Apple iPhone Ditching AT&T Exclusivity: A Sign of Desperation

Ever since Apple (NasdaqGS: AAPL) introduced the iPhone in June 2007, it has only been available on the AT&T wireless network. AT&T (NYSE: T) is estimated to pay Apple $600 per activated iPhone for the privilege of this exclusivity arrangement. Since AT&T offers the phones to the public for $199 (or even less with a two-year contract), Apple is receiving a huge subsidy of $400 or more per phone. Since there are about 11 million active iPhone users in the U.S., that subsidy represents a lot of moola to Apple. AT&T is doing well also.

Apple iPhone Has Been Very, Very Good to AT&T

The iPhone has helped AT&T grow its wireless subscriber base to 85 million in the U.S., second only to Verizon’s (NYSE: VZ) 91 million. But in the highly lucrative “smartphone” market (e.g., high-speed Internet, email, video games), AT&T is number one with a 43% market share compared to Verizon’s lowly 23% share. Furthermore, AT&T outgrew Verizon last year, adding 7.3 million new mobile subscribers versus only 5.7 million for Verizon.

Apple is Scared of Google’s Android

Given the benefits the exclusivity arrangement has provided to both participants, I was shocked to read numerous press reports that Apple plans to cancel the arrangement with AT&T starting in 2011.  Why is Apple trying to fix something that ain’t broke?  One word comes to mind: Google (NasdaqGS: GOOG). Google has developed the Android wireless operating system (OS) that is taking the cell phone market by storm. The OS is what’s important to mobile users, not the hardware, and Android is a better OS than the iPhone hands down. Let me (actually ZDNet) count the ways:

1. Google voice
2. Google maps
3. Voice text
4. Status bar
5. Better home screen
6. Multi-tasking
7. Combined email
8. wireless software updates: no cable required
9. Free access to music library
10. Free add-on applications that are useful, not like iPhone’s junk apps.

Google’s Nexus One is Better Than the iPhone

Last November 5^th, Motorola (NYSE: MOT) introduced the Droid phone, which is based on the Android OS and operates on the Verizon Wireless network. It was initially quite popular, but got upstaged on January 5^th by Google’s own Android smartphone called Nexus One. The Nexus One was initially available only on the mediocre T-Mobile third-generation (3G) network and AT&T’s low-speed 2G network, but on March 16th Google announced that Nexus One would soon be available on both AT&T’s and Sprint’s high-speed 3G networks. In other words, AT&T agreed to allow Nexus One to be available on the same 3G network that the iPhone operates on. Apple saw this move as an AT&T betrayal.

Is Google Going to Acquire T-Mobile?

A second bombshell hit Apple earlier in February: rumors of Google acquiring T-Mobile and providing all 33 million T-Mobile subscribers with Nexus One phones for free!  Although mere unconfirmed speculation, analysts have given it some credence because T-Mobile’s parent – Germany’s Deutsche Telekom (NYSE: DT) – has indicated an interest in selling T-Mobile to the public in an IPO. How much do you think Apple could charge for its iPhone if customers had the choice of obtaining a Nexus One phone for free?  Answer: Not much.

Google Android is Unstoppable

I believe it was a combination of the February T-Mobile rumor and the March 16^th Google announcement concerning Nexus One and AT&T that caused Apple to rethink its exclusivity arrangement with AT&T. The momentum of Android is unassailable. In the table below, check out the changing market shares of smartphone OS platforms:

Source: comScore, Inc.

Google’s Android has recently showed the most market share growth by far, whereas Apple’s market share has remained essentially flat. More bad news for the iPhone: in the first 74 days after a smartphone’s initial launch, Motorola’s Droid outsold Apple’s iPhone:

Source: Flurry.com

The iPhone Killer

While this is bad enough, it understates the Android threat faced by the iPhone. Meet iPhone’s worst nightmare that will launch this summer: the HTC EVO 4G.  One analyst calls it the “Android-powered knight in superphone armor.” PC World says the HTC EVO has “killer features” that will absolutely crush the iPhone. Although the HTC EVO will initially be available only on Sprint Nextel’s (NYSE: S) network, Sprint has a 4G network with speeds up to 10 times faster than the AT&T 3G network iPhone currently operates on or on the Verizon 3G network it may soon be operating on.

WIMAX vs LTE in 4G

Sprint’s 4G network is based on the WIMAX technical standard, whereas AT&T and Verizon are building 4G networks based on the Long-Term Evolution (LTE) technical standard (launch dates sometime in 2011). Some analysts think LTE is superior to WIMAX, but full-scale LTE won’t be ready for at least another year whereas WIMAX is ready now. Furthermore, LTE currently suffers from a lack of radio spectrum whereas WIMAX has more than enough. I don’t care how good a radio technology is; if you don’t have enough radio real estate, you can’t have a viable service.

Bottom line: I’m betting that many iPhone users, who are sophisticated first-adopters when it comes to technology, will switch to HTC EVO in order to get 4G now, rather than suffer on Verizon’s relatively slow 3G network for another year or longer. Sprint and Google obviously hope that I am right.

Apple is Between a Rock and a Hard Place

Apple is in a pickle with no perfect solution. On the one hand, eliminating AT&T exclusivity will allow millions of subscribers on other U.S. wireless networks such as Verizon to use the iPhone, which will spur iPhone sales. Some analysts predict that Apple could almost double the 11 million iPhones currently in service.

But there is a downside. Without exclusivity, no wireless carrier is going to subsidize the sale of the iPhone. The only reason AT&T was willing to subsidize is because it knew that each customer had no choice but stay with AT&T if it wanted to use the iPhone. Consequently, there was a high likelihood that AT&T would recoup the cost of the subsidy through two years of monthly cellular service payments. But once exclusivity is gone, customers can buy the iPhone from AT&T and immediately switch to another network, leaving AT&T holding the bag with no chance to recoup the cost of the subsidy. No carrier will take that risk.

iPhone Subsidies are History

Gone will be the days when a customer can buy an iPhone for only $99 with a two-year contract. Customers will have to pay the full cost of an iPhone, which is substantial. According to a leaked Apple internal document, the cost is $499 for an 8 gigabyte phone, $599 for 16 gigabytes, and $699 for 32 gigabytes. Without AT&T’s massive phone subsidy, far fewer people will buy the iPhone, and I predict Apple will get nowhere near a double in iPhone sales. Sure, sales will increase somewhat as they did in France after a similar exclusivity arrangement ended, and that’s a plus for Apple. But it won’t be enough to stop Android smartphones – which already are available on a multitude of wireless networks – from outselling Apple within a year. To sum up: Apple is desperate to accrue as much income now as possible, since it sees the future and the future is Android.

AT&T Doesn’t Need iPhone Exclusivity

An equally interesting question is what impact a loss of exclusivity will have on AT&T.  I’ve heard doom and gloom predictions, but I don’t buy it. In fact – and this may surprise some people — I think AT&T is in a much better position than Apple going forward.  The benefits to AT&T from a loss of iPhone exclusivity are numerous:

1. End of expensive $400-$450 subsidy per iPhone
2. Fewer system overloads by iPhone users that caused AT&T network service quality to suffer, which hurt its reputation
3. More cash available to spend on system upgrades. In fact, AT&T plans to spend $2 billion more on network upgrades in 2010 than it did in 2009. AT&T already has the fastest 3G network and recently announced the completion of a high-speed packet access (HSPA) 7.2 software upgrade to all of its 3G cell sites nationwide, which promises to make its 3G network even faster (7.2 Mbps fast compared to the current 3.6 Mbps theoretical limit).
4. Low probability of losing many iPhone customers. Almost 70% of AT&T’s iPhone customers were AT&T Mobility customers prior to upgrading to the iPhone, so they should stick around even after exclusivity ends. Furthermore, many of AT&T’s iPhone customers are still in the early stages of two-year service contracts and they are likely to stick around so that they don’t have to pay a $175 early termination penalty.

Buy AT&T, Not Apple

One of Warren Buffett’s famous sayings is: “Be fearful when others are greedy and greedy when others are fearful.” No question that investors are very fearful concerning AT&T’s future and are absolutely giddy (i.e., greedy) concerning Apple’s future. The contrarian in me says to sell Apple and buy AT&T.

Regarding Apple, at $214 billion it has the third-highest market capitalization of any stock in the S&P 500 — higher than Wal-Mart, General Electric, or Procter & Gamble. C’mon folks, this is Apple we’re talking about, a technology company with no monopoly like Microsoft (#2 on the list) and vulnerable to immediate obsolescence if a competitor comes up with a better mousetrap. There is no way Apple deserves such a high market-cap. Even if it did, the law of large numbers dictates that Apple’s growth prospects must decline sharply in the years ahead; otherwise, it would soon grow larger than the U.S. economy itself! As I wrote in my article on small-cap investing, the biggest gains come from investing in small companies and Apple doesn’t qualify.

Regarding AT&T, KCI’s own Roger Conrad, editor of the award-winning Utility Forecaster investment service, wrote a glowing piece about the telecommunications company back in February. He said:

On the operations front, it’s all coming up roses for AT&T this year. The company reported a 24.4 percent boost in fourth-quarter 2009 earnings. In contrast, as a stock AT&T gets less respect than ever. Good news has been routinely dismissed by investors. The stock is down 10 percent thus far in 2010. The yield of 6.7 percent is near an all-time high, while AT&T’s price-to-book value of 1.46 is scraping a low. Expectations are rock-bottom. All the company has to do to ensure huge upside eventually is to keep performing as a business.

Roger is a relatively reserved person, so it’s rare for him to say a stock has “huge upside.” When he does, it pays to take notice.

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