AT&T’s Challenges In Innovation And Competition

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In a prelude to upcoming fourth quarter earnings release, AT&T (NYSE:T) announced it sold a record 10 million smartphones in 4Q12, and we estimate around 8 million of these to be Apple’s (NASDAQ:AAPL) iPhone (see AT&T’s Smartphone Sales Point To A Strong Holiday Quarter For Apple).  Before we pop the champagne, it’s important to understand what this truly means for AT&T and visit a few key drivers that will impact the business over the next few years.

By virtue of being the oldest player in the telecommunication industry, AT&T is considered the grandfather of the American Telecom Sector. However, its lack of strategic planning coupled with poor service and underestimating competition has put the company in a tough situation. In a fast paced and constantly changing sector, AT&T has proven to be slow to adapt and this has hurt the company in the past.

See our complete analysis for AT&T here

EBITDA Margin Pressure

An entry level iPhone without subsidy costs around $650 while AT&T sells the same for $200 under a 2-year contract. This translates to $450 subsidy on an iPhone or nearly $3.6 billion for 4Q just on iPhone. Surely, AT&T hopes to recover this investment over the 2-year contract period through higher internet revenue per subscriber, and we feel the short term impact on the margins in 4Q12 is what caused the stock to drop nearly 3% on the holiday sales figure release. The pressure on margins will continue as manufacturers continue to launch high-end smartphone models and AT&T will be forced to subsidize it to hold its ground in a fiercely competitive market place.

Long History of Mismanagement

Everyone remembers the time when having an iPhone on AT&T meant borrowing your friend’s non-AT&T phone to make calls. AT&T’s mismanagement of the iPhone has left consumers skeptical of the carrier’s ability to adapt to fast evolving technologies, and its poor understanding of the industry became evident when it bet big on HSPA while Verizon (NYSE:VZ) made strategic investments in 4GLTE. The popularity and superiority of the LTE network forced AT&T to make a late stage $14 billion investment in LTE to match Verizon’s data prowess (see AT&T Speeds Up LTE Rollout With An Eye On Mobile Data Growth). This is a poor reflection of the management’s strategic planning and inability to gauge consumer needs. This debacle had led to a significant spike in mobile investment, and we believe going forward AT&T will need to maintain this level to be competitive with Verizon.

The intense competition among the carriers mean AT&T has little room to make mistakes and we wouldn’t be surprised going forward, AT&T will simply follow Verizon and fail to innovate thus relinquishing its position as an industry leader.

Little Bargaining Power

Research in Motion (NASDAQ:RIMM) recently announced that all the major carriers including AT&T will be offering its Blackberry 10 handsets that are slated to be launched later this month (See RIM To Launch Six BB10 Smartphones In Make-Or-Break Year). While this is good news for RIM, we believe AT&T which for far too long has ridden the success of the iPhone will not be taking any chance with future device manufacturers to avoid the possibility of market share loss. AT&T is backed into a corner where Verizon is quickly closing the gap in the lucrative smartphone category. Verizon announced it sold 9.8 million handsets (see Verizon’s Q4 Smartphone Sales Imply Another Big Holiday Season For Apple) compared to AT&T’s 10 million. The only silver lining for AT&T is Sprint’s distraction with DISH Network (NASDAQ:DISH) over Clearwire (NASDAQ: CLWR) eliminating a potential short term threat (see How Much Pain Can Dish’s Clearwire Bid Inflict On Sprint?). While its important to provide a broader choice for consumers, we feel AT&T is in a difficult position to negotiate as it can’t afford to lose any further market share in the smartphone category.

See our complete analysis for Sprint here

End Of Landline Era

With increasing penetration and usage of cell phones, landlines are undergoing a slow and painful death. AT&T’s legacy business in this segment has been steadily declining over the years. We expect this trend to continue, adding pressure to the wireless business to outperform. Margins have been deteriorating as the American consumer shifts from a traditional family landline to individual cellphones.

This trend has a far reaching impact because a large number of AT&T landline users are also AT&T wireless customers. These customers enjoy loyalty discounts coupled with the benefit of shared data plans and ease of billing that has made them stick to AT&T wireless. With landlines disconnected, these customers now have the freedom to shop around for better wireless deals and service. Verizon which is perceived in the market place as technologically superior in the wireless category will gain market share from AT&T.

With Verizon close on its heel and quickly closing the gap, AT&T will be under immense pressure to meet market expectations. As long as management doesn’t make hasty strategic decisions or lose focus, the company will be able to navigate the bumpy ride ahead.

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