Here's the Real Reason Investors Should Be Worried About Apple's iPhone 5

Antoine Gara - The Street  JAN 14, 2013 2:30 PM

Investors should be worried about the iPhone 5... and it has nothing to do with Apple's shares.


In the daily speculation on everything Apple (NASDAQ:AAPL), investors may be missing what could be the biggest story to emerge from the iPhone 5 after its September 2012 release.

The release of Apple's newest iPhone and a lineup of tablet products will provide a key fourth-quarter test to the sustainability of profit margins for telecom giants Verizon (NYSE:VZ), AT&T (NYSE:T), and Sprint (NYSE:S).

A recent Wall Street Journal report indicates that Apple may be cutting orders with suppliers who build the iPhone 5, potentially indicating less than anticipated demand for the company's newest smarthphone. The report, which cites anonymous sources, adds to a frenetic 2013 in the Apple rumor mill.

Previous media reports indicated Apple might start selling iPhones as low as $99 by year-end, however, Phil Schiller, Apple's head of marketing quickly nixed such speculation.

Apple, at its 11 price-to-trailing earnings multiple, seems to attract an ever growing number of bulls who see the cheap multiple attached to America's most profitable company as an obvious 2013 value -- and skeptics who call the company a value trap and foresee a commoditization of its premium-priced tech products.

In the interim, the more urgent iPhone 5 story may have little to do with Apple or its shares.

As telecom giants Verizon and AT&T prepare to report fourth-quarter earnings, analysts are bracing for the full impact of smartphone subsidies and, in particular, the earnings hit that might come from an entire quarters worth of subsidized iPhone 5 smartphone sales.

Already, carriers have indicated that Apple's newest smartphone will have an impact on earnings, even if trends like underlying subscriber and average revenue per user growth indicate a strong outlook for the industry's top players.

Earlier in January, Verizon CEO Lowell McAdam said that the company added 2.1 million wireless subscribers in the fourth quarter, "a truly impressive result," according to Craig Moffett of Bernstein Research. Still, the oftentimes bearish telecom analyst noted such subscriber growth may come at a cost, highlighting two January 8-K filings Verizon made with the Securities and Exchange Commission that indicate wireless service margins for the fourth quarter might fall on a year-over-year basis.

A decline in wireless margins as a result of subsidized new iPhone and Google (NASDAQ:GOOG)- Android operated handsets would cut against three successive quarters where Verizon's margins have improved, according to a Monday note by Moffett. It means investors in the likes of Verizon and AT&T might have to temper expectations what the sustainable level of wireless profitability is.

Such a scenario of fourth quarter weakness could either vindicate long-time skeptics of wireless profitability. A moderate earnings hit might give telecom investors little reason to believe the industry's economics aren't on a long-term uptrend headed into 2013. Moffett of Bernstein Research and other industry bears have long pointed to a looming iPhone handset upgrade cycle as contradicting forecasts of structurally higher profits for wireless carriers.

"Verizon's margin for full year 2012 will be something like 46.8%, or perhaps a bit lower. In 2010, Verizon's margin was... 47.0%. They're actually flat over the timeframe the margin expansion thesis gained popularity," writes Moffett. "For the foreseeable future, however, margin volatility rules...and that dictates that the sloppy margins the industry will surely post in Q4 must not be ignored," the analyst adds.

Other analysts across the telecom sector have slowly been cutting at their earnings expectations for Verizon an AT&T heading into the fourth quarter.

In an early December research note, bullish comments made by AT&T about overall quarterly smartphone sales caused Guggenheim Partners analyst Shing Yin to cut fourth-quarter earnings and margin forecasts for the carrier.

Given an estimate of 10 million smartphone sales in the fourth quarter - 80% of which Yin calculates are iPhones -- the analyst now sees wireless EBITDA margins at 31% for the quarter, bringing overall margins at or below 40% for the year.

"We believe 2012 upgrade rates had benefited from a one-time impact related to upgrade policy changes made in early 2011. Now that this one-time impact has passed, we expect upgrade rates, and subsidy expense, to be higher in 2013," wrote Yin, in a December 6 note to clients that followed comments made by AT&T's head of wireless.

That insight into what the analyst calls the "basic principles of smartphonomics" caused Yin to cut AT&T's price target from $35 per share to $33. Yin made a similar downward revision following Verizon's January disclosures on smartphone sales and subscriber growth.

The potential deterioration in wireless margins for growing industry players comes at a time when the likes of Sprint, the industry's number three player, are investing billions to grow out wireless networks and take on smartphone users. So far, however, efforts to handle the iPhone and slow-moving network upgrades have led to subscriber losses that raise more questions then they answer

For investors growing tired of the tick-by-tick hysteria surrounding Apple's value and shares, a focus on the iPhone's impact on overall telecom carrier profits may prove to be a far more revealing exercise.

Watch wireless margins to either provide a wrench in the profitability story of telecom giants, or to quiet skeptics once and for all.