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iPhone May Drive Telecom's Paranoia In 2012


Words like détente and duopoly are regularly used by consumers and industry skeptics to describe the telecom sector, which is dominated by giants AT&T (T) and Verizon (VZ), as second tier players like Sprint (S), MetroPCS (PCS), Leap Wireless (LEAP), and T-Mobile USA struggle.

Despite moving to usage-based data pricing in 2011, AT&T and Verizon continue to add to their market dominance. But paranoia cuts both ways.

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Both carriers have spent billions to build networks to handle rising smartphone data loads, all with an uncertain payoff that's tempered by the safety of their 5% dividend yields.

Conflicting fears of concentration and uncertain capital investment returns in the telecom sector have now evolved with Verizon's move to a "share everything" plan, which allows families to bucket mobile devices, in addition to talk, text and data usage onto one bill. As investors weigh a fast changing industry, they should focus on carrier relationships with Apple (AAPL) as an early read on whether AT&T and Verizon are primed for rising returns on their network investment, or whether their feared "duopoly profits" will fizzle.

Verizon's pricing change indicates that it is focusing on adding smartphone and tablet devices to its network, while connecting phone bills directly to data usage, over a mélange of data, text and talk. When AT&T follows suit, both carriers will need to prove that device-based network growth -- led by smartphones like the iPhone -- can be done profitably.

Meanwhile, headwinds like subsidies to gain iPhone subscribers, consolidation among second-tier players, and the emergence of DISH Network's (DISH) as a competitor loom as threats to AT&T and Verizon.

For instance, Craig Moffett, a Bernstein analyst and sector skeptic, questions whether the center can hold on the prospective profits that some feared would gush into AT&T and Verizon, at the expense of consumers.

"I think the end of the year is going to look more like the beginning of the year than people think," says Moffett. By that he means a return to challenging revenue trends that put wireless investment returns at or below AT&T and Verizon's cost of capital, after they recently posted strong quarters.

"The big issue in the industry for investors is whether or not carriers can show better discipline in handset subsidies," says Moffett. Recent attempts by Sprint and Leap Wireless to add the Apple devices to their networks have hit shares, as investors anticipate the costs of subsidizing the iPhone.

But as Sprint and Leap Wireless add iPhones to pre-paid mobile plans, Verizon and AT&T's expected "share everything" plans may signal a willingness to continue subsidizing new iPhone users, which can cost roughly $500 a device. "Whether or not discipline sticks when a new iPhone arrives on the shelf remains to be seen," adds Moffett.

With the pending rollout of the iPhone 5, Jefferies analyst Peter Misek is skeptical that carriers will be able to cut their Apple subsidy habit, even if they can wean off of Google's Android. "We believe the iPhone 5 will be LTE-enabled and that the subsidy reallocation will likely help rather than hurt Apple," wrote Misek in a note to clients earlier in June.

In a note to clients after Verizon's plan change earlier this week, Moffett called the move "the most profound change to pricing the telecom industry has seen in twenty years," making the point that with plans based on fees per device, AT&T and Verizon are likely to add to their smartphone and tablet market shares. While Moffett concedes that's a positive for near-term growth, over the long-term, they may be undercutting the benefits of hard-won usage-based pricing, which was front and center of 2011 paranoia.

"For years, the telecom industry has thrived on obfuscation. Different prices for voice, text, roaming, wireless-to-wireless, calling circles, and times of day all conspired to make it more difficult to compare prices," notes Moffett. "Plansthat abandon distinctions between voice, text, and data will be simpler to compare... and price will therefore be a more prominent comparator. There's an easy way to beat a $10 per device surcharge. Price it at $9. Or $8."

Still, Moffett says that the tradeoff between increased market share and price commoditization is warranted.

As some expect the smartphone market to concentrate, consolidation may be more likely in the telecom sector, especially among second tier industry players. "I think both the FCC and DoJ recognize that there are benefits of scale in the industry," says Michael Wise, an attorney at Paul Hastings who focuses on antitrust and competition. "If Sprint or someone else came forward with an efficiency story to show that they could better compete with other players in the market, I think the agencies could be amenable to that argument," adds Wise of the prospect of M&A. Efforts will hinge on proving M&A aids consumers and could benefit from a broader definition of the wireless market, he adds.

Recently, Sprint has been reported to consider with tie ups with T-Mobile and MetroPCS. "It's easier to see how Sprint could do something with Leap and Metro, because they all operate on a CDMA network," notes Moffett of Bernstein Research. Consolidation may be helpful for some carriers, who've seen shares tumble over 50% in the past year as they struggle to add smartphones profitably.

Meanwhile, DISH Network's stated desire to build a wireless network and bring cheaper, better service looms as an increasingly viable threat to the entire carrier balance of power. After building a satellite TV giant to take on cable providers like Comcast (CMCSA) and Time Warner Cable (TWC), DISH Network chairman Charlie Ergen has his sights set on Verizon and AT&T, even if arcane spectrum regulatory approvals remain a hurdle.

"I do expect the FCC's rulemaking, once completed, to permit the build-out of a terrestrial wireless network," says Bryan Kraft, an analyst with Evercore Partners.

After regulatory comments regarding spectrum earlier in June, Deutsche Bank analyst Brett Feldman wrote in a note to clients that "DISHremains on course to alter the wireless landscape over the next few years."

Feldman cites a pending approval of spectrum deals cut between Verizon and cable companies like Comcast as an early read on whether the FCC will allow DISH to build a national wireless network. "Whether DISH actually builds a network or partners with other carriers remains to be seen, but suffice it to say that DISH seems likely to emerge from the rulemaking as the holder of what is arguably the most valuable portfolio of unused spectrum in the US," he adds.

All things be told, after years of consumer and regulatory fear that AT&T and Verizon will conspire to raise prices as consumers become smartphone addicts, the iPhone and a quickly changing wireless landscape may be conspiring against any hidden agenda for monopoly pricing.

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