Can AT&T meet iPhone network demands?

When AT&T cut the deal that made it the exclusive U.S. distributor of Apple's iPhone, the carrier bet correctly it would attract millions of new subscribers. What it didn't bargain for: the huge demands the device would impose on AT&T's network. Thanks largely to the iPhone's ability to surf the Web, play videos, and run all manner of software-based tools called apps, by some estimates AT&T now handles more than twice as much smartphone traffic as any other U.S. carrier. Or mishandles, as the case may be. In areas where the devices are most common, such as San Francisco and New York, the iPhone often drops calls or fails to deliver Web access at speeds implied in Apple ads.

The shortcomings leave AT&T under pressure to make its network iPhone-ready or risk losing its edge in smartphones. The company is almost sure to lose the exclusive partnership with Apple (AAPL), possibly as early as next year. That would open the door to AT&T losing millions of customers as iPhone owners depart to rival carriers such as Verizon Wireless. More important, AT&T would have wasted a golden opportunity to become the clear leader in the multibillion dollar market for wireless Web access. "Nobody is in the same boat we're in," says AT&T Chief Technology Officer John Donovan. "We're shaping the landscape for the whole industry, and I relish the opportunity to be the first to figure it out."

Odds are against AT&T. Many of its 60,000 cell towers need to be upgraded. That could cost billions of dollars, and AT&T has kept a lid on capital spending during the recession—though it has made spending shifts to accommodate skyrocketing iPhone traffic. Even if the funds were available now, the process could take years due to the hassle and time needed to win approval to erect new towers and to dig the ditches that hold fiber-optic lines capable of delivering data. And time is ticking. All carriers are moving to a much faster network standard called LTE that will begin being deployed in 2011. Once that transition has occurred, the telecom giant will be on a more level playing field.

Tailoring capacity for the Super Bowl

AT&T is getting a move on. It has upgraded much of its network, including in Manhattan and parts of San Francisco, to airwave frequencies capable of providing stronger signals. The company plans to add 2,100 new cell towers by 2011, while upgrading thousands of existing ones so that the system delivers data at twice the speed now available.

One of the biggest choke points in AT&T's network is found in what's called back-haul capacity, or the size of the pipe that connects cell towers to the Internet, according to a person familiar with the matter. AT&T is trying to remedy this shortcoming by increasing its back-haul capacity. Donovan tells BusinessWeek that the company has nearly doubled the number of these connections it plans to add this year. While it had planned on adding 55,000, it now plans to add 100,000 to accommodate skyrocketing mobile traffic.

And AT&T is making big changes in how it plans and runs the network. In the days when a cell phone was just for voice calls, it was easy to forecast network capacity across large regions. But in February, AT&T began creating specific plans for 295 individual cities. "Green Bay is a lot different than Los Angeles," says Donovan. The company even has a team whose job is to tweak network reception at big events such as the Super Bowl—say, to shift from a torrent of phone calls as fans look for each other before kickoff to then deal with a flood of texting and photos once the game has begun. "No other carrier is even close to that degree of sophistication," Donovan claims. "We're solving problems for the world in how to deal with these loads."

Apple spokeswoman Natalie Kerris says the company is pleased with the progress made by AT&T. Still, an executive familiar with the partnership says the companies have at times locked horns over AT&T's inability to handle network demands. The executive says some Apple staffers fumed last year when AT&T told them of its plans to hype cell tower upgrades without investing in backhaul capacity. The concern was that AT&T's improvements might make it appear people were getting a strong signal on the phone, though the lack of backhaul pipes might still interfere with their phone calls or Web surfing. Apple was "dumbstruck," the person says. "For 50% of the iPhone customers, there would be no benefit."

Limits to how fast AT&T can move

Also vexing to Apple was AT&T's inability to support Multimedia Messaging Service, a technology offered by other carriers that lets consumers easily attach photos and video to brief messages, say two people familiar with the matter. Apple—which famously refuses to share product plans even with close partners—told AT&T over a year ago that it hoped to offer MMS in mid-2009, one person says. "Apple felt like they'd given AT&T huge amounts of warning and unprecedented insight into its product roadmap, only to find that AT&T couldn't react," the person says. Donovan says he recalls no friction over the matter, and reconfirms that AT&T hopes to add MMS support by "late summer."

To be sure, Apple has contributed to coverage problems as well. The original iPhone shipped with glitches in its communications software that led to dropped calls. And while AT&T typically likes to hand out thousands of units of new phones so they can be tested as broadly as possible, two sources say Apple gave the carriers only a few hundred.

At this point, both companies say they are making fast progress. Donovan says an internal metric of customer satisfaction has risen 30% over the past four months. The company declined to divulge exact data.

But the challenge is only getting bigger—and quickly. Not only are iPhone sales still red-hot, but customers are downloading more of the 65,000 programs available on Apple's online App Store. That gives them one-click access to an array of wireless services unimagined when the store opened a year ago. Donovan says it's not uncommon for iPhone owners to check a stock 40 times a day. "Anytime a Do Not Walk sign flashes in Manhattan, people pop on their iPhones for that 30 seconds," he says. Many of these services involve video, which chews up vastly more bandwidth than making a simple call or sending a text message.

And there are limits to how fast AT&T can move. While it may take only a few weeks to deploy new-fangled wireless gear in a city's cell towers, techies could spend months tilting antennas at the proper angle to make sure every square foot is covered. It can take two years to get approval for new towers, or to dig fiber-optic cable ditches.

Economics is another problem. Investing in a top-notch network may be critical to keep iPhone owners happy, but it does nothing for Ma Bell's cash flow. Not only could it cost billions of dollars, but it may not bring in much additional revenue. Under the arrangement with Apple, AT&T gets only a flat monthly rate per line for unlimited data usage, normally $30. Extra revenues to use all those App Store apps are shared by Apple and the developer; AT&T doesn't see a penny. "AT&T has a very tough decision to make: How many customers are they willing to piss off?" says Michael Howard, principal analyst with market research firm Infonetics. And, when Apple's exclusive ends, "how many will leave for other carriers?"

Burrows is a senior writer for BusinessWeek, based in Silicon Valley.