Arik Hesseldahl

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AT&T’s Quarter: Great, Except No New iPhone

Shares of AT&T are trading lower this morning, after it reported quarterly profits that were down by more than 70 percent, and quarterly sales that missed the consensus expectations of analysts. IPhone activations were light, mainly because consumers were waiting for the iPhone 4S, which was released too late for the quarter.

On the bright side, the company added 2.1 million wireless subscribers, which sent its total base past the 100 million mark. Total churn — the rate of customers who cancel service — was 1.28 percent, down from a year-ago level of 1.32 percent.

During the call, CEO Ralph de la Vega and CFO John Stevens sounded bullish notes on the smartphone business. For example: Smartphone users now account for more than half of AT&T’s subscriber base, and will, as de la Vega put it, eventually reach 100 percent. My notes from the conference call are below.

6:56 am: Good morning from New York. I’m tuned in to AT&T’s Webcast and waiting for the conference call to get under way. Right now I’m hearing the soothing tones of a peppy New Age guitarist. Or actually what sounds like a pair of them.

7:03 am: And we’re getting under way.

John Stevens, CFO: Comments on T-Mobile: FCC review is continuing. DOJ case is continuing. Our expectations continue to be that we will reach a successful conclusion.

Now on to the business at hand: Sales were strong across the board, with gains in every category. Smartphone sales were robust in a quarter where you would expect sales to be slow. Impressive service margin results. In addition to solid earnings, we delivered excellent free cash flow. Strongest cash flow in two years, even with significant Capex spending.

Consolidated revenues: Strengths were offset by declines in voice and directory. Last year’s iPhone launch during the quarter made for a difficult compare this year.

7:09 am: Year to date, 75 percent of services come from wireless and wireline data and services.

7:10 am: Now CEO Ralph de la Vega is taking over.

De la Vega: 4.8 million smartphones sold this quarter and 16 million-plus so far. Strong sales of data-only branded computing devices, our best quarter ever.

De la Vega: Our enhanced backhaul network is delivering incredible speeds. Also launched LTE. Fifteen cities will get it. Boston is among those about to be turned on. Missed the other city, sorry.

First LTE handsets are coming this quarter. And the other city getting LTE is Washington, D.C.

De la Vega: We expect the fourth quarter to be the best for smartphone sales ever.

De la Vega: Subscribers north of 100 million for the first time. Postpaid net adds 319,000. Another 473,000 added through resellers.

De la Vega: Total churn improved year over year and sequentially. It seems like a long time ago when performance with the iPhone was top of mind. He says a lot of iPhone users are choosing to stay with AT&T rather than move to competing carriers like Verizon and now Sprint.

7:16 am: Now that we offer a free iPhone with a two-year contract, we expect to broaden the iPhone base.

7:17 am: Smartphone subscribers now make up more than half of post-paid customers. He says that’s an important milestone.

De la Vega: Wireless margins expanded. Best margin performance in six quarters, and this comes amid a strong sales quarter. Our service margins this quarter were better, and we sold almost a million more smartphones than we did a quarter ago. He’s comparing last year’s second quarter, which was ahead of another iPhone launch, to this quarter.

7:19 am: CFO John Stevens is back to talk about wireline business.

Consumer and U-verse: Stevens is bragging about J.D. Power and Associates giving them an award for best video experience. IP Data now represents an annual revenue stream of $11 billion, growing 19 percent year over year. 176,000 subscribers added during the quarter. Offset by an equipment upgrade and storms in some areas.

ARPU on customers is $176, up 6 percent year over year.

Wireline business subscribers: First sequential growth in three years. What makes this more impressive is that it’s occurring amid a weak economy, slow employment and the transition to IP-based products.

Stevens: Now he’s talking about margins and cash flow. Consolidated operating margin 19.8 percent. After adjusting for Alltel and the storms, the margins would have been higher than that.

7:26 am: Free cash flow: Cash flow from operating activities was $27.2 billion in the first nine months of the year. Capex was $14.7 billion. There’s more than $10 billion in cash on the balance sheet. Net debt-to-EBITDA ratio is 1.41.

Now Stevens is recapping the results, and then I guess we’ll get into the Q&A with analysts.

7:29 am: Question from Morgan Stanley: Can you talk about the LTE rollout? How should we think about LTE over the next few quarters, driving ARPU and revenue and efficiency gains?

De la Vega: I have been a part of many network device transformations. This technology is the best I’ve ever seen. The devices are great and thin and have great battery life. It’s a home run right off the bat. I think we’ve timed it perfectly. What I see happening with LTE and data is just a huge growth opportunity. Smartphones are now 52 percent of post-paid base. The smartphone is going to equal the phone. It will be 100 percent in a few years.

De la Vega: And then you add on top of that tablets and Mi-Fis and e-readers and telematics. The growth opportunity goes off the charts. Add the cloud on top of that, great data and connectivity. Huge growth opportunities all around.

De la Vega: We’re doing it with a technology, LTE, that reduces the cost per megabyte, and is more spectrum efficient. I’m very bullish on what we’re seeing on data.

De la Vega: While there are several puts and takes on ARPU, it was slower smartphone growth. Third quarter was slower than normal because we didn’t have an iPhone refresh. So we expect the best smartphone quarter ever, and ARPU will improve along with that.

Question from Sanford Bernstein: Given the decline in interest rates, what do you expect in terms of cash contributions to the pension?

Stevens is answering. We’ll make those decisions at the end of the year, and make determinations on funding at that time. That said, we commonly follow and review that process. We have functions for pension funding and think we can handle those within the normal course of cash flows. They’re also tax deductible. Tax planning. Zzzzz …

7:37 am: Question from J.P. Morgan: Wireline business. How should we think about margins going forward, and what to expect from the consumer business?

Stevens: On a full-year basis, we’re in the range of 10-20 basis points, lagging on an operating income basis for wireline. Hope to make it up in Q4. Hope to maintain margins at this level. It’s a challenging endeavor, especially from high-margin legacy products. With regard to DSL, the most encouraging piece of the DSL story — while net adds were in the 5,000 range — was that we were able to convert a huge piece of DSL to U-verse, where available. And for those who don’t have U-verse available, there will be LTE, which they say will be available to 97 percent of the country.

Question from Citi Investment Research: Another question about margins. Slower device sales, related to the iPhone. Can you talk about having mid-40s margin as people move more typically to smartphones?

Stevens: Margins for the quarter included almost five million smartphone sales. When you compare it to prior quarter before an iPhone launch, our margins were 60 basis points higher, and we had a million more smartphones.

7:43 am: Question from Nomura Securities: More detail on expectations of the 2 percent ARPU growth in the fourth quarter?

De la Vega: What we typically see is customers on feature phones step up to the smartphone category. We expect that to happen in greater numbers in the fourth quarter. That is going to dramatically change. Another device will move a lot of people to smartphones — the free iPhone 3GS. We’re getting more new subs on average with that than the other devices. We’re sold out on that device right now. We feel very confident. Impact from Alltel acquisition was about 23 basis points.

Question from Bank of America: Revisit the Capex outlook for Q4. We’ve had a number of companies suggest that things are slowing down. Yet your spending to date seems healthy. Also, take another crack at the topic: You’re seeing about half of smartphones on tiered plans. With more than half the base on smartphones — so the next 47 percent of the base will be taking cheaper smartphones, and next half is lower-tiered customers — can the ARPU still grow in the face of that?

Stevens on Capex: Our guidance remains unchanged. We have less than $15 billion so far, and still expect to spend $20 billion this year. Cash flow is funding it. We’ll continue to invest in LTE and in all the successful growing products. I expect Capex will continue in the $20 billion range. We’ll ramp it up a little get to that $20 billion range.

De la Vega: We’re going to see customers use more data, not less. These products are too good, an incredible amount of streaming content is available. No decline, and I don’t see any way that it could decline. We plan to make more tiered options available. What I see is exactly the opposite, where everyone is using more data.

Stevens: We have 18 million tiered customers, and we built that base in about a year. You’ve seen our churn, and frankly not sure you’ve noticed any harm. We’re well-positioned for that growth. Not only from a network capability and quality of service and ability to capture revenue.

7:51 am: What is overage from tiered plans contributing?

De la Vega: Not significant.

De la Vega: We’re going to have lots of data options. Also, what’s exciting is the tablet revolution. Customers will want both a smartphone and a tablet.

Question from Credit Suisse: A question on wireline margins, impact from the storms, and a negative shift in mix. Will there be margin expansion?

Stevens: I do believe the margins were impacted by the storms and other things. I still believe there is an opportunity to grow revenues and then have that impact on margin. The distinction: We did grow revenue. The growth was not dramatic, I don’t think anyone would have expected it to be dramatic. And we’re still feeling the pressure from the legacy products.

7:55 am: Question from Goldman Sachs: We’ve still seen deterioration in wireless voice ARPU. Are people trading down? Also, on handset upgrade rates. At 7 percent, it was the lowest rate we’ve seen in awhile.

De la Vega: We had a smaller impact as a result of the mobile-to-any-mobile plans in the third quarter. The biggest impact to the ARPU number was in data, not voice. Again, it’s a tricky compare because the last iPhone refresh happened in September, and not October as it did this year.

Final question from Deutsche Bank: Turnaround in prepaid plans.

De la Vega: We’ll continue to do well in GoPhone. I think the third quarter is a preview that should play out stronger in the fourth quarter. We have a great product and a great price.

7:59 am: That’s it. Stevens is recapping the results again. I’ll close out the post from here. Thanks for playing along.

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Another gadget you don’t really need. Will not work once you get it home. New model out in 4 weeks. Battery life is too short to be of any use.

— From the fact sheet for a fake product entitled Useless Plasticbox 1.2 (an actual empty plastic box) placed in L.A.-area Best Buy stores by an artist called Plastic Jesus