Reporting a better-than-expected second quarter Wednesday, China Telecom said that it added 8.35 million subscribers during the period, and saw its average revenue per user rise, increases the company attributed to the iPhone.

“Our short-term profitability was under pressure due to the launch of iPhone in March and an [associated] increase in marketing,” China Telecom Chairman and CEO Wang Xiaochu said during the company’s earnings call. “[But that] investment is helping us expand into the high-end market and achieve breakthroughs in our mobile business … enhancing our long-term value.”

Looking ahead, Wang said he expected the second half of the year to play out much like the first, with the iPhone luring in more wireless subscribers, even as its subsidy costs weigh on the company’s profitability. Said Wang, “The effect of the iPhone began to show in the second quarter, leading to the increase in mobile subsidies. In the second half, mobile subsidies will be more or less the same as the first half.”

That’s because, for every transaction, they usually pay the payment processors 2 percent or more. On small purchases, that can often be the retailer’s profit.

But, starting today, LevelUp is providing merchants an alternative that will charge absolutely nothing. It is calling the program Interchange Zero, because when both merchants and consumers use LevelUp, it won’t cost a single cent to accept a payment.

On the consumer-facing side of LevelUp’s business, consumers must pay using a mobile application on their phone that is tied to their debit or credit card. This makes LevelUp one of dozens of companies also competing in the hotly contested mobile payments space.

LevelUp CEO Seth Priebatsch says he’s been talking about charging zero interchange fees for the past eight months, but only now has figured out a way to roll it out. ”Once you go to zero, you can’t go back,” he said, noting how confident he is in making the move.

But getting both merchants and consumers to adopt the mobile payments has been challenging for others, including Google Wallet, PayPal and Square, which are all arguably in the very early stages. Others, including Groupon and Apple, are also contenders, and, oh yeah, don’t forget about Visa, MasterCard and American Express, which all have healthy businesses based on charging interchange rates.

Crazy as it sounds, Priebatsch believes that his Boston start-up, which is a division of Scvngr and raised a modest $12 million in its most recent round, has an honest chance against them all.

That’s because he is leapfrogging everyone else by going directly to zero.

“It’s a commodity. Everyone is competing on price,” he said.

Up until now, LevelUp was charging about 2 percent per transaction. Under that model, it had signed up 3,000 merchants, and said that roughly 200,000 active users were spending about $2 million a month on its network. Going forward, rather than making money on interchange, it plans to sell services to merchants with the aim of getting new consumers in the door and keeping them coming back.

For instance, a common promotion that a merchant could offer would be offering $2 off a purchase. When redeeming the offer, LevelUp earns 35 cents for every dollar off. In this example, the merchant would have paid $2.70 to acquire the customer, which becomes a whole lot more economical if there’s no interchange. Priebatsch believes that by offering such promotions, they can sustainably bring interchange to zero. Currently, 98 percent of the businesses using LevelUp are running campaigns.

“We don’t need it [interchange] anymore. We’ve found ways to add value that can fully subsidize it,” he said.

It also helps that LevelUp is trying to come up with creative ways to limit the amount of interchange it pays.

Priebatsch didn’t go into details on how, but he said that the company has built proprietary algorithms to route money more intelligently, which saves it 50 percent compared to when LevelUp didn’t have the technology. The company also worked aggressively to reduce fraud in the system, and says it has 99 percent less fraud than a standard credit card because merchants never see a consumer’s 16-digit code, but instead scans a QR code.

But even if merchants like it, will consumers be willing to adopt mobile payments?

Priebatsch is insanely optimistic on that front, too, believing that merchants will do most of the legwork for LevelUp, because if they save money, they can ultimately pass it along to the consumer. So far, that’s penciled out, with LevelUp reporting that 85 percent of users are signing up for the app inside of a store.

LevelUp is not the only one moving fast on this front.

Dwolla is working hard to build its own network that limts interchange; Google Wallet plans to subsidize its network with advertising; and PayPal believes that it can continue to charge as long as it offers other perks and services to the merchant.

For more information, here’s the whole release:

LevelUp Becomes First Payments Solution to Achieve ‘Interchange Zero’
“Merchants Will Never Pay a Processing Fee Again,” says CEO Seth Priebatsch

Boston — July 12, 2012 — Accepting credit cards costs merchants a total of $50 billion every year. In fact, payment processing fees are the single largest ‘invisible tax’ on businesses in the American economy. This hurts consumers, too. That $50 billion comes out of your pocket in the form of higher prices anywhere you swipe your card.

Luckily, that fee is going away forever.

As of today, any merchant accepting LevelUp as a form of payment will join the Interchange Zero revolution and stop paying processing fees forever.

What is this “Interchange Zero” thing?
Interchange Zero is the revolutionary — and now, real — idea that it shouldn’t cost merchants a single cent to accept a payment. No ifs, ands, or buts. Instead of making money just for moving money, payment providers should add value above the transaction in ways that help businesses thrive and grow, such as customer acquisition and customer loyalty campaigns.

Priebatsch first broached Interchange Zero as a burgeoning shift in the payments industry last fall at Fast Company’s Innovation Uncensored conference. He’s written on the topic in Inc. Magazine and this spring at SXSW Interactive, Priebatsch addressed the crowd about this inevitable payment revolution.

And now it’s finally here.

OK, this is cool. But why is interchange a dying business?
Fifty years ago, interchange — the movement of money — had reason to be costly. For example, physical lines were laid to connect merchants to the network and large fraud risks had to be covered.
But this day in age, those lines are already laid and heavy-duty security innovations have lessened the real value of interchange. Yet, as these real costs went down, the interchange rate stuck around. What a swindle!

“The process of moving money is now becoming a commodity, a de facto service. We’re entering an era in which merchants should get — and will eventually only pay for — value above and beyond the transaction,” said Seth Priebatsch, Chief Ninja of LevelUp. “LevelUp is skipping this ‘race to the bottom’ happening between the major payments companies and leading the way by providing real value beyond the transaction.”

Today: 0% payment fee. Forever.
Today, LevelUp is taking the bold step of dropping its interchange to zero. Entirely. Forever. From here on out, LevelUp will only make money by providing value beyond the transaction.
LevelUp provides that value with campaigns. The first two are built to solve big problems:

Customer Acquisition campaign: On LevelUp, businesses easily create a compelling incentive to bring new customers in the door. LevelUp will promote it. By bringing in new customers, LevelUp is providing real value. The consumer saves. The merchant wins a new customer. No other payment processor does this!

Customer Loyalty campaigns: Businesses create awesome loyalty campaigns on LevelUp. In doing so, LevelUp motivates customers to come back more often to unlock the loyalty incentives. More visits per week is real value. The consumer is rewarded. The merchant is busier than ever!

OK this is pretty sweet. But how does LevelUp make money?
When merchants choose to run a campaign on LevelUp, LevelUp earns 35 cents for every dollar of credit redeemed through that campaign. That means LevelUp is only making money when real value — which is determined by the merchant when they set up their campaign(s) — is created.

That’s it?
That’s it. So businesses, stop paying interchange! Like, now. Accepting your customers’ money should be free. And with LevelUp it is. Zero percent means zero percent.

Now, take that money, and reinvest it in campaigns that actually grow your business. If they don’t work, improve them. Or stop running them. All the data is yours, all in real-time.

And one last thing…
“Google gave away access to all the world’s information for free. They could have charged per search, but they didn’t. They chose to make money only when they added real value for an advertiser by driving a consumer to a website with a click,” added Priebatsch. “We’re doing the same thing with payments. We’re going enable the frictionless flow of money and only make money when we add real value for merchants — in this case, by driving a new customer to a business with a transaction.”

Britannica might not have liked Google giving away access to information for free. But consumers and businesses sure did. We don’t think everyone will like Interchange Zero. But businesses and consumers sure will.

To join the 3000+ brick-and-mortar merchants already on LevelUp, please visit TheLevelUp.com/business.

About LevelUp

LevelUp is a revolutionary new way to pay. Users pay with their phone, saving time and money. Businesses pay 0% payment processing fees and re-invest those savings into growing their businesses by attracting new customers and bringing them back.

LevelUp is a part of SCVNGR which is backed by Google Ventures, Balderton Capital, Continental Advisors, Highland Capital and Transmedia Capital.

Why?

They’re far too worried about what would happen to their customer-retention rates if they did so.

“We continue to believe carriers would lower iPhone subsidies if they collectively felt that competing devices would drive the same economics as iPhones,” says BMO Capital’s Keith Bachman. But right now, they don’t. And with no other hero handset to mitigate the risks of the spike in customer churn that might follow a reduction in iPhone subsidy, we’re unlikely to see one in the near term.

There are other reasons, as well, one being the presumed launch of a new LTE iPhone. That device will likely inspire a strong surge of upgrades late in the year. And with carriers looking to move subscribers onto their LTE networks, they’re probably not going to mess with a device that will surely be instrumental in helping them do it.

Finally, as we’ve noted here before, Apple’s multiyear agreements with its carrier partners very likely prevent them from changing iPhone subsidy pricing. These deals are said to have most-favored-nation clauses, so that any reduction in subsidy offered to one carrier would have to be offered to the others. And with Verizon and Sprint both newly locked into their contracts for some time, Apple has no cause whatsoever to even entertain the idea of a lower iPhone subsdidy.

Don’t worry so much. Apple doesn’t.

Remarking on the subsidy issue during the company’s second-quarter earnings call Tuesday, Cook dismissed it, essentially saying that the iPhone is so exceptionally profitable for carriers that they’re not likely to mess with it.

“From the carriers’ perspective, it’s important to remember the subsidy is not large relative to the payments across a two-year contract period,” Cook said. “Any delta between the iPhone and another phone is even smaller.”

Beyond that, there are a number of advantages to carrying the iPhone.

“A number of carriers have told me that churn from iPhone customers is lowest of any phone they sell,” Cook said. “That’s obviously a significant, direct financial benefit to the carrier.”

But the iPhone’s greatest advantage is this: It’s a device that customers want to use every day.

“At the end of the day, the vast majority of carriers want to provide what their customer want to buy,” Cook said. “That’s what motivates them. … The iPhone is the best smartphone on the planet to entice a customer who is currently using a traditional phone to upgrade to a smartphone. This is by far the largest opportunity for Apple and our carrier partners. It’s a win-win. All of these factors are missed in this discussion of subsidy.”

Some argue that it is. BTIG Research analyst Walter Piecyk recently cut his rating on Apple, theorizing that U.S. carriers will soon rein in their iPhone subsidies in an effort to boost their own margins. And were that to happen, a significant contraction in iPhone sales would likely follow.

Question is: Will it happen? According to a new analysis from CLSA, the answer is probably no — at least not for the next 18 to 24 months.

Which is great news for Apple. CLSA figures iPhone subsidies accounted for $19 billion of Apple’s fiscal 2011 revenue. And about 46 percent of that came from North America. So if AT&T, Verizon and Sprint were to push to lower the subsidies they pay to sell the iPhone, Apple could take a revenue hit. Indeed, some observers have estimated that a $100 drop in the iPhone subsidy would trim $7.50 from Apple’s earnings-per-share for fiscal 2013.

But that’s an unlikely scenario.

Why? Because, CLSA argues, the structure of Apple’s carrier agreements will prevent it from occurring.

“We believe these are multiyear agreements which tend to stipulate subsidy policies up front,” CLSA analyst Avi Silver explains. “For the major carriers, we believe these agreements have most favored nation clauses so any offering from Apple to one carrier would have to be offered to the other. During the length of these multiyear agreements, we believe U.S. carriers would need permission from Apple to alter subsidy levels.”

And if that’s the case, they’re obviously going to have a difficult time getting it. More to the point, that hypothetical most-favored-nation clause — if it exists — is going to make it tough to trim iPhone subsidies for a while.

Says Silver, “For AT&T, we do not know when its multiyear agreement expires but Verizon and Sprint are likely locked in for some time. As a result, we think that an outright reduction in subsidies is an unlikely scenario in the U.S. market.”

Apple reports earnings after market close today.

A shocker of a call, coming as it does when Apple shares are so ascendant that some analysts have slapped a staggering $1,001 price target on them. But Piecyk has his reasons, and they’re worth considering, even as AAPL shrugs them off in midday trading. Top among them: He believes Apple’s carrier partners are tired of offering such high subsidies on the iPhone, which eat into their own margins while delivering huge ones to Apple. And soon they’re going to begin reining them in.

“Subsidies by post-paid wireless operators have fueled the growth of Apple’s $600 iPhone since its inception,” says Piecyk. “Wireless operators have been happy to subsidize smartphones to new and existing customers in order to provide a lift to the average monthly bill (ARPU) of their customer base, a metric which had been falling for the past three decades.”

But now that the pace of the smartphone upgrade cycle has quickened, subsidizing iPhone upgrades only one year into a two-year contract is becoming a costly proposition. Case in point: AT&T’s wireless margins, which used to be more than 44 percent, are these days hovering around 30 percent (see slide at right). So, to raise margin levels back to where they once were, AT&T is implementing stricter upgrade policies.

“We expect post-paid wireless operators to remain firm in their plan to stunt the pace of phone upgrades in 2012 and we expect to see some initial evidence of their success in the current quarter,” Piecyk said.

And that could cause a significant contraction in iPhone sales; more so, if other carriers follow AT&T’s lead, as Piecyk believes they might.

How significant?

Says Piecyk, “We expect Apple’s iPhone sales to drop to 27.5 million units in Fiscal Q3, resulting in a revenue estimate that is $1 billion below consensus.”

Which would obviously make for a hell of a surprise.

So what do we think of Piecyk’s rationale? Does it hold water?

Sprint will sell the device for $399.99 in exchange for a two-year commitment to a data service plan. Sprint will begin selling the Galaxy Tab on Nov. 14, three days after Verizon Wireless.

Verizon Wireless said last week it would sell the device for $599.99, but offered a prepaid data plan without the requirement for a contract.

For any mobile product, getting the proper marketing and subsidy support from a carrier is crucial to a successful launch. A subsidized device can dull much of the sticker shock that comes from seeing the actual retail prices. Carriers are willing to offer a discount because they can lock customers into multi-year service agreements.

Verizon Wireless’s decision to sell the product without a subsidy had some industry analysts speculating that it wouldn’t fare well against the iPad, which the carrier also plans to sell for as little as $629.99.

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This according to iSuppli’s tear-down analysis of the device, which estimates its bill of materials to be $187.51 (click on chart below to enlarge). That’s a bit more that the iPhone 3GS, which had a BOM of $178.96, but then, Apple’s newest iPhone model boasts a number of enhancements, among them the Retina Display and A4 processor, which iSuppli figures cost $28.50 and $10.75, respectively.

No word on what carriers pay Apple for the device. But right now a 16GB iPhone 4 on AT&T (T) without contract or subsidy costs $599.

[Image credit: iSuppli]

The increase comes amid speculation that AT&T’s (T) iPhone-exclusivity deal with Apple (AAPL) is nearing its end. But a company representative tells me it has “nothing to do with the iPhone or any other device.”

$325. That’s a pretty steep increase from $175. Though to be fair, it’s not quite as bad as the one already implemented by rival Verizon (VZ). Last November, that carrier doubled its smartphone ETF from $175 to $350, a move AT&T was quick to cite as partial justification for its own decision.

And, indeed, the company is following in Verizon’s footsteps here. Like its rival’s ETF, AT&T’s drops $10 per month for each month of a two-year contract. Which means that at the 23rd month of a two year contract, AT&T subscribers must pay $95 to leave the carrier. The contract is nearly over, yet subscribers are obligated to pay nearly a third of the full ETF if they break it at that time.

Now it’s true that ETF’s were created as a means of recovering legitimate costs associated with subsidizing mobile phones. If AT&T is paying a $325 subsidy for the iPhone, the company should be able to recoup that money when customers break their contracts. But does it really stand to lose $95 if they do so in the 23rd month? Doesn’t seem likely if those customers can walk away just a month later without consequence, taking their handsets with them.

If these documents are legitimate, they would appear to confirm that Google (GOOG) does indeed hope to rebalance the wireless market power structure, disintermediating carriers by selling the Nexus One directly to users, who will be allowed to choose the wireless provider of their choice.

But that $530 price point is a bit daunting, and it seems unlikely that many customers will be eager to pay it upfront–even if they’re given a post-purchase carrier subsidy once they select a provider and a wireless contract. So while the Nexus One might shake up the current wireless market model a bit, it’s probably not going to upend the market as it might have had Google opted to sell the device at cost or subsidize it with online advertising.

Google’s plan, may, however, set the bar for how an Android phone should be done and set the stage for some much improved second-generation Android devices.