pre-market trading on Tuesday, Verizon shares recovered and closed up on the day, validating Schildkraut's analysis.

So what gives?

Schildkraut and other analysts forecast a surge in fourth quarter subscriber additions and handset upgrades for Verizon and AT&T, which would hit margins because of subsidy costs. In the wake of the weak reports, those analysts also expect subscriber growth and rising revenue per user to again be at the forefront of investor focus, as it was through the first nine months of 2012.

In an analyst call following Verizon's earnings - which showed over 2 million customer additions and revenue per account rising 6% to $146.80 a month - the company forecast its wireless margins could be as high as 50% in 2013, representing strong year-over-year growth. "We believe the business is becoming increasingly seasonal, but is still capable of expanding profitability," wrote Schildkraut of Evercore, in a note to clients.

Schildkraut expects a fairly similar dynamic to play out in AT&T's fourth quarter earnings, which are due on Jan. 24.

The real question now is whether the fourth quarter iPhone 5 earnings hit to carriers represents a peak of subsidies in an increasingly competitive and commoditized smartphone market. The carriers have a lot to prove -- iPhones are projected to represent between 75% and 80% of new handset activations in the quarter, according to Evercore.

"With Verizon now feeling the impact of iPain, and smartphone penetration reaching 58%, our concern shifts to what the company can do to mitigate the margin hit during future iPhone refreshes," Mike McCormack, a telecoms analyst at Nomura wrote in a note to clients.

On Tuesday, Cannacord Genuity analyst Greg Miller saw the prospect of falling iPhone subsidy costs and expanding wireless margins as a reason to upgrade Verizon's shares to 'buy' from 'hold' for the first time in over three years.

"We expect the impact to be temporary and device subsidies to be a source of margin expansion on a full year basis... This is primarily driven by less aggressive device promotions, longer upgrade cycle and the potential of lower priced smartphones, as Verizon increasingly focuses more on profitability than on mere subscriber growth," wrote Miller.

Product releases such as Research In Motion's rollout of BlackBerry 10 may be another opportunity for carriers to gain ground in the subsidy battle.

"The introduction of the new Blackberry may possibly drivesubsidies down, thereby helping margins," writes Gimmie Credit bond analyst Dave Novosel, in a Jan. 23 note to clients.

That's where Apple's growth concerns begin.

On Tuesday, UBS analyst Steven Milunovich cut his earnings estimates for Apple on an expectation that the company will see a drop in the average selling price of its handsets as customers flock to the cheap iPhone offerings.

"We have moderated our iPhone price estimates because the survey finds that demand for storage has declined from about 30GB with the 4S to 20GB for the iPhone 5 with fewer customers opting for the 64GB model... Demand for older models has increased from 33% in the 4S cycle to 50% so far for the 5," wrote Milunovich, in a note to clients.

Such expectations might indicate a commoditization of Apple's iPhone products in the eyes of consumers and warrant a subsidy change in the New Year. That's especially the case given forecasts of Apple's falling market share relative to Google's Android ecosystem.

"Given the strong showing from Samsung, under most scenarios for iPhone shipments in the December and March quarters, Apple will lose smartphone unit share y/y, raising concern about the on-going dominance of iPhone," wrote Citigroup analysts in a preview of Apple's earnings.

"Based on our understanding of the iPhone5S (same form factor), we do not view the forthcoming launch (scheduled for the second quarter of 2012) as a catalyst for market share regain," the analysts add.

If buyers of subsidized smartphones are increasingly turning to low-cost iPhone options or cheaper non-Apple products, the fourth quarter of 2012 might indicate the peak of handset subsidies paid by carriers.

Such a scenario would turn Apple's relationship with the likes of Verizon and AT&T from a money-making machine to a growth drag. It would also clear the air on a hazy outlook for the telecom sector.

Watch Apple and AT&T's guidance, in addition to analyst and investor commentary to see if language surrounding the direction of subsidies points to a fourth quarter 2012 peak.

For more on Apple's shares, see why investor amnesia might make the company an obvious 2013 value

-- Written by Antoine Gara in New York

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