AT&T's iPhone Dilemma

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Regardless, AT&T's exclusive is unlikely to last long. Apple's share of the smartphone market has ballooned to 22% today from zilch in 2006. To maintain such growth, analysts say Apple needs broader distribution than even AT&T, as the largest U.S. provider, can deliver. Outside the U.S., Apple's pattern consistently has been to widen its circle of carrier partners. Since granting exclusives to AT&T and carriers in the U.K., Germany, and France in 2007, Apple has signed multiple carriers in nearly every one of the 76 countries it has entered since.

Apple in Talks with Verizon

In the U.S., the prime iPhone candidate is Verizon Wireless, owned by Verizon Communications (VZ) and Vodafone (VOD). BusinessWeek has learned that Apple has been in talks with Verizon Wireless about at least two products.

AT&T declined to comment for this story, but executives routinely crow that the Apple partnership has been nothing but glorious for the telecom giant. "There's virtually no dissension inside the company on that point," says a consultant to the company. And there's no doubt AT&T would be in far worse shape had it not done that deal. "AT&T was perceived to be way behind the curve," says Hodulik of UBS. "The iPhone gave new life to the brand." And now AT&T has earned the battle scars that come with being the first carrier to handle massive mobile-Web traffic. When it comes to ensuring their network can handle reams of YouTube (GOOG) clips and other online fare, "they have a first-mover advantage that will take a long time to dissipate," the consultant says.

AT&T's iPhone story will get better before it gets worse. Most analysts expect Apple to unveil an upgraded iPhone in June, when it has said it will introduce new software dubbed iPhone 3.0. And just as the initial iPhone made mobile Web browsing mainstream, the new iPhone may make it a snap to watch home movies on a handheld. A person familiar with Apple's plans says it's simple to record and edit stunningly sharp video with the device—and then wirelessly send it to friends with a few clicks or watch it on the phone's improved screen. The person compares the video capabilities to those of the Flip, whose maker was recently acquired by Cisco Systems (CSCO). Piper Jaffray (PJC) analyst Gene Munster hasn't seen the device but expects Apple to push this movie-making much as it has pushed digital music in the past. "I think they'll make a big deal out of this—and Apple is pretty darn good at making a big deal out of stuff," Munster says.

Over time, Apple will also have more products to sell through AT&T and whatever new partners sign on. One of the two Apple products that have been the source of discussions with Verizon is a cheaper version of the iPhone, which most likely will also be available on AT&T's network. Munster expects Apple to introduce a $100 model by the end of this year.

Category Trailblazer

Apple has also shown Verizon a larger, more computer-like device dubbed by one person as a "media pad." Former Verizon Wireless marketing executive Mark Lowenstein smells an opportunity for Apple to define yet another product category, as it did with its original PC, the iPod, and the iPhone. Suppliers have plans to crank out a range of midsize, low-cost devices, including PC-like netbooks and smaller gizmos known as Mobile Internet Devices. So far, none has emerged as a mainstream favorite—or much of a moneymaker. "There is no iconic device in the category right now," Lowenstein says. "That would be a logical market for Apple to go after, and Verizon would be a natural partner" given its high-performance network, he says.

To be sure, Apple doesn't hold all of the cards in its negotiations with AT&T. The carrier was instrumental in creating the overall iPhone user experience, from easy activation to customer support. AT&T helped design the "visual voicemail" application in the iPhone that lets users view messages rather than have to listen to them.

AT&T has weathered the loss of lucrative exclusives in the past. It was the only carrier that could sell Motorola's Razr when it was all the rage in 2005. One Motorola insider recalls the uproar when the company informed AT&T it would also strike a deal with Verizon. Soon thereafter, Motorola executives took note as AT&T began giving preferential treatment to competing handsets. "It was holy hell," the person says. "The company's relationship fractured that day and never really recovered."

Motorola's inability to follow the Razr with a comparable best seller proved calamitous in the years since. AT&T will need to ensure it's well suited for life in a world where it's no longer the exclusive iPhone carrier.

With Spencer E. Ante in New York.
Burrows is a senior writer for BusinessWeek, based in Silicon Valley.

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