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Customers Aren't Upgrading Their Phones. Should Wireless Carriers Worry?

By Adam Levy - Aug 6, 2016 at 12:04PM

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The upgrade cycle extension is hurting carriers' revenue, but margins are improving.

Image source: Getty Images.

It's no secret that the smartphone upgrade cycle is getting longer. Earlier this year, Citigroup analysts estimated the smartphone upgrade cycle would extend to 29 months this year, from a range of 24 to 26 months two years ago.

The driving force behind the extension is the shift in carriers from a subsidy model to equipment installment plans. And the move is now starting to cut into carriers' revenues. Verizon ( VZ 1.03% ) saw its equipment revenue fall 4.1% last quarter, leading to its first quarterly revenue decline in over six years. AT&T ( T 1.32% ) has seen its equipment revenue fall three straight quarters as customers hold on to their smartphones longer.

But while wireless carriers are seeing a decline in revenue in part because of declining equipment sales, the lengthening smartphone upgrade cycle shouldn't worry investors.

It's all about the bottom line

The margins on smartphone sales are significantly worse than on carriers' wireless service. While carriers may receive incentives to sell phones from certain hardware makers, the devices are generally sold at cost. Samsung (NASDAQOTH: SSNLF) pays salespeople notoriously high commissions, which is why sales reps often recommend Samsung devices over other manufacturers. Still, those commissions don't amount to much in the grand scheme of things, and AT&T's and Verizon's margins on its wireless service are much better.

That's evidenced in the companies' wireless segment margins. Verizon's wireless business saw its operating margin increase 2.9 percentage points year over year, and its EBITDA margin improved 3.6 percentage points in the most recent quarter. AT&T's consumer mobility segment improved its operating margin a more modest 1.5 percentage points, and its EBITDA margin improved 2.2 percentage points.

The shift to separate service and equipment billing has also lifted service margin at AT&T. Verizon doesn't break out service margin. Both have seen service revenue decline as a result of the shift as well.

Verizon has managed to continue increasing its operating income and EBITDA. The same can't be said of AT&T, but that's due more to high-value postpaid phone subscriber losses than to an extension of the smartphone upgrade cycle.

Verizon will face its first big test this quarter

On Verizon's second-quarter earnings call, CFO Fran Shammo told investors he doesn't really know what kind of impact equipment installment plans will have on existing customers' decisions to upgrade their phones. "We have our first set of EIP customers coming up on their two-year anniversary," he told analysts. "And there's not enough volume yet of those customers to really get a behavior track, if you will, whether they are going to hold their phone and take a $20 to $25 discount on their bill or if they are just waiting for a new phone."

He also noted that the company saw a similar trend in 2014 ahead of Apple's ( AAPL -0.80% ) iPhone 6 launch, but it wasn't quite as "dramatic." There are reports that Apple's upcoming iPhone release this fall won't be a major upgrade like the iPhone 6, which may cause some iPhone customers to hold on to their devices even longer. Apple holds a 43.9% market share in the United States, and that percentage is likely even higher for Verizon with its premium customer base.

For what it's worth, AT&T saw its first round of EIP customers finish their first round of installment payments in the second quarter last year, when equipment revenue stayed flat. It improved marginally in the third quarter before falling nearly 21% in the fourth quarter. That may be partially due to the tough comparable with the iPhone 6 release in 2014, though. Operating income continued to increase nonetheless.

Investors should look closely at Verizon's results in the third quarter. Verizon could report another revenue decline, but if it's mostly the result of customers who are holding on to their phones longer, it shouldn't be too much of a concern.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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