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One Way Apple Could Kill Its Empire

There's no question that Apple (AAPL) benefits from its ability to extract considerable subsidies from wireless carriers.

While hardcore fan boys and girls would happily shell out $600 for an iPhone, most iPhone owners might opt for another, less expensive device in the absence of a subsidy. At the very least, they might be less likely to take the plunge multiple times as Apple introduces new iterations of the smartphone.

Consider the following admittedly rough math. We can safely say that wireless carriers eat about $400 for each iPhone sold. On an estimate of 30 million iPhones sold per quarter, you're looking at about $12 billion in subsidies every three months. One report estimates that it costs Apple $196 to make an iPhone 4S.

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In its most recent quarterly report, Apple credits iPhone with the company's impressive gross margin:

The gross margin percentage in the second quarter of 2012 was 47.4% compared to 41.4% in the second quarter of 2011. The gross margin percentage for the first six months of 2012 was 45.9% compared to 39.9% in the first six months of 2011. The year-over-year increase in gross margin was largely driven by favorable sales mix towards products with higher gross margins, particularly iPhone, lower commodity and other product costs, and leverage of fixed costs on higher net sales.

In the same report, Apple warns that these subsidies might not last forever:

Carriers providing cellular network service for iPhone typically subsidize users' purchase of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company's agreements with these carriers or in agreements the Company enters into with new carriers.

Margins, however, at wireless companies are not quite as hot as they are at Apple. Of course, it all depends on how you do your calculations.

Many wireless carriers, such as Verizon (VZ), report wireless margins using service revenue, focusing less, if at all, on total revenues. As Verizon explains in its most recent quarterly report:

Service revenues primarily exclude equipment revenues in order to reflect the impact of providing service to the wireless customer base on an ongoing basis.

In other words, someday, as a result of widespread smartphone adoption, which leads to increased data usage among customers, we'll make our money back. Therefore, we report only service revenue because that's all that matters in the long run.

In the most recent quarter, Verizon saw wireless service revenue increase 7.7%, year-over-over, from $14.3 billion to $15.4 billion. Data revenue accounted for 42.9% of service revenue, clocking in at $6.6 billion for the quarter ending March 31, 2012. That's up from 38.1% and $5.5 billion in the year-ago period.

From a margin standpoint, wireless EBITDA service margin increased from 43.7% to 46.3% between the periods ending March 31, 2011 and March 31, 2012. Overall wireless operating income margin moved from 25.8% to 28.6% over the same timeframe.

Apple CEO Tim Cook is not concerned much by the discrepancy. Cook discounted the notion that wireless carriers might pull back on, or eliminate, subsidies all together, noting on the company's most recent conference call that iPhone reigns superior to competing smartphones, has more loyal customers and the subsidy is not all that "large relative to the sum of monthly payments across a 24-month contract period."

Cook's optimism fails to take into account the other costs associated with servicing iPhone data hogs and other smartphone users. Somebody has to buy and maintain the infrastructure devices such as iPhone require to thrive and survive. Certainly, Apple does not send cash to Verizon, AT&T (T), and other companies to pay for wireless spectrum.

It also blows off an emerging consensus that these subsidies will not last forever. In fact, BTIG analyst Walter Piecyk downgraded AAPL to neutral from buy, in part, because of concerns over subsidies. In doing so, he cited the costs wireless carriers incur to drive user revenue as one reason why the generous subsidies might come to an end sooner rather than later.

Call Piecyk an idiot all you want, but since his downgrade in early April, and while everybody was busy upgrading the stock and setting stratospheric price targets, AAPL is off about 11%.

Another observer, wireless industry expert Whitey Bluestein, expects Apple to dip into its cash pile to compete with the likes of AT&T and Verizon. Bluestein thinks Apple has not made the move yet, thanks in large part to the subsidies it receives from carriers.

While I thought the dividend and buyback decision by Cook is a bad move that foreshadows a pivotal and profound shift in Apple's Jobsian culture, this type of move could really doom the company. Empires often begin to die when they get too big for their britches.

First off, if Apple goes it alone, there's no way in the world it sells iPhone for $600. It will absolutely need to knock the price point down or face backlash from consumers who expect a seemingly "free" ride. This alone will pressure margins.

Second, Apple needs wireless infrastructure if it truly intends to compete directly as a mobile services provider. While Bluestein points out that Apple "has more than 250 million credit cards on file for iTunes users who could be billed directly for wireless service," it does not have spectrum and the structures in place to buy and maintain that spectrum at the present time (as far as we know).

It could always lease or buy spectrum from an AT&T, Verizon or, keep this in the back of your mind, DISH Network (DISH), but that arrangement turns the tables. It allows the wireless carrier or a shrewd Charlie Ergen at DISH to tighten the screws on Apple.

Just as Apple does not operate from a position of strength in its quest to buy premium content for iTV, the company could find itself on the unfamiliar short end of the stick if it looks to oppose AT&T, Verizon, and other powerful telecommunications around the world.

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