Fran Shammo, the CFO of Verizon Communications (NYSE:VZ), once told investors:
We believe that the subsidy model is an extremely good model. It has done wonders for us in this industry. So I think to abandon that is a mistake.
But that was way back in 2014. It's 2015 now, and Verizon has changed. Effective last week, Verizon will stop offering phone subsidies to new customers.
Verizon is following T-Mobile (NASDAQ:TMUS), which abandoned subsidies a while ago, and only offers phones at full price with the option to pay in installments. AT&T and Sprint still offer subsidies for customers who sign a two-year contract, but more of its customers are switching to installment plans.
Here's what consumers and investors needs to know about this big shift in Verizon's business model.
Prices aren't really changing, but they're simpler to understand now
Some customers may see their monthly bill go up or down by $5 or $10 a month when their current contract ends, but for the most part, Verizon has priced the new options to maintain its current average revenue per account. The company's retail postpaid revenue per account stood at $153.73 as of the end of last quarter.
The new pricing offers customers just four data-cap options -- small, medium, large, and x-large -- and charges all customers a separate fee for each phone, tablet, or IoT device. There are no contracts, and no family plans. The lack of contracts means that customers can switch between data plans from month-to-month if they know they'll be traveling a lot one month, or realize they need more data.
Verizon's goal isn't to compete on price with T-Mobile and Sprint; instead, it wants to offer as much flexibility to its customers as possible without compromising its revenue per customer. T-Mobile has grown rapidly during the last couple of years, attracting more than 1 million net new customers in each of the last nine quarters. Most of those new customers are smartphone subscribers.
Comparatively, Verizon's customer growth has been concentrated in lower-value tablet connections with minimal net new phone customers. Perhaps the new pricing plans will stop smartphone customers from switching to T-Mobile, or attract subscribers that left to return to Verizon.
The bigger impact on financials
While the average revenue per account won't change much under Verizon's new pricing structure, it's still going to have an impact on Verizon's financials. In particular, Verizon's cash flow could face challenges.
Most customers will likely opt to pay for their phones in installments. That means Verizon is paying the cost of the phone upfront with the expectation of recouping the cost during the next two years. Right off the bat, Verizon loses about $200 in upfront cash on your average high-end smartphone. Additionally, Verizon doesn't charge interest on its installments, so it's not receiving any premium for taking on the risk. From an accounting stadnpoint, the company will end up putting significant percentage of the phone's retail value in its accounts receivable instead of just putting a $200 smartphone sale on the books with a cost of $650.
Verizon's solution is to securitize its device installment payments, and sell them to banks. This is something only possible because equipment billing is separate from service billing under the new equipment install plans. Of course, it's not getting the full value of the installments, because the banks will charge a premium for taking on the risk. However, it allows Verizon to recoup most of the cost of the phone relatively quickly, so it can invest that money in other parts of its business, like improving its network.
Verizon may find that customers keep their phones longer after they're paid off to take advantage of the lower service fees in the no-contract model. To counter this, the company might have to devise promotions aimed at customers who want to upgrade their phones more often now that they're off the two-year contract.
The percentage of phone activations on Verizon's installment plans increased to 49% last quarter, so the company must be seeing positive results from those customers. Management expects that number to rise to 60% in the third quarter, and it should continue to rise in subsequent reporting periods -- we'll see the results it has on the company's cash flow.