Verizon, AT&T warn of falling margins - but don't freak out, the industry is healthy

Phil Goldstein

The U.S. wireless industry is going to hell in a hand basket, didn't you hear? Verizon Wireless (NYSE: VZ) is going to report sluggish earnings and lower margins in the fourth quarter! AT&T Mobility (NYSE: T) too will likely see higher churn in the fourth quarter and is also predicting narrower margins! Oh, the humanity!

I'm being a little flippant, but the Wall Street financial analysts who watch the nation's carriers are in a bit of a tizzy this week because Verizon and AT&T, the two dominant players in the market, are warning of pressure on earnings and margins from promotions and higher subscriber growth in the fourth quarter. The analysts, who evaluate companies based on what market developments mean for their stock and not necessarily for consumers, are worried because they think the competition from T-Mobile US (NYSE:TMUS)  and Sprint (NYSE: S) could get more intense.

I think that'd be fine if that happens. If Verizon and AT&T lost profits and customers to Sprint and T-Mobile, I'd say that would be a grand development for the U.S. market and would be broadly beneficial for consumers.

The main argument that the worried financial analysts have is that the current competitive dynamics are simply unsustainable long term. In a research note, Jefferies analysts Mike McCormack, Scott Goldman and Tudor Mustata wrote that they have "doubts for the sustainability of the four player market," and that "without a more accommodative M&A environment, short-term lower pricing for consumers will likely end poorly for all."

The Jefferies analysts also highlight what they see as the importance of average revenue per user, and that a drop in ARPU is 2.5x more damaging to a carrier's EBITDA as a loss of subscribers (assuming ARPU changes drop straight to EBITDA). "The bottom line is the industry needs to stop obsessing about subscribers when ARPU is so much more important," they added. "In our opinion, going negative on subscriber growth may be just what the doctor ordered."

Further, they argue, the fact that T-Mobile and Sprint are not generating positive free cash flow should worry the industry no matter the relative health of Verizon and AT&T. I think there's something to that--it's hard to run losses every quarter forever. "In our view, innovation, both in the network and in the handset, has caused increasing industry pain," they wrote. "Now, with too many competitors in the market, carriers are unable to price at levels to properly recoup investment."

Macquarie Capital analyst Kevin Smithen wrote in a research note that as part of an effort to heal the industry, Verizon and AT&T "should immediately focus on creating a sustained network performance advantage over" Sprint and T-Mobile--and let around 5 percent of their subscriber bases churn. What Sprint and T-Mobile need is more scale, and the addition of 8 or 9 million subscribers between them would give them enough scale to create free cash flow and then lower their debt. Meanwhile, Verizon and AT&T "could be spending their cash on spectrum and capex rather than on subsidies/devices and retention marketing. If not, T and VZ could further exacerbate their network capacity issues down the road."

Meanwhile, according to Benzinga, Morgan Stanley analyst Simon Flannery worries that competition is showing no signs of "flagging," and he is more cautious about the carriers in 2015 due to more spending on promotions (and likely attendant price cuts), higher upgrades and churn rates. "Going forward, our estimates reflect our concerns that, while the current promotions will end shorty, we may only be in the early innings of a wireless war," he wrote.

Yet I think all of the hyperventilating is misplaced and is a function of the job sell-side analysts have to perform. What's good for investors is not necessarily good for consumers, and vice versa. More competition on price, better value and a generally more transparent wireless experience is net positive for consumers.

The worry, as explained to me by New Street Research analyst Spencer Kurn, is that a never-ending price war will force Verizon and AT&T to stop investing in their networks, which will degrade the entire wireless industry. I think that's a fanciful idea, to put it politely.

And the carriers seem to think so, too. Verizon Communications CFO Fran Shammo said at the UBS Global Media and Communications Conference that the company will continue to invest heavily in LTE capacity. "And quite honestly, that's a good thing because as we continue to invest in wireless, that means usage is going up and revenue will continue to accrete. ... The day that we start to cut wireless capex, that's the day that we should start to wonder where the future of the business is going," he said, according to a Seeking Alpha transcript of his remarks.

AT&T CFO John Stephens noted that even with the carrier's decision to cut capex to $18 billion in 2015 from $21 billion this year, it's still going to be spending $1.5 billion per month. Stephens acknowledged that higher churn as well as higher growth in smartphones, tablets and connected cars would put pressure on AT&T's margins in the fourth quarter. "But that's a good pressure, that gives us the opportunity for future growth," he said at the UBS conference.

T-Mobile CFO Braxton Carter, also speaking at the UBS conference, was similarly sanguine. "Where I would be worried is permanent, foundational pricing changes in the marketplace," he said. "But promotions, you know they've always been out there."

Kurn argued we are seeing foundational changes in wireless pricing, with Verizon and AT&T being dragged down by competition from T-Mobile and Sprint. "The price war isn't going to stop until the industry reaches an equilibrium where all four carriers have enough subscribers to cover their fixed costs and earn an appropriate return," he argued, adding that an appropriate return would be at least above a carrier's cost of accessing capital in the debt or equity markets.

I think that's probably true. The battle over pricing and competition will continue. And I think that's a great thing--it helps make carriers more efficient and it creates an incentive to introduce new services, like LTE Multicast or equipment installment plans.

The $43 billion carriers have spent in the AWS-3 auction thus far shows that they are betting this industry is going to be healthy for a long time to come and that demand will continue to increase. In the meantime, things might not be so cheery for Verizon and AT&T's shareholders, but it's looking good for U.S. consumers.--Phil

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