Wireless Carriers: Will the iPhone5 or New Spectrum Revive Carrier Competition?

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The 2007 introduction of the iPhone changed wireless competition, stymieing carrier ambitions of AOL-like walled gardens and setting the subsidy bar much, much higher.  For AT&T, the exclusive deal with Apple was worth it for the big market share gains and rising ARPU, but for #1 Verizon, the impact was unequivocally negative.  Over the next five years, the industry balance of power stabilized, with the dominant players holding the line on data caps, service pricing, subsidies and capital investment, leading to notable outperformance by both stocks.  However, historically, co-operation amongst wireless carriers has been unstable.  The iPhone5, with high subsidies and new support for LTE service could spur more vigorous rivalry in the near term, with AT&T under pressure to counter Verizon’s superior 4G coverage.  New spectrum, transitioned to commercial use by existing licensees or FCC auction, could also shift the competitive balance, particularly if new players – e.g. Google, Apple, Microsoft, etc. – step in to help smaller carriers co-ordinate network sharing and finance build-outs.  These dynamics call into question the sustainability of oligopolistic returns for the leaders, and thus, the extraordinary dividend yields that they have supported.

 

The iPhone changed everything for the wireless web.  Prior to the iPhone, carriers sought to control the wireless internet through tightly curated, premium priced, packages of content exclusive to their brands.  The iPhone took advantage of the growing reach and speed of 3G networks to offer a true browser, augmented by “app” shortcuts to popular web services, and an intuitive and powerful touch screen interface.  AT&T, which had spent 5 years changing its network technology, had fallen far behind Verizon and agreed to unlimited open internet access, full Apple control of branding and apps, and extraordinary subsidies to get an iPhone exclusive.  The deal reversed AT&T’s market share slide, and forced competitors to counter with unlimited plans and hefty equipment subsidies of their own.

Over the past 5 years, carrier rivalry has stabilized.  Now, T and VZ have the iPhone, and while carrier aspirations of controlling content are long dead, data usage caps, high prices and falling network capex are driving record cash flow for both leading operators and attractive dividend returns for investors.  The question is whether the peace can be sustained – history shows that periods of strong carrier returns have been short lived.

The iPhone5 could change everything again.  Verizon has a huge advantage in 4G LTE, with a big head start on coverage and more and better spectrum than AT&T.  Meanwhile, the iPhone5 finally adds LTE, 18 months after the first 4G Android devices hit Verizon’s network.  To date, the expiration of AT&T’s iPhone exclusive has not driven the churn that many expected, but the stark difference in coverage and network capacity vs. Verizon, along with unlimited data offers from iPhone newcomer Sprint, could spur market share movements.  Détente thus disrupted, usage caps could be lifted, prices could be dropped, and capex could be increased.

The spectrum map STILL favors Verizon.  With approval for its spectrum purchase from the cable industry, Verizon has two nationwide blocks to devote to LTE – its initial 4G deployments are in the 22MHz C-block VZ picked up in the 2008 700MHz license auctions, and the company now has 40MHz in the well supported AWS band.  With these two widely supported bands, equipment and devices for Verizon’s network straightforward and easily available.  In contrast, AT&T is deploying its LTE in 12 to 24 MHz of 700MHz spectrum, but lacks a national footprint and plans to augment its initial build-out with a variety of unusual frequency blocks, including some which do not have natural 2-way pairing and cannot be supported until the next version of LTE.  The spectrum hodge-podge makes it more difficult to provide coverage and to source equipment or devices.

New spectrum could also intensify competitive rivalry.  DISH is awaiting an FCC ruling on its plan to use 40MHz of its spectrum for terrestrial services.  Clearwire plans to build out LTE in its 150MHz of spectrum, but is cost and coverage disadvantaged by its very high frequency, requires specific equipment and devices, and has been challenged in raising financing.  The FCC plans to issue rules for a new auction of up to 120MHz of the 700MHz band, with the proceeds to be shared with the TV station owners currently using it.  Given the large amount of spectrum already controlled by T and VZ, it is likely that their participation in any auctions would be limited, and any attempt by them to acquire further spectrum through acquisition would be closely scrutinized.

Internet players are a spectrum wildcard.  Google, Apple, Amazon, Microsoft and others have substantial wallets and vested interest in seeing cheap and unlimited wireless data services.  While we would not expect these companies to enter the carrier market directly, they could finance and support network building by others, perhaps coordinating wholesale network builds and facilitating network sharing agreements that would give smaller operators the capacity and cost structure to compete with the leading carriers on price and service.

Increasing rivalry is a risk to AT&T and Verizon cash flows.  Carrier cash flows are highly sensitive to changes in ARPU, customer acquisition costs and capital spending, all of which could move against the leading operators should either the iPhone5 or new spectrum catalyze competition on price, subsidies or data limits.  Both telecom leaders currently generate operating cash flows after capex of greater than 11%.  AT&T pays out roughly 70% of that cash as dividends, with Verizon paying out only half as much.  Should rivalry push cash generation into single digits, where it has been during other stretches of more vigorous rivalry, even Verizon’s lower payout could be put at risk.

Device platform players and small carriers would benefit from more vigorous competition.  Google, Apple, Microsoft and Amazon are obvious beneficiaries should wireless prices fall and/or data caps become less restrictive.  If new spectrum were to enable a viable wholesale LTE network, smaller carriers like Metro PCS, Leap Wireless and US Cellular would benefit.

 

For our full research notes, please visit our published research site.

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