T-Mobile Is Paying for Customers: Is It Sustainable?

T-Mobile's subscriber base grew over 2 million for the first time last quarter, much more than Verizon and AT&T. Unlike Verizon and AT&T, however, T-Mobile has declining margins.

May 6, 2014 at 1:05PM

The goal of business is to make a profit, and the challenge for CEOs in highly competitive markets is figuring out a way to grow market share without giving away margin. Even though T-Mobile (NASDAQ:TMUS) blew Verizon (NYSE:VZ) and AT&T (NYSE:T) out of the water in terms of subscriber base growth, first-quarter margins declined by 12%.

New strategy: attract and retain
Referred to as investing in margins, the goal is to buy customers upfront for long-term subscription revenue. Since subscribers can turn into lifelong customers, the ends justify the means and free equipment such as phones and chargers are given away in exchange for the mere possibility of a new subscriber. There's no need for contracts because people genuinely want to avoid a hassle. The strategy makes sense, but will it work? The best-laid plans of mice and men oft go astray, as they say.

Below is a partial list of initiatives rolled out over the past year aimed at both attracting and retaining customers:

  • "Simple Choice" service plan with no annual service contract -- as of the end of the first quarter, 75% of T-Mobile's base was on the Simple Choice plan.
  • JUMP!, a way to accelerate phone upgrades. More than 5.3 million customers subscribed as a result of the program.
  • Reimbursement of early termination fees from switching to T-Mobile. 21% of first quarter customer additions are from this offer. 
  • Free data for life plans for tablet users.
  • Three new programs eliminating domestic overage charges for customers, even those on legacy plans.
For the quarter ended March 31, 2014, AT&T's consolidated revenues totaled $32.5 billion, up 3.6% versus the year-ago period; this was the company's strongest growth in more than two years. Compared with results for the first quarter of 2013, operating expenses were $26.2 billion versus $25.4 billion; operating income was $6.3 billion compared to $5.9 billion; and operating income margin was 19.3 percent compared to 18.9%. The company made $1.15 in earnings per share (EPS) and $0.84 in adjusted EPS (non-GAAP), excluding net non-operational gains and losses – compared with $0.68 in both reported and adjusted EPS in 1Q 2013.

As a result of these initiatives total revenues increased 15.3% on a pro forma basis. "And here is where it gets interesting," as the CEO says on the earnings call, "Our phone adds were over 1.2 million, outperforming our nearest industry competitor by a multiple of 12 times."

During the first quarter of this year, Verizon reported 549,000 new wireless customers and AT&T added 1 million new wireless subscribers, a far cry from T-Mobile's 2.4 million subscribers. That said, while EBITDA fell 12% for T-Mobile, it increased by 15% for Verizon and 11% for AT&T. So, top-line growth is strong at T-Mobile, but only because it's giving away margin. 

The fourth largest wireless service provider added 2.4 million subscribers last quarter, up from an increase of 579,000 a year ago -- that's quite a jump. Indeed, it is the first time the company has added more than 2 million customers in one quarter, but at some point subscriber growth must turn into margin or the company will go out of business.

The good news is that we'll know if this is working by the next earnings call. Listen out for issues with service and quality levels as a sign of growing pains -- this level of growth is unprecedented and may be too much for the company to handle. Otherwise, there's no reason to believe this won't turn into a break-out year for T-Mobile.

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C Bryant has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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