AT&T Inc posted a smaller-than-expected drop in quarterly profit on improved margins for its wireless service, helped by the iPhone, and strong growth for its video and high-speed Internet service.

Subsidies for Apple Inc's iPhone had cost AT&T dearly in recent quarters, but analysts said the partnership is now starting to help rather than hurt profits as users of the touch-screen phone spend heavily on data services.

AT&T shares rose nearly 4 percent as analysts said the biggest U.S. phone company had reported impressive results given the weak economy.

For this economy, it was an outstanding performance, said Commresearch analyst Gregory Lundberg, citing very strong broadband, video and wireless growth.

AT&T's first-quarter profit fell to $3.13 billion, or 53 cents per share, from $3.46 billion, or 57 cents a share, a year earlier. Analysts on average were expecting 48 cents per share, according to Reuters Estimates.

IPHONE BOOST/PREPAID DRAG

AT&T reported a wireless profit margin of 40.9 percent, above the 39.2 percent forecast by Bernstein analyst Craig Moffett, who saw iPhone as the key driver.

AT&T said 1.6 million Apple iPhone customers had activated services on the AT&T network during the quarter, more than 40 percent of whom were new to the telephone operator.

The base of iPhone customers is now large enough to offset the subsidies for new iPhone users, said Moffett.

Shares of Apple rose $1.75, or 1.44 percent. to $123.51 on Nasdaq early Wednesday afternoon after the news.

AT&T added 1.2 million net cell phone customers in the quarter, in line with analyst expectations. It trails Verizon Wireless, owned by Verizon Communications and Vodafone , in mobile phone customers.

Some analysts worry that AT&T, the exclusive U.S. provider for the iPhone, depends too heavily on one device, with an estimated three-quarters of its net new monthly bill-paying customers being iPhone users.

It's a little bit worrisome as to what happens if and when their exclusivity ends, said Stifel Nicolaus analyst Chris King. Without iPhone their net adds would be negligible.

Bernstein's Moffett noted that AT&T had lost 155,000 prepaid customers who pay for calls in advance in the quarter, likely the result of pressure from a new $50 per month plan for unlimited services from Sprint Nextel unit Boost.

Chief Financial Officer Richard Lindner told analysts on a conference call that AT&T was testing new options for prepaid services including a $3 a day option for unlimited calls.

VOICE PRESSURE

AT&T's revenue edged down 0.6 percent to $30.57 billion, below analysts' average forecast of $31.06 billion. Lindner told analysts that wired voice services were putting pressure on revenue because business clients are paring back costs and some consumers continue to disconnect home phones.

As we go forward in the year we will continue to see some pressure as we see reductions primarily in wireline voice revenues, but we're going to stay focused on costs, he said.

Lindner said he saw no significant change in his view of the economy from the fourth quarter to the first quarter. During the recession, AT&T will continue to focus on growth areas, both in the United States and abroad, he noted.

VIDEO/BROADBAND GROWING

Aside from wireless data services AT&T is also pitting its U-verse video service against cable TV providers like Comcast Corp and satellite services such as DirecTV .

It added 284,000 U-verse subscribers in the first quarter, giving it a total subscriber base of 1.3 million.

U-verse additions were ahead of three analysts' estimates that ranged from 240,000 to 281,500, and above the service's fourth-quarter additions of 264,000 subscribers.

AT&T added 359,000 broadband Internet subscribers in the first quarter, ahead of Lundberg's 225,000 expectation.

AT&T shares were up 93 cents, or 3.68 percent, at $26.21 on the New York Stock Exchange. The stock has risen about 20 percent since March 9, when it hit $21.71.

(Reporting by Sinead Carew; editing by John Wallace, Derek Caney, Lisa Von Ahn, Richard Chang)

Electronics Broadband Iphone Video