AT&T's iPhone puts Verizon on the defensive
Rising phone subsidies up the ante in wireless war
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| Verizon's Seidenberg is under pressure to boost phone subsidies as AT&T scores early success with the new iPhone 3G. |
NEW YORK (Fortune) -- Verizon CEO Ivan Seidenberg used to bristle about how Apple was crowned a wireless success without earning the title. But with Apple announcing it sold 1 million 3G iPhone in just three days, the AT&T/Apple partnership is starting to look like a formidable contender.
Seidenberg's ire is somewhat understandable, Verizon (VZ, Fortune 500) hasn't exactly enjoyed smooth sailing this year, the stock is down 20% amid a widespread market selloff. The ride has been particularly choppy at Verizon given its rapidly declining land line count, soaring debt and its costly no-win video expansion effort. Until now, Verizon has been able to deflect scrutiny of its weaknesses by delivering a strong performance in wireless with strong profits and market share gains.
That winning course is likely to change as wireless growth slows, the economy falters and competition heats up.
While still early, AT&T's (T, Fortune 500) blockbuster $199 iPhone promotion looks to be a tremendous hit. And if last year's pattern holds, about 40% of the iPhone customers will be defectors switching service from other telcos, namely Verizon, Sprint (S, Fortune 500) and T-Mobile (DT).
"It's another home run," says IAG Research analyst Roger Entner. "And for better or worse, the other carriers don't have that iconic device."
Verizon has been through this a few times before, with AT&T initially having an exclusive deal with Motorola's (MOT, Fortune 500) Razr and last year with Apple's (AAPL, Fortune 500) original iPhone. After some initially challenging weeks, Verizon soon saw order trends return to normal. But this time around, Verizon is up against a cheaper faster iPhone and the customers that it will be losing to AT&T aren't just your rank-and-file subscribers with $50 monthly bills, but more of the $95-plus a month variety.
In an effort to stop the stampede of high-paying customers out the door and attract new subscribers, Verizon will have to spend more in the form of phone subsidies covering a big portion of the phones price. But spending more to steal customers can lead to a bit of a bloodbath - just look at the triple-play battle against cable.
"We see weakness in the overall industry," says Citigroup analyst David Hamburger. "And then at that stage it becomes a market share grab. The ones with the best products and best networks have the advantage. And after that it becomes a matter of price, and the ones with the best price will win."
To be sure, the subsidy war can take a toll on profits. AT&T, which is underwriting between $300 to $400 for each customer's iPhone, warned last month that the heavy cost would cut about 11 cents off its bottom line for the next two years.
For its part, Verizon defends the higher spending to rope bigger customers. Company spokesman Jim Gerace says subsidies are going up because phones are more expensive and more advanced - think e-mail, GPS, Net browsing. "Those devices drive higher revenue," he says.
Higher subsidies, however cut into cash flow, the engine that keeps the enterprise humming.
Verizon has the fattest margins in the wireless industry, with a 32% operating margin - that's the percentage of cash remaining after business expenses. That margin has widened from 30% a year ago, and some analysts expect it to grow to 35% in 2010. For comparison, AT&T's operating margin is 28%.
Analysts and investors like to see widening margins since it shows costs aren't outpacing sales.
"Verizon is valued on the amount of free cash flow they generate," says Citigroup's Hamburger, a debt analyst who has been one of the first to raise a warning flag on Verizon's ballooning debt amid a more challenging economic climate. "Margin compression will affect that."
Last month, Verizon agreed to buy smaller rival Alltel. The deal calls for Verizon to take on $28 billion in additional debt, putting its total debt load at $63 billion. And with the higher costs of competition in Verizon's wireless unit - its showcase business - that debt burden will get heavy.
"We see a gradual deterioration in the overall credit profile at Verizon," says Hamburger. 
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