Are Phone Subsidies a Bad Idea for Service Providers?

Handset subsidies largely are responsible for rapidly increasing smart phone penetration. On the other hand, the subsidies put pressure on service provider profit margins. Assume a service provider subsidies a device at about 50 percent of its actual cost, in exchange for a two-year service contract.

A device that costs the service provider $400 might be sold for $200, with the subsidy value recouped over the life of the service contract.

One might say handset subsidies are a necessary evil, allowing service providers to more easily acquire new customers, reduce churn and increase sales of smart phone data plans.

Typically, smart phone users commit to new multi-year-term contracts and generate average revenue per unit nearly twice that of voice-only consumers.

But handset prices are a major issue for consumers, in China and elsewhere.

But there is a price: the subsidies are a real cost of acquiring customers and reduce both cash flow and operating margins.

“In Canada, operators are seeing the benefits of higher sales and upgrade volumes largely wiped out by the impact of discounted handset pricing,” says Joss Gillet, Wireless Intelligence senior analyst.

The acquisition cost handset subsidies represent is in the range of $350 to $400 per new subscriber in Canada, and about the same amount in the U.S. market.

Nevertheless, Canadian operators value these costs as positive investments since they help to acquire and retain higher ARPU, lower-churning customers on longer-term contracts.

In markets that are saturated, there now are pressures to reduce subsidies. But nobody really can predict what will happen if service providers do so. One has to think (economics suggests higher prices for any product people want will lead to lower demand; while lower prices lead to higher consumption) much-higher handset prices will reduce purchases of new handsets.

At the very least, that will reduce the rate of innovation in devices, as users will refresh their devices at a slower rate, and it is device innovation that drives change in the mobile business.

Lower subsidies also will drive consumers to buy less-expensive devices, as well. On the other hand, at least some might argue that service providers should “double down” by extending contracts and refresh cycles, essentially gaining longer contract terms at the price of more-rapid refresh rates.

Some might say the solution is simply to provide more prepaid options for consumers. Such plans require that users buy their phones at full retail prices. But that also means there is no need for an operator subsidy.

But service providers also differentiate postpaid service from prepaid by the selection of devices. Typically, the hot new devices only are available on postpaid plans, in part to encourage purchase of the higher-margin postpaid plans.

If for no other reason than the differences in average revenue per user and profit margin, it seems unlikely service providers will want to shift too far in the direction of greater sales of prepaid plans.

Another tactic, namely making less costly phones available, will likely be preferred. But some of that potential also depends on supplier ability to create attractive devices at lower cost, as well as user willingness to buy those devices.

So far, no service provider has been willing to take the risk of selling even the most highly desired Apple iPhone without a subsidy. Whether a workable solution can be found--allowing service providers to reduce subsidies without losing customers--remains to be seen.

Some might say the consumer net present value actually is higher when users do not buy on contract, the logic being the early termination charge that could apply. But consumers do not perform an NPV calculations when shopping for a new phone or new service provider.

Also, one might argue that the potential payment of an early termination fee is about the same as the incremental cost of a full-price phone, so that in most cases there is not much difference between buying a subsidized phone under contract, and paying full price for the device to avoid the contract.

Each consumer has to make their own evaluations, but the evidence so far suggests buyers prefer the subsidies, even if they don't like the contracts. It's a bit like attitudes and behavior in the video entertainment business.

People always tell researchers they don't like advertising. But if you ask whether they would prefer to get free or highly-discounted content they want, in exchange for ad exposure, they vote for ad exposure.

Service providers would prefer not to have to provide subsidies. Consumers would prefer not to have contracts. But consumers clearly prefer less-expensive prices for their devices. In a business where the enabler of service--the phone--costs more than a PC, subsidies probably are necessary.