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Could Apple Benefit From the End of iPhone Subsidies?

Apple's current flagship phone, the iPhone 5s. Source: Mashable.

Ask anyone in the market about Apple (NASDAQ: AAPL  ) , and you're likely to get two distinct responses. The first is almost sycophantic; the other is very bearish. The latter's most-developed argument involves the supposed end of cell phone subsidies from the major wireless carriers. However, it is entirely possible that Apple bears are reading this incorrectly. Apple could actually benefit from the end of subsidies.

The bear argument makes sense -- sort of
On the surface, the bear argument makes sense. The cell phone market is heavily subsidized: Apple's current flagship iteration -- the iPhone 5s -- costs $649 unlocked. However, you can purchase the unit for $199 with a two-year contract from the three major carriers: AT&T, Sprint, and Verizon. The carriers value the relationship with Apple so much that the price of the phone is effectively lowered by $450. Free money for buyers, right? Not so fast.

To understand this relationship in more detail, it helps to look deeper into the subsidy. Going back to the first rule of economics -- there's no such thing as a free lunch -- the carrier isn't paying the subsidy, you are. The carriers are simply paying up front to lock you into a contract; they price the monthly plans accordingly to reap the costs of the initial hardware subsidy.

The downside of the traditional two-year contract
However, what Apple bears aren't considering is the downside of subsidies for Apple and other hardware manufacturers. A two-year contract essentially guarantees a two-year refresh cycle for its customers. The early termination fee -- which is as high as $350 at some carriers -- essentially locks the buyer into the phone as well as the contract.

To that end, Apple fans who want the latest and greatest iteration of the iPhone are stuck with rather onerous hurdles to jump: They are forced to pay the full cost of the phone out of pocket and to remain with their carrier, or to jump to a new carrier and get the subsidized phone price while paying a termination fee upward of $350 -- rinse, lather, and repeat each year. The end result is that many would-be serial upgraders tough it out and wait for their contract to expire.

Economics of the end of subsidies
The question on subsidies for Apple then becomes whether the serial upgraders and new converts outweigh those who will trade down to lower-cost models and those who will actually slow their upgrade cycle. Personally, I feel the serial upgraders will win out here.

First, it's important to look at how carriers are ending these subsidies. T-Mobile has been at the forefront with its "Un-carrier" initiative. For all intents and purposes, this plan is similar to the standard two-year contract. T-Mobile basically lowered the cost of its monthly plans and offered consumers the opportunity to pay for the phone in installments. And although the company decoupled the cost of the phone from the monthly plan, you pay for both in one bill -- the end result is a bill much like what one paid originally.

It's not just T-Mobile, The recently announced AT&T Next plan spaces payments for Apple's 5s unit over 20 months at $32.45 -- with 0% interest -- with the ability to trade it in after 12 months. This plan appears to be discounted by $15 per month, but when one considers that buyers don't have to pay $200 up front for the phone, or the nearly $40 activation fee, and can upgrade every year, it seems like a good deal for serial upgraders.

Final thoughts
Here, as in many cases, the common consensus is wrong. If subsidies end, it could put in wrinkle in Apple's iPhone plans. That's a strong bearish argument on the stock, because Apple's iPhone line provides over 50% of its revenue haul. However, the new archetype appears to be similar to the current two-year contract model in both form and substance.

The end result from AT&T's Next plan appears to be a modest price increase for the ability to upgrade every year instead of every two. When reading the tea leaves, Apple seems likely to actually benefit from the end of hardware subsidies by a shorter upgrade cycle.

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  • Report this Comment On September 15, 2014, at 8:05 AM, Yogi1976 wrote:

    The end of the phone subsidy model could be the worst thing to happen to Apple. I was discussing just this topic with a friend of a friend on Facebook just the other day. Here was my post...

    The subsidy business model has allowed high-end smartphones, especially the iPhone, to keep artificially high prices by hiding the cost of the hardware. This can be demonstrated by comparing the build cost versus sale price of the iPad and iPhone. Upon initial release, the iPad Air with 16GB and Wi-Fi + Cellular cost approximately $310 to build(1). Meanwhile, again upon initial release, the iPhone 5s with 16GB (and Wi-Fi + Cellular, obviously) cost $198.70 to build(2). Yet, that iPad had a retail price of $629 while that iPhone had a retail price of $649. So it cost approximately $111 more to build that iPad but it was priced $20 less at retail. Why is that? Because very few people think of the iPhone's full retail price. They think of it at the subsidy cost of $199. My contention is that thought process will go away once phone subsidies finally die.

    With that death of phone subsidies will come a change to better transparency of phone costs which will have a major impact on high-end phone, including iPhone, market share. This can be demonstrated by looking at the market share of the iPhone in countries that still use the subsidy model versus those that don't. In countries that still use subsidies; such as the USA, Canada, Australia, and Japan; the iPhone usually has between 30-50% market share. In countries that don't use subsidies, such as in Europe and South America, the iPhone usually has 10-20% market share(3).

    So if the subsidy model does die in the USA, as I think it will, Apple will be faced with either losing substantial market share or lowering its price and losing some of its large profit margin. Either option is not particularly good for Apple, especially since the iPhone makes up 68% of Apple's profits(4). Apple has traditionally accepted lower market share in order to maintain large margins, as they have in the computer market with Macs, and I think they would do so again with the iPhone. Apple has demonstrated that they are fine being a niche, high-end device maker. That is the difference between Apple and other phone manufacturers of high-end phones, such as Samsung. Samsung will make low-to-mid-range phones to complement their high-end offerings, while Apple has not demonstrated that they will. They tend to stick to the high-end. Even the iPhone 5c, their "cheap" model, started at $550 retail price.

    The reason I think the subsidy model is dying in the USA is that all the major carriers finally offer non-subsidized plans. Yes, the change has been a bit of a slow process initially, starting with T-Mobile and slowly spreading to other carriers. However, now that it is actually rolling on all the carriers I think it will snowball. In the past week, all the commercials I’ve seen for T-Mobile, Sprint, and AT&T have been using non-subsidy pricing… AT&T with their “best plan ever” of 4 lines with 10GB shared for $160, T-Mobile with their 4 lines with 2.5GB each for $100, and Sprint with their 10 lines with 20GB shared for $100. The Sprint one is a bit of a “come on” since it’s only that cheap until the end of 2015 and then adds an additional $15 per line, but whatever. Verizon, being the largest USA carrier, is the most resistant to the move to no-subsidy pricing. Rather than lowering their prices, they offer "month-to-month discounts" for people that choose not to upgrade or pay full price for their phones.

    People are going to change to these no-subsidy plans based on price. They see the ads and they call their carrier and ask how to switch to those cheap rate plans. Then next time they upgrade their phones, the reality of the hardware costs will hit them. That’s why it won’t affect this round of iPhones, and probably not next year’s refresh either. But when the iPhone 7 comes out in two years, Apple could be in trouble. They'll have to either compete on price or lose market share. As I said earlier, either option isn't particulary good for Apple, espcially since they're profits are so dominated by iPhone sales. That is why I think Apple should be scared by the change away from the subsidy model.

    The one saving grace for Apple in all of this is that all of the carriers offer payment plans for phone hardware in conjunction with their no-subsidy rate plans. However, since with payment plans the real price of the hardware is still much more transparent than with the old hidden hardware costs of the subsidy model, I'm not sure how much it will help.

    All that being said, I'm not proposing that Apple or the iPhone is going anywhere. I'm just saying that, with the death of phone subsidies, Apple may end up becoming in the phone market what they are in the computer market, a high-end niche player.

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  • Report this Comment On September 15, 2014, at 8:12 AM, Mathman6577 wrote:

    According to Tim Cook only 25% of all phones are now sold on a subsidy (and the number is dropping). It may not affect the company all that much if the carriers end the program.

  • Report this Comment On September 15, 2014, at 7:41 PM, Yogi1976 wrote:

    Yes, globally only 25% of iPhones are sold on subsidy, but that is why globally the iPhone only has 12% market share. In the USA the vast majority of iPhones are still sold on subsidy, which is why the iPhone can maintain a 40-50% market share. If subsidies go away in the USA, the iPhone's market share will drop to a range closer to its global market share. That is my entire point.

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Jamal Carnette

After working at The Motley Fool, Jamal Carnette decided to try his hand at writing for a change. You can find him writing about technology, consumer goods, sports, and pontificating on any competitive advantage. His previous jobs include Mortgage Trainer, Financial Advisor, and Stockbroker. Jamal graduated from George Mason University with a bachelors of science in finance and is a CFA Level III candidate. Follow me for tech trends, info on consumer brands, and sports banter.

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