Telecom giants


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are set to report second-quarter earnings results in the next week, but eroding wireline margins amid increased competition may overshadow growth in wireless divisions.

With AT&T's second-quarter earnings scheduled for Wednesday and Verizon for next Monday, the struggles of the wireline businesses, which have come under pressure as customers have disconnected home phone lines in favor of wireless connections, should be on full display.

In its first-quarter report, AT&T said total switched access lines fell 7.7% from the year-ago period, worse than many analysts anticipated. In its wireline segment, operating revenue has declined over the previous three quarters, while operating expenses have continued to climb. Adjusted operating margin for the wireline segment slid to 18.5% last quarter from 20.1% in the same quarter a year earlier.

An increase in U-verse video connections was a positive for AT&T in the first quarter, but that gain was offset by a sharp decline in retail consumer primary and additional access lines. Also, retail business access line connections continued to drop, falling 3% over the previous year. Many observers expect the same to show up in the company's second-quarter earnings release.

Verizon's core business also suffered in the first quarter as wireline revenue fell 1.4% from a year ago. Total switched access lines fell more than 8% in the first quarter from a year ago, with a large amount of that pullback coming from the residential segment. Verizon's operating income margin fell to 8.8% in the first quarter from 9.1% in the same period a year earlier.

"Unfortunately, trends in the wireline

segment are nothing short of dismal," writes Craig Moffett, an analyst with Sanford Bernstein, in a research note. "As telco performance erodes, margin expectations for the whole wireline business will need to come down, in our view. Access line losses are accelerating. The rate of incremental broadband penetration is slowing.

Average revenue per subscriber growth is therefore decelerating."

Fear over what Verizon and AT&T will say about wireline losses has prompted analysts to cut estimates for their second-quarter profit, especially given current macroeconomic conditions. According to Thomson Reuters, analysts have reduced estimates for earnings per share and revenue for both companies over the last month.

Credit Suisse analyst Chris Larsen is among those ratcheting back estimates, citing the weakening macroeconomic environment and more aggressive wireless competition.

"We believe these factors drove greater wireless and technology substitution than we had anticipated," Larsen writes in an earnings preview. He expects total access line losses to be 7.9% year-over-year at AT&T and 8.6% at Verizon, adding that loss rates for both may not improve to 2007 levels "until mid-2010."

However, Moffett notes two important differences emerging from state-by-state trends at AT&T relative to Verizon. "Access line declines at AT&T have been somewhat less severe," he says. "Access line declines at AT&T have, at least thus far, had a much less severe impact on margins."

On the positive side, the average revenue per subscriber, or ARPU, has been rising each quarter, which Moffett attributes to increased broadband penetration and price hikes. In the first quarter, Verizon said that wireline consumer ARPU rose nearly 10%, with FiOS service ARPU of $129. In the same quarter, AT&T's average revenue per primary line rose 5.4%, an increase that was "driven by growth in broadband and bundled video," the company said.

"These ARPU gains have created a non-linear 'threshold' effect, where moderate access line losses like those in the Southeast can be offset by rising ARPUs, but steeper access line losses like those felt in the Northeast cannot," writes Moffett. "The emerging video businesses at Verizon and AT&T are helping ARPU, but may be worsening margin declines. Expanded video footprints will likely put further pressure on margins."

On the positive side, wireless results from both Verizon and AT&T should be strong in the second quarter, although analysts are turning more cautious with their outlooks for the balance of the year. While both companies have feasted on

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subscriber base, the embattled carrier has lately shown signs of a turnaround.

"An improvement in Sprint could put more pressure on Verizon's net ad share,

and increased wireless pricing competition could hurt margins," writes Larsen. "Sprint should improve its competitiveness in 2008, which combined with slower industry growth should significantly reduce subscriber growth at the other carriers, particularly AT&T and Verizon."

Additionally, with wireless penetration above 80% in the U.S., there is a limited pool of new subscribers for AT&T and Verizon to compete for. With AT&T unveiling a lower-priced


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iPhone 3G in the quarter, Verizon could be faced with slower wireless growth.

"While the first-generation iPhone had a limited effect on Verizon's net adds, the lower price point and potentially broader appeal of the 3G iPhone could be a larger competitive threat," Larsen adds.

The main focus of the earnings reports from Verizon and AT&T, though, will be that access line losses are showing no sign of relenting. "Neither the maturation of the cable VoIP threat nor the broad deployment of fiber is having a discernible impact on the rate at which the access line base is eroding," Moffett says.