Behind the Phone Carrier Collapse

Dana is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Internet did two things for phone companies.

First, it made connections pay, so government support was no longer necessary. Unfortunately it's tough to kick the habit of free money, so AT&T (NYSE: T) and Verizon (NYSE: VZ) still like some. This has left them with lawyers and lobbyists on the payroll who are great at keeping good things from happening.

Second, it made connecting the bottom of a very long chain of value. The cost of moving a bit with a wife dropped to nothing, and the cost of moving one without a wire is doing the same. But if moving bits is your business model, what do you do?

End of the monopoly game

What the carriers have done is rush to the government, demanding both monopoly status and the end of restrictions on the use of that status. Thus, they “own” the infrastructure built with government help or permission, and they have been able to force consumers to pay based on the value of access, not its cost.

Even that game has its limits, as both companies have learned over the last few years. AT&T blamed its fourth quarter loss on pension obligations. Verizon blamed its loss on Hurricane Sandy.

These are excuses, look closer. The truth is hidden inside the wireless numbers. Both companies are adding subscribers, especially iPhone subscribers, but the cost of discounting the phone to get the contracts is starting to bite.  The phone contract is the only value-add carriers have, and it's a blatant rip-off. For $200 someone gets to charge you $60-70 per month for two years -- do the math. 

The irony here is that AT&T and Verizon actually do better on the bottom line when there isn't a hot new iPhone coming out. They're collecting that subsidy, and more, in contract revenue, but they're not paying the upfront costs.

Sprint puts the squeeze on everyone

All this should be a little ominous for Sprint (NYSE: S), which Japanese entrepreneur Masayoshi Son wants to combine with Clearwire (NASDAQ: CLWR) to create a third carrier powerhouse.

Son's plan is to do what he did in Japan, building networks with tons of capacity and undercut rivals on price. If he succeeds in his buyouts and construction plans, he is going to put an enormous squeeze on both AT&T and Verizon Wireless, which as noted are already hurting from pension obligations they can't easily erase. Sprint shares are running strong because many investors think he will succeed – he has a track record of making that work.

But what happens then? When costs are rising but income streams are narrowing, that's never a good thing.

The measure that matters to all these carriers is called ARPU – Average Revenue Per User. The industry insists this is bound to grow, but only by 10% over the next three years. The market reality is that ARPU is declining, but even the predicted rise won't make up for increased costs. The value of a bit, as a bit, continues to decline with technology, but if all you're selling are bits your waterhole is shrinking.

The only way to play AT&T or Verizon is for yield, the way you would play a cigarette stock. AT&T's dividend gives it a current yield of 5.27%, while Verizon sports a 4.81% yield. That's fat, but the same risks apply as they do to, say, Philip Morris. It's not that customers are dying, it's that value is drying up. You have to watch quarters like the last one carefully, because any cut to the dividend severely undercuts the case for owning shares, and that can happen with very little notice.



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