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Extra2/5/2010 10:28 AM ET

AT&T's iPhone mess creates tough choices

Neither the cell phone carrier nor Apple, the smart phone's designer, predicted the popularity of the iPhone, to the chagrin of both companies and their customers.   

By BusinessWeek

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, news, msgs) 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, news, msgs) 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, Apple CEO 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 smart-phone 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 smart phones 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 Earth on a palm-size device feel 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.

A citizenry mobilized

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.

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, news, msgs) comes in. The 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.

Continued: Ma Bell was back

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