Apple (AAPL)'s shares crossed the $700 mark in trading after the company announced record pre-orders for its iPhone 5. The company announced that it sold 2 million phones on Friday, and that it will succeed in selling almost 60 million iPhone 5s by the end of this year. It all seems to be going well for the biggest company in the world in terms of record breaking sales; however, it doesn't bode all too well for telecom companies like Verizon (VZ) and AT&T (T), who have to incur significant costs to provide the new smartphone at a much cheaper price to its customers.
The shares of both telecom operators fell by more than 2% on Friday, after the iPhone 5 pre-orders announcement, which is a worrying sign for these companies that have long been considered safe, defensive stocks. Moreover, Christopher King, an analyst at Stifel Nicolaus, cut his buy rating on both stocks to hold, on fears that the earlier-than-expected launch of the iPhone 5 will weigh on the companies' margins. Another analyst, Craig Moffett, also recently updated his estimates for the two companies, believing that AT&T's margins could drop by 3.6%, while Verizon could take a hit of 2.7%.
Both companies pay Apple hundreds of dollars to be able to offer the very pricey smartphone to their customers at a cheap price. It is estimated that both companies are currently paying around $450 per phone, while charging only $200 to its customers. This upfront cost is a huge burden on the companies, and it reflects in the contraction of their margins. Even though the new phone has a short selling period for the month of September, the record first few day sales suggest that their margins will take a hit, even in the third quarter. Perhaps that is the reason why Stifel's analyst has cut his 2012 EPS estimate for T to $2.34, down from $2.44. He also expects Verizon to post a six cent drop in EPS from his previous estimate of $2.51. Forecasts for 2013 have also been revised down.
These telecoms have a love-hate relationship with Apple. They keep paying Apple huge sums of money because they are aware that its products attract customers to their networks, and bring in revenues. However, both telecom giants have been pushing for lower subsidies and phones that carry less subsidy costs, since on average they pay more in subsidies for an iPhone than they do for most other smartphones. A prime example of the telecom companies' push towards other phones is when T's CEO said at a JPMorgan investor conference that the company has to keep subsidies under control, one way of doing which was by offering phones from Nokia (NOK) and HTC. Moreover, as pre-orders for the iPhone 5 are increasing at a rapid pace, both AT&T and Verizon are pushing harder for their shared data plans, alongside other measures like raising their upgrade fees for a new smartphone. Under Verizon's linked data plan, any customer who buys the iPhone 5 will have no choice but to buy the company's shared data plan. Moreover, if existing customers don't switch to the new plan, they won't get the new phone at a subsidized price of $200. These measures indicate that the companies are not too happy with the mounting subsidies, and are trying to tap into the data market to drive growth.
The stocks are trading at high valuations, indicating that VZ and T are currently overvalued. On a forward P/E basis, T is currently trading at almost 15 times its earnings, while historically it has traded at 11x. Verizon, on the other hand, is trading at 15.7 times its forward earnings, also higher than its historic average. Other multiples like P/S are also high for both companies (VZ: 1.12x, T: 1.7x), as compared to the industry multiple of 0.85x. We believe that the recent downgrades by various analysts are well founded, and that even though Verizon and AT&T, which have the biggest market share in the U.S. and sell more iPhones than any other telecom, the margins and profitability of both carriers will be hit in the second half of the year. Even though AT&T and Verizon have both gained 24% and 11%, respectively, since the start of the year, we believe they have limited upside potential because of the margin erosion. For investors with a focus only on dividends, both stocks look attractive.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.