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iPhone crushing AT&T's profits

Wall Street not seeing a payback as AT&T spends $375 per Apple iPhone customer.

By Scott Moritz, writer
Last Updated: October 22, 2008: 4:24 PM ET

NEW YORK (Fortune) -- Sometimes a sharp phone can cut both ways. AT&T saw its profits trimmed a little as its popular Apple iPhone turned into a huge sales success.

The Dallas phone giant missed Wall Street's adjusted earnings expectations by 4 cents a share in the third quarter as iPhone-related sales costs eroded margins. AT&T says it spent $900 million in the quarter on iPhone sales - that's a whopping $375 in upfront costs for every new iPhone customer.

The impact of these expenses on earnings came as a surprise to investors and, it seems, the company, which had warned in July that iPhone sales would likely cut 11 cents per share off the bottom line this year. But in Tuesday's earnings announcement, AT&T (T, Fortune 500) said the iPhone cost the company a dime a share in the third quarter alone, as it forked over an estimated $300 or more of its own cash to keep the price of the iPhone at $199.

AT&T says it sold 2.4 million iPhones in the quarter, helping to attract 1.7 million net new post-paid subscribers. This is a company milestone and an impressive achievement given the slowdown in wireless growth and the slump in consumer spending.

However, investors were not pleased by the drag on profits from the sensational iPhone performance. AT&T shares were down 6% Wednesday. Apple (AAPL, Fortune 500), meanwhile rose 7%.

For its part, AT&T chief Randall Stephenson defended the costly exclusive arrangement with Apple and says the dilution will be less in the fourth quarter and even less in the first quarter of next year.

"We are confident the investment we made this quarter will generate significant returns," Stephenson said on a conference call with analysts Wednesday.

The winner here, of course is Apple, which had a blowout iPhone sales performance, with 6.9 million of its iconic touchscreen phones sold in its fiscal fourth quarter.

Analysts cautioned that AT&T is taking a greater immediate risk for the sake of winning market share from rivals by taking their higher-paying customers. Meanwhile, writes JPMorgan analyst Mike McCormack, AT&T is "transferring shareholder wealth to Apple."

The painful costs of AT&T's iPhone success highlights the harsh effects of the telcos' ongoing subsidy war. With the rise in popularity of the more expensive smartphones like the iPhone and Research in Motion's (RIMM) BlackBerry, AT&T, Verizon (VZ, Fortune 500) and Sprint (S, Fortune 500) have been underwriting bigger chunks of the phones' costs in an effort to lure customers away from rivals.

This competitive pressure takes a big toll on cash flow at a time when AT&T is trying to dig out from under a $64 billion debt pile.

"In the current macroeconomic climate, this doesn't seem very constructive, but in the rearview mirror it looks like the right move," says Roger Entner with Nielsen IAG. "You've given people devices that gets them to spend $20 more a month with you." To top of page

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