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One Way Apple Could Kill Its Empire

NEW YORK (TheStreet) -- There's no question that Apple (AAPL - Get Report) benefits from its ability to extract considerable subsidies from wireless carriers.

While hardcore fan boys and girls would happily shell out $600 for an iPhone, most iPhone owners might opt for another, less expensive device in the absence of a subsidy. At the very least, they might be less likely to take the plunge multiple times as Apple introduces new iterations of the smartphone.

Consider the following admittedly rough math. We can safely say that wireless carriers eat about $400 for each iPhone sold. On an estimate of 30 million iPhones sold per quarter, you're looking at about $12 billion in subsidies every three months. One report estimates that it costs Apple $196 to make an iPhone 4S.

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In its most recent quarterly report, Apple credits iPhone with the company's impressive gross margin:

The gross margin percentage in the second quarter of 2012 was 47.4% compared to 41.4% in the second quarter of 2011. The gross margin percentage for the first six months of 2012 was 45.9% compared to 39.9% in the first six months of 2011. The year-over-year increase in gross margin was largely driven by favorable sales mix towards products with higher gross margins, particularly iPhone, lower commodity and other product costs, and leverage of fixed costs on higher net sales.

In the same report, Apple warns that these subsidies might not last forever:

Carriers providing cellular network service for iPhone typically subsidize users' purchase of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company's agreements with these carriers or in agreements the Company enters into with new carriers.

Margins, however, at wireless companies are not quite as hot as they are at Apple. Of course, it all depends on how you do your calculations.

Many wireless carriers, such as Verizon (VZ - Get Report), report wireless margins using service revenue, focusing less, if at all, on total revenues. As Verizon explains in its most recent quarterly report:

Service revenues primarily exclude equipment revenues in order to reflect the impact of providing service to the wireless customer base on an ongoing basis.

In other words, someday, as a result of widespread smartphone adoption, which leads to increased data usage among customers, we'll make our money back. Therefore, we report only service revenue because that's all that matters in the long run.

In the most recent quarter, Verizon saw wireless service revenue increase 7.7%, year-over-over, from $14.3 billion to $15.4 billion. Data revenue accounted for 42.9% of service revenue, clocking in at $6.6 billion for the quarter ending March 31, 2012. That's up from 38.1% and $5.5 billion in the year-ago period.

From a margin standpoint, wireless EBITDA service margin increased from 43.7% to 46.3% between the periods ending March 31, 2011 and March 31, 2012. Overall wireless operating income margin moved from 25.8% to 28.6% over the same timeframe.

Apple CEO Tim Cook is not concerned much by the discrepancy. Cook discounted the notion that wireless carriers might pull back on, or eliminate, subsidies all together, noting on the company's most recent conference call that iPhone reigns superior to competing smartphones, has more loyal customers and the subsidy is not all that "large relative to the sum of monthly payments across a 24-month contract period."

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AAPL $124.25 -0.14%
T $32.89 0.74%
VZ $48.92 0.60%
FB $81.66 -0.67%
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