Did AT&T give too much for iPhone?

The Apple 3G iPhone is shown in this publicity photo released to Reuters June 9, 2008. Apple Inc on Monday unveiled a next-generation iPhone with faster Internet access that will run on advanced wireless networks and sell for as low as $199 -- half the current entry-level price.

NEW YORK (Reuters) - Has Apple Inc done it again? After setting the pricing agenda for digital music to suit its own needs rather than those of the record industry, the iPod maker has now clinched an iPhone deal with AT&T Inc that may allow it to do the same in wireless.

AT&T's plan to subsidize the next iPhone is almost certain to boost the No. 1 U.S. service provider's customer growth and revenue from data services like Web surfing. But in return, it appears to be taking a much bigger upfront risk than Apple.

The high-speed version of iPhone goes on sale July 11 at $199 with 8 gigabytes and a $299 model with twice the memory.

Instead of paying Apple a portion of service fees each month as it did with the last iPhone, AT&T will shoulder part of the price of Apple's latest device to the tune of $200 to $500 per phone, according to analyst estimates. AT&T said the subsidy, aimed at boosting volume sales, will cut earnings per share by 10 to 12 cents in 2008 and 2009.

Apple, on the other hand, is expected to see its earnings dip only about 3 cents a share this year, according to some estimates, as it forsakes the percentage of recurring monthly service revenue it got from AT&T's iPhone users.

While some applauded the new deal for its promise of wireless customer growth in a slowing market, investors pushed down AT&T shares and analysts worried that the unusual earnings hit signaled too big a concession from the U.S. phone company.

"With dilution running at levels we never fathomed, we believe AT&T is assuming more risk than the previous arrangement," JPMorgan analyst Michael McCormack wrote in a research note. "We question whether a handset exclusivity agreement should warrant such a dramatic financial impact while other successful carriers have not found it necessary."

Subsidizing handsets to boost demand is widespread among U.S. service providers, which sometimes offer free phones in exchange for lengthy contracts. But even so, investors are not used to operators cutting earnings expectations as a result of subsidies, especially from an individual phone.

"Clearly Apple had the upper hand in the negotiations," said Stifel Nicolaus analyst Chris King. "That's a big hit to earnings for one product set for AT&T."

A day after the news, analysts forecast AT&T calendar 2009 earnings per share before items at $3.44, according to Reuters Estimates, giving the company a trading multiple of about 11. Apple is expected to earn $6.41 per share for its fiscal year ending September 2009, or about 29 times.

SUBSIDY NECESSITY

As 85 percent of U.S. consumers already own cell phones, King said AT&T is under more pressure than ever to lure customers from Verizon Wireless, Sprint Nextel Corp and Deutsche Telekom's T-Mobile USA. Verizon Wireless is owned by Verizon Communications Inc and Vodafone Group Plc.

"They're going to need to push the iPhone heavily to offset this dilution," King said.

Other analysts saw AT&T's move as a sign of intensifying competition in the U.S. mobile market, where subsidies are one of the few ways carriers can boost growth.

Credit Suisse analyst Chris Larsen saw the move as "mildly negative" but necessary as AT&T's rivals are also courting customers like the typical iPhone user, who can afford big bucks for phones and add-on fees for data services like email.

"They're doing the right thing because this is a land grab right now for customers that want smartphones," said Larsen.

Even assuming that AT&T pays a subsidy of $350 for each iPhone, Larsen said it could still come out about $200 ahead as the subsidy would be mitigated by an increase in data service revenue and the elimination of monthly fees to Apple.

By Larsen's rationale, AT&T would have paid Apple $250 in service fees per iPhone user in two years under the old pact.

AT&T raised its mandatory monthly data service fee to $30 for users of the new iPhone from $20 for buyers of the first device. On top of this, iPhone users would likely spend another $5 a month on a text messaging plans, Larsen said.

The new data fees are in line with what AT&T already charges other smartphone users, potentially leading some investors to question if iPhone merited special treatment compared with other smartphones.

Another concern will be whether iPhone, which attracted lines of customers when it launched last year, would still hold consumers in thrall by 2010, when AT&T expects to see the new subsidy model finally starting to boost its earnings.

"How do I know for certain that the industry doesn't get more competitive two years out," said Larsen, adding that other phone makers are already trying to replicate iPhone.

Yet even though AT&T is taking the bigger earnings hit, some analysts think it may have pushed for the new agreement in a move calculated to boost customer growth.

"I think AT&T drove the boat here. I think they wanted to change the agreement because they benefit from the volume," said UBS analyst John Hodulik.

Hodulik said AT&T assured him that the economics of its first and second Apple deals are similar -- the only difference being the timing of one-off upfront subsidy fees per phone versus smaller recurring fees spanning the user's contract.

But it is hardly reassuring to investors that they cannot work out the math on their own as AT&T did not detail fees paid under the old model or the size of the new subsidy.

"The main problem for the company at this point is that they started off at one structure and they converted to another structure. They're doing it with a phone that is expensive and has a lot of volume," Hodulik said.

(Editing by Dave Zimmerman)