Cover Story

AT&T's iPhone Mess


In mid-December, Fake Steve Jobs, the alter ego of widely read journalist and blogger Dan Lyons, posted the following appeal to his fellow members of iPhone Nation: "On Friday, Dec. 18, at noon Pacific time, we will attempt to overwhelm the AT&T data network and bring it to its knees. The goal is to have every iPhone user (or as many as we can) turn on a data-intensive app and run that app for one solid hour. Send the message to AT&T that we are sick of their substandard network. …Join us and speak truth to power!" Soon thousands of hooligans—or if you prefer, frustrated customers paying AT&T (T) as much as $150 per month—took to Twitter and Facebook to join up.

Operation Chokehold might have been a landmark consumer uprising had the federal government not stepped in. Two days before the planned protest, Jamie Barnett, the Federal Communications Commission's chief of public safety and homeland security, issued a statement warning that to "purposely try to disrupt or negatively impact a network with ill-intent is irresponsible and presents a significant public safety concern." Doing so could interfere with 911 calls. Fearing a boomerang of negative publicity, the Chokeholders called off the stunt, but the popular backlash against AT&T raged on. On the Dec. 20 broadcast of NBC's Saturday Night Live, Weekend Update anchor Seth Meyers noted that Google's new phone might pose a threat to Apple's (AAPL) iPhone and added: "Also a challenge to the iPhone: making phone calls."

AT&T has stumbled into a quagmire. When it secured exclusive rights to support Apple's iPhone on its wireless network in June 2007, investors hailed the deal as a masterstroke. Here was stodgy, safe AT&T positioning itself to gulp profits from a cutting-edge technology. But AT&T and Apple vastly underestimated the iPhone's appeal. At launch, Real Steve Jobs said he'd be happy if the device could grab 1% of the global cell-phone market, or about 10 million units for 2008. Instead, Apple has sold at least 42.4 million—25.1 million in 2009 alone, 14% of the global smartphone market. AT&T, which markets the iPhone in the U.S., simply can't handle the traffic.

Making matters worse is the proliferation of "apps," those bandwidth-sucking programs that make smartphones so much smarter. According to Apple, iPhone users have downloaded at least 140,000 different apps a total of 3 billion times. Watching broadcasts of Major League Baseball games and studying the globe via Google (GOOG) Earth on a palm-size device feels like a promise from the future, but the networks delivering all this data are still just catching up with the present. "We expected this was going to open up a new level of engagement, and we knew we'd be successful in the market," says AT&T Operations President John Stankey. "We missed on our usage estimates." Case in point: It's not atypical, he says, for 80% of a college football crowd to be using their iPhones.

The rise of iPhone Nation—with its media-savvy and data-greedy citizenry—has left AT&T with a tough set of options. It could significantly upgrade its network to handle all the new demand, but that would cripple profits. It could charge more for network access or limit what customers can do on their phones, but that would enrage the all-you-can-eat subscriber base as well as Net Neutrality types who seek to prevent telecom companies from dictating customers' options. It could permanently halt iPhone sales in overcrowded markets, but that would bring more mockery, not to mention place AT&T in the unusual position of denying consumers access to a product it doesn't even make.

To keep its uneasy equilibrium, AT&T is trying a little of everything: It's marginally increasing capacity while trying to squeeze network hogs and subtly reshape the definition of Net Neutrality.

Blowing Kisses

So far the gambit has paid off. On Jan. 28, AT&T said its fourth-quarter profit had risen 26% from 2008 and that it had added 7.3 million wireless customers in 2009, equaling its most ever in a single year. What's more, Apple hasn't lost faith; when it unveiled its iPad tablet PC in January, it said it had given AT&T the exclusive right to provide data service. But this time Apple has stipulated that AT&T can't lock customers into service contracts for the iPad, making it easier for them to bail if another carrier starts offering service.

That's where rival Verizon (VZ, VOD) comes in. The New York-based carrier has been blowing kisses to iPhone users for months, signaling that it's ready to serve them as soon as Apple wants to make a deal. Verizon is already racing ahead of AT&T in upgrading its slow copper wires to fast fiber-optic lines that carry FiOS, its bundle of telephone, Internet, and television services. By contrast, AT&T's competing U-Verse service, which runs over a patchwork of fiber-optic and copper wires, has gained little traction. The iPhone was supposed to be the great equalizer for AT&T, but since the launch in 2007, AT&T's stock has underperformed Verizon's by 12 percentage points and the Standard & Poor's 500-stock index by six.

For AT&T CEO Randall Stephenson, managing one division for growth and another for costs is "a delicate and very tricky balance," says Zhiping Zhao, a telecom specialist with New York-based research firm CreditSights. "And if AT&T doesn't find that balance, it doesn't grow." Adds Gerard Hallaren, director of research at TownHall Investment Research in Littleton, Colo.: "It's a juggling act."

AT&T says the usage issue is broader than one company. "I don't think there's been any significant shift in consumer technology that hasn't come with growing pains," says Stankey. "Think back to America Online (AOL) and busy signals. It's not that these problems can't be solved—it's that mobile is a different game."

Ma Bell Is Back

Today's AT&T, with nearly 300,000 employees and annual sales of $124 billion, is in some respects a remarkable turnaround story. After the historic dissolution of Ma Bell in 1984, Southwestern Bell (SBC), one of the seven regional Bells created after the breakup, spent a quarter century reassembling broken-off pieces under the stewardship of deal-happy CEO Ed Whitacre (now chief executive of General Motors). By 2006, having rolled up four of the original Bells and the remains of AT&T proper, SBC rechristened itself AT&T and returned to using the iconic stock symbol T (for telephone).

Ma Bell was back. Then came the iPhone and its array of network-sapping apps. Wireless profits soared, but at a cost. In December AT&T Wireless said 1% of smartphone customers accounted for 20% of the data drain on its network, while its top 3% were using up 40%. Several recent surveys, including those by Consumer Reports and research firm Yankee Group, have placed AT&T last in customer satisfaction among major carriers.

When AT&T suggested in December that some customers were using too much bandwidth, it failed to anticipate the backlash that would follow. Business schools are littered with case studies of companies that have paid the price for insensitivity to customers' wishes. (New Coke (KO), anyone?) The perils have only increased in an era when it's easy to make complaints heard globally. Apple, for one, had to deal with its own customer-service crisis in 2003 when brothers Casey and Van Neistat of New York discovered that their iPod batteries were irreplaceable and lasted just 18 months. They made a film called iPod's Dirty Secret and launched a protest Web site that drew millions of hits, after which Apple addressed the problem. And following the success of Super Size Me, in which documentarian Morgan Spurlock chronicled his decline in health while eating meals only at McDonald's for 30 days, the fast-food chain did away with its Super Size meal option. Companies from PepsiCo (PEP) to Facebook have also discovered the power of consumers in changing everything from products to privacy policies. A 2009 study by Keller Fay Group in New Brunswick, N.J., found that only 22% of conversations about a brand refer to the company's advertising. Says customer service consultant Jeanne Bliss: "The marketing message is no longer under a company's control. We trust other customers first."

The most vulnerable targets are often companies such as AT&T that have an ongoing relationship with their customers. Locked in by long-term service contracts and powerless over everything from network failures to wait times for reaching a human being in customer care, subscribers are easily frustrated. "The telecom industry has been a laggard relative to other industries on the customer-service front," says Macklin Martin, director of consulting at International Customer Management Institute in Colorado Springs. He points to the high costs of maintaining the network and customer support, combined with intense competition, as factors. "It's a difficult business model to maintain," Martin says.

Among the angriest customers is John Rust, a freshman at Patrick Henry College, a Christian school in Purcellville, Va. Rust is one of the Three Musketeers, a splinter group formed from the Operation Chokehold campaign for the purpose of pestering AT&T. Outside class, the soft-spoken, polite 19-year-old—he closes his e-mails with "Blessings"—works as a video editor and Web designer for a local film company. After purchasing an iPhone in September 2008, Rust says, he quickly became frustrated with the numerous dead spots and poor service quality on AT&T's network. "Unlimited should be unlimited," he says. "When I bought my iPhone, I signed a contract with AT&T. They haven't upheld their end of the bargain. Simply put, I want what I'm paying for." AT&T's Stankey says: "I don't think you can have an unlimited model forever with a scarce resource. More people get drunk at an open bar than a cash bar."

When Rust joined Operation Chokehold, he linked up with pals Dylan Pine of Nashville and Peter Serven of St. Louis via social networking. Serven started a Facebook group and reserved Twitter usernames and domain names related to Chokehold. Within a few days, thousands of users had joined. The Musketeers put together a central site, drafted marketing material, and traffic-copped their Facebook and Twitter pages. In the final 24 hours before the planned operation, the Musketeers were featured on CNN. Rust says he isn't finished. He and the Musketeers are working with developers to create an online mapping service (and possible iPhone app companion) that lets users post AT&T dead zones and poor service areas for everyone to see. Also on tap: organizing "flash mobs" to picket AT&T Wireless stores. All three say they're eagerly awaiting a Verizon iPhone.

Musketeers, Chokeholders, and other critics want AT&T to spend to improve its network. Wireless is by far its fastest-growing division, contributing 44% of total revenue in 2009, up from 36% in 2007. But overall capital spending hasn't kept pace, falling from $20.3 billion in 2008 to $17 billion last year. AT&T vowed in January to boost 2010 wireless spending by as much as $2 billion. "We think it's a start, but not much more than that," says TownHall's Hallaren, who contends that AT&T would have to spend $5 billion to $7 billion to bring its network up to Verizon's quality. AT&T rejects an apples-to-apples comparison with Verizon. "For someone to sit outside our business and try to derive a relative investment value—I can't imagine anyone trying to do that," says Stankey.

Even if AT&T were willing to boost its wireless network investment significantly, figuring out precisely how much to spend without sacrificing profits would be hard. Craig Moffett, a telecom analyst at Bernstein Research, has analyzed various scenarios. His findings: If AT&T were to triple its capital spending on wireless, the value of an iPhone customer to the company would be halved. A sixfold increase in spending would make all iPhone customers worthless to AT&T. Stankey disputes Moffett's conclusions but agrees with "the thought process that we need a return on capital."

Limiting Access

Instead of betting big on new investment or aggressively raising prices, AT&T is choosing a controversial third way: It's trying to limit the iPhone features customers can use. The company prohibits Webcasts and file sharing on its unlimited data plans, activities some other carriers allow. "We need to be able to manage our traffic," says Stankey. "You can't have everybody watching YouTube during an emergency." The Net Neutrality movement disagrees with that reasoning. "We're at a critical moment," says Ben Scott, policy director of Free Press, a nonpartisan group that argues telecom providers should have no ability to limit their customers' network access. "Do we as a country invest in bandwidth, or the network tools to limit bandwidth?"

AT&T also takes a hard line on iPhone "tethering," the process by which users hook up a computer to a smartphone to gain Net access. Most carriers allow tethering for a small fee. AT&T does, too, but not for the iPhone; instead, iPhone customers who want laptop Net access must pay at least $40 a month for a separate mobile laptop device and data account. Mackay Bell, a 39-year-old freelance writer in Los Angeles, says he's "pissed off" that AT&T won't let him tether. "It's ridiculous that I should have to get a USB toggle and pay so much extra," he says. His blog, at attcritic.blogspot.com, features the AT&T logo as Dr. Evil from the Austin Powers movies. Bell says he would jump at the chance to have a Verizon iPhone. AT&T says it plans to offer iPhone tethering, but for now, says Stankey, "You don't want to throw more gasoline on the fire."

The Mackay Bells of the world wouldn't be so worrisome for AT&T were its once-mighty landline business still strong. But Bernstein estimates that the unit's profit margins will fall from 32% today to 26% in three years, which translates to a $3.6 billion plunge in that segment's operating income. Like the rest of the telephone industry, AT&T is being hit hard by the growing share of households opting for only cell phones. It also has been buffeted by competition from cable companies, which bundle phone service as part of their phone, Net, and TV packages. Upgrading phone lines to compete with cable companies isn't cheap. FiOS has gone from zero customers to 3.5 million in five years—but to get there, Verizon is investing more than $23 billion in fiber-optic wires.

Fraying Landline

Given the economics of landline telecommunications, it's little wonder AT&T hasn't made a market-altering investment in its U-Verse service. The company hasn't divulged how much it has devoted to date, but says it has invested less than half of what Verizon has spent per customer home. CreditSights' Zhao places the total U-Verse investment in the vicinity of $10 billion. AT&T concedes that it won't be rolling out U-Verse to 100% of its homes and will opt instead to resell third-party satellite television in the homes it isn't rewiring. "Instead of bundling a good value proposition to keep customers away from the cable triple play, they adopt half-baked solutions," says Zhao. Bruce Kushnick, chairman of TeleTruth, a consumer-advocacy group, calls U-Verse "a cheap copper afterthought" and faults AT&T for neglecting its still substantial number of landline-only households. Says Stankey: "We're having an awful lot of success for something that's an afterthought."

Not all the feedback has been positive. Adam Alix, 20, is a Northeastern University student whose parents in Connecticut say they've had chronic sound problems with U-Verse and are considering switching to cable. In December, Alix filed a complaint on their behalf with Connecticut's Public Utilities Control Dept. and on Jan. 4 sent a letter to State Attorney General Richard Blumenthal. "What was most unsettling to me was that AT&T never seemed to listen to what I had to say, never acknowledged that the fault lay with them instead of with our hardware and wiring, and that they wasted so much of my time," says Alix.

Yet AT&T can't afford to redouble its landline efforts now, because a bigger war is flaring up in wireless. For years Verizon had resisted cutting its wireless prices, but on Jan. 15 it slashed the monthly rate on its unlimited calling plan from $99.99 to $69.99. AT&T quickly matched the offer for all its cell-phone products, even the iPhone. The upshot? An iPhone customer who had been paying $149.99 a month for unlimited calling, Web-browsing, and text service now pays just $119.99. "We obviously want to remain competitive," says AT&T Wireless spokesman Mark Siegel.

With customers in open revolt, AT&T's definition of "competitive"—modestly lowering prices and raising investment spending—might not be enough to stave off Verizon. "I'm not aware of any company in this country that has had so aloof a stance toward quality of service," Rich Doherty of The Envisioneering Group, a Seaford (N.Y.) telecom market research firm, says of AT&T. "And that's after two and a half years of fronting the world's most elegant and entertaining handheld data device."

Maybe losing some customers to Verizon wouldn't be the worst thing for AT&T. Its data network could use a breather. And AT&T wouldn't mind seeing Verizon strain under the weight of iPhone Nation. Soon after Operation Chokehold hit the blogosphere, Verizon signaled that it was ready for Apple's business. Sure about that?

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Farzad is a Bloomberg Businessweek contributor. Follow him on Twitter @robenfarzad.

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