AT&T Doth Protest Too Much, Methinks

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For years - since the dawn of the American mobile industry - carriers have sold subsidized phones in exchange for multiyear contracts. Instead of paying $500 for a phone, you pay $100 or $200, and commit to staying on their network 2 years.

Now, out comes Randall Stephenson, AT&T CEO, and whines, "we cannot afford to subsidize those phones anymore!" Is it possible? Could AT&T be losing money (or at least potential profit) by subsidizing phones? Let's take a look.

The latest 16GB iPhone 5S costs $649 to buy outright from Apple, but only $200 upfront from AT&T with a 2-year contract. AT&T is subsidizing the phone to the tune of $449. In exchange, the customer commits to two years of paying at least $60/month for the base plan, which includes unlimited nationwide talk and text and 300MB of monthly data. If you bring your own device AT&T will shave $15 off your bill.

So how much is that phone costing AT&T vs profit for them? After all, it is highly unlikely AT&T would be doing the subsidy for two decades, if they did not make a nice profit on it.

AT&T's Weighted Average Cost of Capital (WACC) is 4.22% (see the end of this article for the calculations). So the monthly financing cost to AT&T over two years is $19.54. Out of the $60/month you pay AT&T, just under $20 goes to finance the phone; the remaining $40 is pure plan revenue.

Does it cost AT&T $40 to provide that basic plan? Not even close. AT&T's company-wide cost of services (it doesn't give information by division) is about 43%. Of the $60 you paid, $25 is a cost to them to provide you with service... including the cost of the phone! So of the additional $40, a grand total of $5 is the cost to provide you with service. All of the rest is pure profit.

Subsidizing phones is a very good business for AT&T! The last thing they want is for customers to bring their own devices. If the do:

  1. They will be much more willing to jump carriers with regularity, as the Europeans do.
  2. They will be much more aggressive in demanding no-contract, post-pay, lower-price plans. For example, my Israeli carrier (I have one for every country in which I operate) charges me 100 NIS (~$29 USD) for unlimited voice, text and data, with no commitments and including all taxes and fees, as long as I bring my own device. These numbers would give AT&T serious heartache.
  3. They will lose the device sale relationship touch point, when they do much of their new customer sale. There is a reason that you had to activate your 2007-2008 iPhone with AT&T, even when you purchased it in an Apple store.

What AT&T is really saying is, "We really want to raise rates. We know if we do, you will get angry and jump to other carriers. So we need to do two things: prepare you for a rate raise, and convince other carriers to raise rates as well."

The first is psychology; the second is constrained by antitrust law. Mr. Stephenson wants to kill two birds with one stone:

  1. By complaining about how much they are subsidizing phones, he wants to paint his company as a do-gooder from its own pockets, reluctantly forced to raise rates to keep phone subsidies in place.
  2. By signalling publicly about the need - even if the reason is false - he hopes to legally signal to other carriers to raise rates as well, since he cannot collude with them directly.

Unfortunately, both efforts are likely to fail. AT&T is hated by most of its customers; a few years back, when the moniker for it was "The Evil Empire", someone photoshopped the AT&T logo into the Death Star. I have no personal opinion, but customers very much do. They feel that the customer service is terrible, the prices are far too high and the company exists to mistreat them.

Second, there may be fewer carriers, but they all want to eat AT&T's lunch. T-Mobile, in particular, has been aggressive about finding ways to make customers feel at home. As uber-VC Fred Wilson said, "T-Mobile is customer friendly." Or, as he quoted T-Mobile's COO, "We sit around and say, ‘What can we get away with not charging the customer'?" Even with a few competitors, competition works.

AT&T is making, not losing, money on subsidies; it is making a lot more on wireless services; and it is unlikely to succeed in convincing customers to allow it to raise rates or competitors to do so with it.

WACC Calculation

All data is taken from Morningstar and Yahoo Finance, as well as AT&T's own filed 10Ks, and the official yields on the US Department of Treasury Web site.

  • Equity/Value: 52.9%
  • Debt/Value: 47.1%
  • Risk Free Rate (given by yield on 10-year Treasuries): 2.81%
  • AT&T Beta: 0.33
  • Market Risk Premium: 8% (historical)
  • AT&T average debt yield: 4%
  • AT&T effective tax rate: 29%
  • After tax debt yield: 4%*(1-29%) = 2.84%
  • Cost of equity: RFR + Beta*MRP = 2.81% + 0.33*8% = 5.45%

WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt = 52.9%*5.45% + 47.1%*2.84% = 4.22%