AT&T's M&A Failure Is a Game Changer

NEW YORK ( TheStreet) -- Make no mistake, the breakup of AT&T's ( T) proposed $39 billion merger with T-Mobile USA is a game changer.

The failure of the deal is likely to change telecom industry dynamics so that margins are pressured by lower pricing and capital spending. At the same time, as if enough wasn't already going right for Apple ( AAPL), the company looks primed for a windfall as use of its iPhone and iPad products proliferates, along with purchases from its App store.

"The fragmentation of the carrier universe is almost certainly a positive for handset makers and suppliers to the wireless industry," said Craig Moffett of Sanford Bernstein in December after the Department of Justice blocked AT&T's acquisition of T-Mobile, which would have been the biggest deal of 2011.

For AT&T, Verizon ( VZ), Sprint ( S) and T-Mobile, among others, the decision means that they may need to plow billions more into developing networks to handle smartphone data, instead of consolidating. Added choice among national carriers, lower data prices and improved coverage may quicken smartphone adoption, adding to the topline of device makers like Apple, even as it cuts at the bottom line of national carriers like AT&T and Verizon.

"When the deal was first announced in March it looked like we were poised for consolidation from four major players to three," wrote Moffett. "As the year closes, it looks more like we're headed from four to five (let's assume for a moment that at least one of Leap ( LEAP)/ MetroPCS ( PCS), Dish Network ( DISH), LightSquared, or Clearwire ( CLWR) builds a national presence)."

For Verizon and AT&T investors, who've been wooed by the 5% dividend yields of the telecommunications sector vs. low bond returns elsewhere, a more fragmented wireless market is cause for "caveat emptor." Calling investors "coddled" by high dividend yields, Moffett wrote "we fear investors are utterly unprepared for upcoming weak wireless margins on the back of staggering iPhone subsidies."

For more on telecommunications stocks see 10 S&P 500 Stocks For 2012 from Scott Rothbort of Lake View Asset Management. For more on Apple see, 5 tech stocks to watch if QE3 happens.

Verizon is just wrapping up a multiyear capital spending plan to bolster its network and drive consumers toward revenue-generating smartphones, just as the adoption cuts at profits.

The company's average revenue per user, or ARPU, lags that of competitor AT&T because its customers have been slow to adopt smartphones, noted Jonathan Schildkraut of Evercore Partners in a recent report.

Verizon's ARPU is a quarter less than AT&T's, which has 50% of its subscribers using smartphones compared with Verizon's 36%, Schildkraut said in November. With the iPhone now entrenched in its universe and strong reviews of network, Verizon is expected to quickly transition its user base to smartphones.

But, in January, Verizon announced that higher than expected smartphone sales were eroding profit margins, causing analysts to cut earnings-per-share estimates and their price targets. Other iPhone sellers like AT&T and Sprint are also expected to see margins hit by payments to smartphone makers.

"This is clearly a major theme for the top 3 carriers in the fourth quarter," wrote John Hodulik of UBS in the wake of the news.

That news is feeding the fear that increased smartphone adoption may not be such a positive for telecoms if they can't maintain a handle on consumer and supplier pricing.

"Smartphones are helping revenue at the cost of margins in the near-term and possibly over the long-term," wrote Citigroup's Michael Rollins.

For Apple investors celebrating record high share prices, it's no surprise that the iPhone maker is a behemoth within the smartphone market. Apple captured 63% of mobile device industry profits in the second quarter, while Samsung came in at a distant second with a 22% share, according to Evercore Partners' analyst Alkesh Shah. He expects that the iPhone 4S will drive further market share gains this quarter.

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The history of the airline industry after it was deregulated the late 1970s may offer a cautionary tale for telecom investors, said Moffett of Sanford Bernstein.

The reason is that if regulators focus on price competition for consumers, as they did with airlines, the telecoms may be up against a difficult mix of high fixed costs to develop networks but lower and lower prices, leading eventually to a high barrier to exit low-margin businesses.

The Airline Deregulation Act was signed into law in 1978. The legislation removed government controls on ticket prices and routes, and airfares subsequently plummeted, along with the profitability of many of the most iconic airlines.

Moffett is not close to predicting an airline-like freefall for AT&T, but he does say that antitrust regulators' focus on consumer prices and increased competition for service may be a "double edged sword" for the industry.

Yes, smaller players like MetroPCS or Leap may get their chance to become a national smartphone carrier but Moffett said a fragmented wireless industry may not work.

What CEO would plan to spend billions to develop their network if a return on investment wasn't assured? It's the argument that AT&T made time and again, as it battled the DoJ and Federal Communications Commission in its T-Mobile merger effort.

Moffett has an underperform rating on Verizon shares with a $32 price target, meanwhile he rates AT&T shares as market perform. Analysts polled by Bloomberg expect Verizon shares to reach $40.15 a share in a years' time, while AT&T's expected to reach $31.12. Both companies have more hold ratings than buys and only two sell recommendations each, according to Bloomberg data.

While the block of the AT&T-T-Mobile deal was the boldest statement made in years, antitrust may remain a key to merger activity in 2012, especially as a presidential election kicks off.

For investment bankers, there's also still plenty of pending deals to worry about. Currently, antitrust authorities are taking a closer look at NYSE Euronext's ( NYX) merger with Deutsche Boerse, Express Scripts's ( ESRX) tie up with Medco Health Solution's ( MHS) and Duke Energy's ( DUK) acquisition of Progress Energy ( PGN).

-- Written by Antoine Gara in New York

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