Q4 smartphone sales to hit record, but wireless operator margins won't

Mike Dano

The fourth quarter of 2011 likely will be a blowout in terms of smartphone sales. But that doesn't mean the nation's wireless carriers should break out the expensive Champagne to celebrate.

Instead, most investment analysts see a short-term drop in carriers' revenues due to the subsidies they pay on smartphones.

For example, Jefferies & Company predicts Verizon Wireless (NYSE:VZ) will report retail postpaid net adds above 1.1 million in the fourth quarter. (Wells Fargo expects Verizon to post 1.3 million net adds, according to the Wall Street Journal.) Similarly, AT&T Mobility (NYSE:T) last month predicted it could sell up to 9 million smartphones in the fourth quarter, destroying the carrier's previous quarterly smartphone sales record of 6.1 million, notched in the third quarter of 2010.

But those sales will come at a price. Jefferies & Company lowered its fourth quarter 2011 estimates on Verizon's margin to 43.3 percent from 45 percent due to the subsidies the carrier pays on its smartphone sales (carriers can pay up to $400 in subsidies for each smartphone they sell, an expense typically recouped in monthly service fees).

Analysts generally blame the mid-October release of the iPhone 4S (and the introduction of a free iPhone 3GS on contract at AT&T) for the explosion in smartphone sales. Apple (NASDAQ:AAPL) said it sold a whopping 4 million units of its new iPhone 4S during the device's first weekend of sales. The launch also marked the availability of an iPhone across three major U.S. wireless carriers: Verizon, AT&T and Sprint Nextel (NYSE:S), which offered the device with unlimited data. (Interestingly, Jefferies & Company recently wrote that "our checks suggest very little impact [on Verizon] from Sprint selling the iPhone with an unlimited plan." For its part, Sprint has said it continues to expect to report sales of at least 1 million iPhones in its fourth-quarter earnings report.)

For Verizon though, the release of the iPhone appears to have cut into its LTE efforts. The carrier launched LTE at the end of 2010, but as Paul Kapustka at PCWorld pointed out, Verizon's LTE net adds haven't really caught fire. The carrier sold 6.5 million iPhones during the first nine months of 2011 and only 1.5 million LTE smartphones during the same period. And Verizon's LTE sales haven't exactly been growing quickly: The carrier added 1.2 million LTE subscribers in the second quarter and 1.4 million in the third, according to PC Magazine. Those figures are roughly split between smartphones and other devices like LTE modems. (Verizon has been is keen to push its CDMA EV-DO customers onto its LTE network, which transmits data more efficiently.)

However, Verizon in the fourth quarter released a number of notable new LTE phones, including the Motorola Mobility (NYSE:MMI) Droid Razr and the Samsung Galaxy Nexus. And the carrier also appears to be goosing the sale of LTE phones with its double data offer. Introduced at the beginning of November, Verizon's LTE promotion, which ends Jan. 15, gives new subscribers double the data the carrier previously offered (4 GB of LTE data for $30, instead of 2 GB, for example). The offer only applies to LTE smartphones--the iPhone is conspicuous in its absence.

So it's reasonable to conclude that the iPhone is outselling everything else, right? Well, comScore's latest numbers cast some doubt onto that conclusion. The firm--which conducts monthly polls to find out what smartphones people currently own--found that the number of U.S. iPhone owners grew from 25.3 million in October to 26 million in November (the period that most closely reflects the results of the release of the iPhone 4S). So the introduction of the newest iPhone garnered Apple only 700,000 new customers--the bulk of Apple's iPhone sales were likely to people who owned older iPhones and wanted to upgrade to the new 4S.

During that same period, the number of U.S. Android smartphone users grew from 41.7 million in October to 42.9 million in November.

So what does the fourth quarter ultimately mean for the nation's wireless carries and the industry in general? In the long term, smartphones do equate to higher services revenues for carriers--Jefferies & Company said higher smartphone and iPhone sales at Verizon would benefit the carrier by increasing the number of customers who pay higher rates for smartphone service. But the Wall Street Journal, quoting figures from Nomura Securities analyst Michael McCormack, found that the profit margins at AT&T haven't significantly improved since the company started carrying the iPhone in 2007. "For the most part, it's really been a wealth transfer from AT&T shareholders to Apple shareholders," McCormack told the WSJ. He said he expects AT&T's fourth quarter profit margin to fall to 30 percent from 44 percent in the third quarter.

Wireless carriers continue to contend that their investments in smartphone subsidies--coupled with their spending on spectrum and faster wireless networks--will pay off in the future by creating massive bases of high-value customers. But that assumes a relatively static market, one that won't be upset by low-cost upstarts like, potentially, Dish Network. Investment in the future is a wise move, obviously, but carefully gauging the levels of those investments will mean the difference between success and failure. +Mike Dano