The One Unexpected Threat To Mobile Carriers

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To subsidize or not to subsidize, that is the question. Whether 'tis more profitable to lock customers into long-term contracts by practically giving away smartphones and suffer the slings and arrows of investor ire over outrageously thinning margins, or to take up arms against the tyranny of demand for Apple's (Nasdaq: AAPL  ) iPhone and say, "No More! Let them pay Full Retail Price for the freedom of month-to-month wireless service!"

The Danish solution
Last year several Danish wireless carriers decided to find the answer. They stopped subsidizing phones and "… saw that the customers valued lower prices on calling plans, and simpler calling plans, higher than the subsidy on the phone," Jon Erik Haug told The Wall Street Journal. (Haug is the CEO of Telenor's Denmark unit.)

Google is taking advantage of the unwillingness of many southern European mobile carriers to pay high subsidies. The company's Android operating system runs many of the mid-tier smartphones that can cost less than $200. Only 5% of smartphone buyers in Greece and 9% in Portugal went for the $680-and-up iPhone.

In the United States, second-tier carriers like MetroPCS and Leap Wireless are strictly prepaid (month-to-month) carriers. They offer only subsidy-free or minimally subsidized phones to their customers. The prepaid wireless business is growing and now holds 25% of U.S. customers.

For the month-to-month carriers, lower smartphone costs will be essential for their success. MetroPCS, which now has a 4G LTE network, has pinned its hopes on the holy grail of offering a $100 LTE smartphone -- without having to subsidizing its cost. MetroPCS Chairman and CEO Roger Lindquist considers the $100 to $150 range the company's "sweet spot." Lindquist says they'll be in that ballpark by the second half of 2012.

On the other hand
Sprint Nextel (NYSE: S  ) was so desperate to join Verizon and AT&T (NYSE: T  ) as a fellow iPhone provider that it signed a deal with Apple to buy $15.5 billion worth of iPhones over four years. Sprint's subsidy payouts went up 42%, to $1.7 billion, from 2010 to 2011. Even Sprint CEO Dan Hesse, the man who pushed hard to get the iPhone as a way of stopping customer churn, said at the Mobile World Congress in Barcelona that "[w]hen you're a carrier paying $400, $500 to $600 for a phone, you're getting more out of it, but the [subsidy] prices continue to go up. That's a challenge."

It was also a challenge even for the deeper-pocketed Verizon and AT&T. Both giant carriers saw their profit margins shaved even as their revenues increased after the release of the iPhone 4S.

According to The Wall Street Journal, the iPhone subsidy that Sprint has to pay is 40% higher than the average for its other smartphones.

Will Apple change its pricing model?
Apple CEO Tim Cook told the Goldman Sachs Conference in San Francisco last month that emerging markets are critical, with a particular focus on China. But it didn't sound like he's ready to go for a lower-price/lower-subsidy version of the iPhone there. What people want, he said, is the best-quality product, not a cheaper version of that product. To that end, he convinced China Telecom to offer the iPhone on a postpaid basis, beginning March 9. Of course, we don't know the terms of Apple's iPhone agreement with China Telecom.

Meanwhile, a third smartphone system has recently been dropped into the subsidize-or-not equation. I'm referring to Microsoft's (Nasdaq: MSFT  ) Windows Phone operating system that runs Nokia's (NYSE: NOK  ) latest smartphones, the Lumias. Those phones have met with critical success, and are being offered by T-Mobile and AT&T. More competition results in cheaper prices, not only for final-use customers, but for the carriers as well.

As reported by Light Reading last January, Chris Collins of marketing research company Compete said, "Carriers won't publicly talk about this, but they're dying for a third ecosystem to emerge. Having an Apple/Android duopoly doesn't play to their best interest."

The rub
Apple is not ready to give up its very profitable iPhone pricing unless forced to. What would force that to happen? Competition. And companies like Samsung, Huawei, ZTE, Nokia, and Microsoft are all working hard to bring down their costs even as they raise their smartphones' capabilities.

And don't forget the carriers. There will come a day when the decreasing returns on their subsidy payouts will force them to say enough is enough. Ah, perchance to dream.

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Fool contributor Dan Radovsky owns shares of AT&T and Nokia. The Motley Fool owns shares of Apple and Microsoft. Motley Fool newsletter services have recommended buying shares of Nokia, Microsoft, and Apple; creating a bull call spread position in Microsoft; and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 01, 2012, at 5:29 PM, ajaykc wrote:

    Very few articles are to the point, simple to understand and not trying to sell you something. This is one of those and one of the best article that I have read in a long time. Thanks for the post.

  • Report this Comment On March 01, 2012, at 5:44 PM, DJDynamicNC wrote:

    Rec'd for the Shakespearean lede, but the whole article turned out to be great.

  • Report this Comment On March 02, 2012, at 9:59 AM, constructive wrote:

    This article is not about an unexpected threat to carriers. It's about an expected threat to Apple.

  • Report this Comment On March 03, 2012, at 7:35 AM, BMFPitt wrote:

    I've been waiting years for this to happen.

    MetroPCS is not viable where I live, but I was very excited when it launched, because it was a sign of good things to come.

  • Report this Comment On March 03, 2012, at 12:48 PM, richj64 wrote:

    I am a big nokia fan, their phones are virtually indestructible. I'd like to see the windows smartphone operating system come up to speed with Android and Iphone.

  • Report this Comment On March 04, 2012, at 8:04 PM, baldheadeddork wrote:

    "Apple is not ready to give up its very profitable iPhone pricing unless forced to."

    Boy, that's the understatement of the year. More than half of Apple's revenues and a much larger share of its profits come from iPhone sales. Apple's financial performance is totally dependent on being able to sell product at wholesale for $600 that retails for $200. Maybe I'm not up on the new math, but that doesn't sound like a sustainable business model.

  • Report this Comment On March 04, 2012, at 9:35 PM, Chontichajim wrote:

    The major carriers including Sprint are just as much lined up against affordable pre-paid service as the high end smart-phone providers (e.g. AAPL) are. You may get this service from Metro PCS with poor service and limited network, or from one of the majors at a premium price but don't hold your breath waiting for affordable and reliable pre-paid. It is as much a fantasy as single channel subscription TV. The technology is there, but those who paid a fortune to build networks need bundling and term agreements to pay off the infrastructure.

  • Report this Comment On March 05, 2012, at 10:30 AM, DJDynamicNC wrote:

    ^^ I've used Virgin Mobile for over a decade. It costs me 25 dollars a month for unlimited texting, unlimited data, and 300 minutes. That's a grandfathered rate, but even new service can be set up on the same plan for just 10 dollars more than that. I have never dropped a call with my current device (of the 4 phones I've owned on the plan, one of them was garbage and would cause me trouble; the other's were fine).

    The last time I bought a new phone, the Radio Shack employee tried to upsell me to a Verizon contract plan to replace my Virgin Mobile phone. I asked about the rates and then laughed in his face when he responded.

    Your mileage may vary - I'm in the heart of a downtown core and although I travel frequently, it's essentially only to other downtown cores, so service is never a problem - but Virgin would have to do soemthing drastic to get me to look elsewhere.

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