The past quarter-century in telecom has seen the breakup of Ma Bell, price wars, and a massive investment bubble. These days, though, look like halcyon ones for AT&T (T) and Verizon Communications (VZ), the former regional Bells that have reconsolidated over the past two decades. Whether or not AT&T’s merger with T-Mobile wins regulatory approval, it and Verizon enjoy a duopoly in the wireless industry. Their stocks are at multiyear highs, with a combined $290 billion in market valuation. And the pair exclusively carry the iPhone. Both recently terminated their unlimited data plans, effectively pushing through a rate hike by forcing new customers to pay for the bandwidth they use.
Yet the calm is deceptive. For all their gains, the wireless incumbents are, by some measures, destroying value. Technology is progressing rapidly and consumers are finding workarounds that let them pay AT&T and Verizon less than they used to—or not at all. Moreover, the changing competitive landscape now includes the well-capitalized likes of Microsoft (MSFT) and Google (GOOG).
There are already financial red flags. “Verizon and AT&T may seem like they’re on top of the world,” says Craig Moffett, a veteran telecom analyst with Bernstein Research (AB). “But tech is slippery. And their profitability is precarious.” Moffett calculates that the companies are not even earning a return above their cost of capital. Finance 101 says that if a dollar costs you X, you should not invest it in something that earns less than X. Thanks primarily to the drain of their landline divisions—which still comprise half of their businesses—Moffett says both AT&T and Verizon are violating this axiom and, in effect, throwing good money after bad. Robert Varettoni, a Verizon spokesman, says that “the company invests for the long term, and to take a snapshot of our return levels during heavier investment and a stagnant economy” does not represent Verizon’s long-term value creation. AT&T says by its own accounting its return on invested capital is positive.
Even their wireless profit centers are not as rosy as they seem. In recent years, calling plans have become commoditized, in part due to pressure from deep-discount prepaid wireless operators, such as Leap Wireless International (LEAP) and MetroPCS Communications (PCS), and cable companies bundling free long distance into subscriptions. As a result, the voice-plan revenue the telcos get from the average wireless subscriber has declined from $50 per month in 2005 to just above $33 today. This has come at a time of surging subscriber counts, and millions of Americans signing up for more expensive data plans for their new smartphones. Plus, the boom in text messaging has cushioned margins. Moffett estimates texting represents 16 percent of Verizon Wireless’s revenue, and contributes as much as 40 percent to total profit. The numbers are similar for AT&T Wireless, he says.
Problem is, that redoubt of profitability is now subject to what Moffett calls the threat of “bandwidth arbitrage.” Put simply, with smartphone apps users can now easily send and receive text messages without paying the telcos for the privilege. These apps, including ones by Facebook and GroupMe, use phones’ data capabilities for texting, reducing the need for subscribers to buy a traditional texting plan. A new messaging feature from Apple (AAPL), expected to be released in the company’s next software update, will bake similar functionality directly into the iPhone. It’s “a very real threat to Verizon and AT&T,” says Moffett.
At the same time, the telcos are trying to learn how to deal with new, nontraditional rivals. “The market structure for wireless data is not just the traditional cellular providers,” says Tim Derdenger, an assistant professor at Carnegie Mellon’s Tepper School of Business. Microsoft recently acquired the Internet calling provider Skype Technologies in an $8.5 billion deal—the Redmond (Wash.) behemoth’s largest ever. Handsets running Skype in a Wi-Fi zone don’t need a wireless carrier’s data, text, or voice plans. Similarly, Google offers free voice calls, texts, and voicemail through its Google Voice app. Both products “are going to compete with traditional cellular,” says Derdenger. “Tech markets evolve very fast and they can quickly become significant competitors.”
Sprint (S) and other traditional telco competitors, though far smaller than AT&T and Verizon, can’t be discounted either. They could well fight back with an aggressive price war. “Sure, it might be somewhat of a détente between AT&T and Verizon,” says Todd Rethemeier, an analyst with Hudson Square Research in New York. “But there are others that could disrupt things.”
Brian Higgins, executive director of ecosystem development for LTE, Verizon’s next-generation wireless network, says the company knows “this isn’t the time to simply watch our growth mature and see what plays out.” Five years ago, he says, a new phone might have lasted in Verizon stores for years. Today the average smartphone sports a shelf life of maybe eight months. That’s a sign of the industry’s accelerating metabolism and, even though two wireless carriers dominate the market, that control over subscribers is increasingly shared with makers of handsets and software.To keep pace, and keep subscribers committed to renewing their contracts, Verizon’s LTE network, launched in December, boasts speeds of up to 10 times the old one. Stephen McGaw, AT&T’s senior vice-president of corporate strategy, says his company’s network investments have led to “incredible growth in data and wireless consumption.”
Those investments could help the companies hold onto their competitive advantages—or become profit sinkholes. Bernstein’s Moffett argues that the huge amount of data being consumed by smartphone customers raises questions about the return from big projects such as LTE. He says Verizon’s stock price should be half its current level.
For now, the two big telcos are counting on the loyalty of people such as Clay Pipkin. Pipkin, 23, a consultant and Sprint subscriber, was lured to a Verizon store in Manhattan on July 6—the last day to buy an all-you-can-eat data plan. Pipkin was switching services to make sure he was grandfathered in. Yet he recognizes that the industry is changing. “I don’t need unlimited at all,” he says. With all the alternatives from Sprint, Skype, Google, and the rest, he says, “realistically data is going to get cheaper, and eventually unlimited data will not be a problem.”