AT&T's iPhone Dilemma

To some, AT&T's agreement to sell iPhones seemed ill-advised at first. Apple (AAPL) CEO Steve Jobs set some exacting demands in exchange for granting AT&T the sole U.S. rights to the iPhone. U.S. carriers had always maintained nearly complete control over the devices on their networks. But Jobs wouldn't even let Ma Bell affix its logo to the handset. He also insisted AT&T (T) surrender a hefty chunk of the monthly service fees it would collect and only Apple could decide what software would be used on the device. In exchange, AT&T got a multiyear deal to be the exclusive network to carry the device.

So far, that bet looks brilliant. Since the first iPhone came to market in mid-2007, AT&T has signed up more than 7 million subscribers who wanted the device—more than 40% of them from other networks. In the quarter ended on Mar. 30, roughly 70% of AT&T's new wireless subscribers signed up to get an iPhone. And while AT&T's rivals sling high-end devices from Research In Motion (RIMM), Nokia (NOK), and others, none has approached the allure of the iPhone. "It's the only one that has made people say, 'I'm willing to change networks for that,'" concedes David Owens, a marketing executive at Sprint Nextel (S).

But now AT&T is having to contemplate life without that iPhone exclusive—and it's bound to be a difficult adjustment. Should Apple widen the circle of iPhone carriers, those new partners will take a slice of iPhone customers, who are not only numerous but highly profitable; they pay an average of $85 in wireless charges per month, roughly double the average. Also, AT&T will no longer be able to lean on Apple's marketing muscle, and it will have to face the long-term impact of ceding so much authority—and brand equity—to Apple. With every iPhone it sells, AT&T becomes known that much more as Apple's partner. "AT&T made a devil's bargain with Apple" that brought short-term gains and long-term problems, says one high-ranking telecommunications executive.

Apple Needs Broader Reach

In the short run, AT&T could still negotiate another exclusive. That's because Verizon Wireless and Sprint Nextel, the next-largest carriers, use a cellular technology called CDMA that will likely be phased out by 2012. "CDMA is a dead technology," says UBS telecom analyst John Hodulik. More likely, Apple would wait to create a phone around the so-called LTE (Long Term Evolution) next-generation cellular standard that AT&T and Verizon Wireless both plan to support. Many analysts say the Verizon Wireless LTE network won't be ready for widespread use until 2012.

Still, AT&T's reliance on the iPhone puts Apple in an excellent negotiating position. Already, AT&T covers roughly $400 of the $600 or so that Apple receives for each iPhone, which customers buy for $200 or $300, says Avian Securities analyst Matthew Thornton. While AT&T earns this subsidy back through two-year contracts, the up-front payments can be tough to swallow. And AT&T has no other exclusives that could approach the iPhone's success. It aggressively promotes devices such as RIM's BlackBerry and recently began selling Nokia's e71x, a huge seller in Europe, but others offer comparable devices, too. Sprint, meantime, has the exclusive on the one device that might invite iPhone comparisons: Palm's (PALM) Pre, expected to hit shelves in June.

Regardless, AT&T's exclusive is unlikely to last long. Apple's share of the smartphone market has ballooned to 22% today from zilch in 2006. To maintain such growth, analysts say Apple needs broader distribution than even AT&T, as the largest U.S. provider, can deliver. Outside the U.S., Apple's pattern consistently has been to widen its circle of carrier partners. Since granting exclusives to AT&T and carriers in the U.K., Germany, and France in 2007, Apple has signed multiple carriers in nearly every one of the 76 countries it has entered since.

Apple in Talks with Verizon

In the U.S., the prime iPhone candidate is Verizon Wireless, owned by Verizon Communications (VZ) and Vodafone (VOD). BusinessWeek has learned that Apple has been in talks with Verizon Wireless about at least two products.

AT&T declined to comment for this story, but executives routinely crow that the Apple partnership has been nothing but glorious for the telecom giant. "There's virtually no dissension inside the company on that point," says a consultant to the company. And there's no doubt AT&T would be in far worse shape had it not done that deal. "AT&T was perceived to be way behind the curve," says Hodulik of UBS. "The iPhone gave new life to the brand." And now AT&T has earned the battle scars that come with being the first carrier to handle massive mobile-Web traffic. When it comes to ensuring their network can handle reams of YouTube (GOOG) clips and other online fare, "they have a first-mover advantage that will take a long time to dissipate," the consultant says.

AT&T's iPhone story will get better before it gets worse. Most analysts expect Apple to unveil an upgraded iPhone in June, when it has said it will introduce new software dubbed iPhone 3.0. And just as the initial iPhone made mobile Web browsing mainstream, the new iPhone may make it a snap to watch home movies on a handheld. A person familiar with Apple's plans says it's simple to record and edit stunningly sharp video with the device—and then wirelessly send it to friends with a few clicks or watch it on the phone's improved screen. The person compares the video capabilities to those of the Flip, whose maker was recently acquired by Cisco Systems (CSCO). Piper Jaffray (PJC) analyst Gene Munster hasn't seen the device but expects Apple to push this movie-making much as it has pushed digital music in the past. "I think they'll make a big deal out of this—and Apple is pretty darn good at making a big deal out of stuff," Munster says.

Over time, Apple will also have more products to sell through AT&T and whatever new partners sign on. One of the two Apple products that have been the source of discussions with Verizon is a cheaper version of the iPhone, which most likely will also be available on AT&T's network. Munster expects Apple to introduce a $100 model by the end of this year.

Category Trailblazer

Apple has also shown Verizon a larger, more computer-like device dubbed by one person as a "media pad." Former Verizon Wireless marketing executive Mark Lowenstein smells an opportunity for Apple to define yet another product category, as it did with its original PC, the iPod, and the iPhone. Suppliers have plans to crank out a range of midsize, low-cost devices, including PC-like netbooks and smaller gizmos known as Mobile Internet Devices. So far, none has emerged as a mainstream favorite—or much of a moneymaker. "There is no iconic device in the category right now," Lowenstein says. "That would be a logical market for Apple to go after, and Verizon would be a natural partner" given its high-performance network, he says.

To be sure, Apple doesn't hold all of the cards in its negotiations with AT&T. The carrier was instrumental in creating the overall iPhone user experience, from easy activation to customer support. AT&T helped design the "visual voicemail" application in the iPhone that lets users view messages rather than have to listen to them.

AT&T has weathered the loss of lucrative exclusives in the past. It was the only carrier that could sell Motorola's Razr when it was all the rage in 2005. One Motorola insider recalls the uproar when the company informed AT&T it would also strike a deal with Verizon. Soon thereafter, Motorola executives took note as AT&T began giving preferential treatment to competing handsets. "It was holy hell," the person says. "The company's relationship fractured that day and never really recovered."

Motorola's inability to follow the Razr with a comparable best seller proved calamitous in the years since. AT&T will need to ensure it's well suited for life in a world where it's no longer the exclusive iPhone carrier.