Verizon Proves iPhone 5 Skeptics Wrong

NEW YORK ( TheStreet) - What a difference a month makes for Verizon ( VZ) and its battle to prove to skeptics that rising profits from wireless subscribers and surging data usage are here to stay, as customers clamor for new Apple ( AAPL) and Google ( GOOG)-powered devices.

Just over a month ago Apple unveiled its newest smartphone -- the iPhone 5 - in a blockbuster launch that set opening records for the company. Amid all the iPhone 5 hysteria, however, not everyone was cheering.

As launch numbers rolled in, investors and analysts following AT&T ( T) and Verizon began to wonder aloud whether the adoption of Apple's latest smartphone would wreck telecom sector profitability and disprove an emerging notion that after spending billions to build national networks, both carriers' investment would pay off in steadily rising profits.

Verizon's stronger-than-expected third quarter earnings released on Thursday signal that, for now, doom and gloom scenarios on the interplay between iPhone 5 sales and wireless carrier profitability are misguided.

At issue is whether the carriers can use new smartphone launches to profitably steer users onto their networks. On one hand, carriers pay in the range of $500 a phone in subsidies to handset makers like Apple to lure in customers - or to meet the terms of upgrade schedules - in a relationship that can cost big money. Over the long term, carriers expect to make their money back on subsidized handsets by way of the monthly cost of wireless contracts, and in particular, the tiered pricing of smartphone data usage.

Heading into third quarter earnings, the fear was that a record iPhone 5 launch at the end of the quarter would cost billions for carriers like Verizon, potentially cutting against steadily rising profits through the first half of 2012.

Verizon's earnings, and, in particular, record wireless revenue and profit margins unveiled on Thursday prove that iPhone 5-related fears are unfounded. At least for now, the company's earnings momentum continues to build.

As profit margins grow, Verizon also appears to be adding new iPhone and Google Android-addicted subscribers at a faster-than-expected clip, potentially disproving a theory peddled by analysts that waves of subscriber additions and phone upgrades could turn stable telecom earnings cyclical. Near 5% dividend yielding carriers like Verizon and AT&T are seen as ballast to equities in a low interest rate and economic growth environment.

Early on Thursday, Verizon reported revenue of $29 billion and an adjusted profit of 64 cents a share for the quarter, both meeting estimates and rising from year-ago levels. While top and bottom line numbers generally met analyst estimates, Verizon's wireless unit - seemingly joined at the hip to iPhone customers - posted far stronger-than-expected results.

Profit margins at Verizon Wireless hit a record 50% in the third quarter based on calculations of earnings before interest, taxes, depreciation and amortization EBITDA, beating consensus analyst estimates compiled by Bloomberg.

Growing profit margins were tied to fast-rising wireless phone bills, which surged 6.5% in the quarter to an average of $145.42 per account. At the same time, Verizon Wireless added far more subscribers than expected in the quarter, bringing in 1.54 million post-paid contracts, surpassing expectations of less than a million subscriber adds.

"The clear highlight of the print was the performance of wireless - where Verizon posted a very impressive 1.8MM retail net adds (of which 1.5MM were postpaid) and grew its smartphone base to 53%, while posting a company record 50% wireless EBITDA service margins," wrote Evercore Partners analyst Jonathan Schildkraut, in a note to clients. " Verizon continues to deliver against a lukewarm macro backdrop," he added.

The results indicate that the carrier can lure subscribers onto its network using flashy iPhone and Android devices without wrecking its profit margins. That contrasts sharply with some analyst expectations, forcing some to backtrack from projections that the iPhone 5 would take the air from a so-called telecom sector dividend bubble.

Previous to earnings, longtime carrier bear Craig Moffett of Bernstein Research calculated Verizon's third-quarter profit margins could fall by 270 basis points as a result of the iPhone 5, and he projected bigger declines at AT&T. Moffett's negative outlook was also matched by other analysts on Wall Street.

Stifel Nicolaus analyst Christopher King cut his buy ratings on AT&T and Verizon as a result of iPhone 5 shipments in the quarter, noting " We believe potential downside to earnings estimates exist as we enter into the back half of the year." King estimated Verizon's wireless service margins could fall by 5.3% through year end. Earnings show they continue to rise.

In the wake of Verizon's earnings, Bernstein's Moffett suspended his thesis that Verizon's earnings momentum would tip negative on the iPhone 5 launch.

"The test we all knew about was wireless margins. Even solid growth (which brings commensurately high customer acquisition cost) and a new iPhone (available for a single week in Q3) couldn't derail the Verizon Wireless margin juggernaut," wrote Moffett, in a note to clients. The analyst highlighted softer wireline revenue - the company still gets nearly 50% of revenue from cord-attached phones -- as a reason overall earnings estimates met expectations, in spite of Verizon Wireless's clear beat.

It isn't the first time in October Moffett's had to step back from his negative outlook on the telecom sector. In March, he began handicapping Sprint's ( S) eventual bankruptcy, but readily available debt financing and the company's sale to Softbank of Japan forced the analyst to suspend odds making on the carrier's demise.

Investors and Verizon's management cheered the record wireless results.

"Verizon Wireless continues to do an outstanding job of balancing growth and profitability," said Verizon CEO Lowell McAdam, in a statement. "Wireless achieved record profitability in a quarter in which we reported the highest number of retail postpaid gross and net adds in four years." McAdam also said that the company's on track to meet its 2012 forecasts.

Verizon shares rose 2.37% to $45.78 in Thursday trading, while AT&T rose nearly 1% to $36.02. Both carriers' shares have risen in excess of 10% year-to-date, excluding dividends, beating broader index returns.

For now, telecom investors can breathe a sigh of relief on the impact of the iPhone 5 on carrier profit margins.

The bigger question for investors and analysts to answer is whether earnings reflected Apple's issues in maintaining iPhone 5 supplies, or if they signal the math behind iPhone subsidy bearishness simply doesn't add up. Watch for analysts to redo calculations on the interplay between subsidies, subscriber adds and overall wireless profit margins in the days ahead.

Meanwhile, the implications of a telecom sector reshuffle on Sprint's takeover and T-Mobile's merger with MetroPCS ( PCS) on Verizon and AT&T's earnings outlook are yet to be fully understood, and may yet turn wireless earnings and pricing momentum negative .

For more on the impact of the iPhone 5 on corporate earnings, see whether iPhone 5 sales can buy some time. See why AT&T is still hungry for more spectrum and how a tower deal twists consolidation for more on the wireless industry.

-- Written by Antoine Gara in New York

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