Last month, T-Mobile surprised the industry by announcing an end to phone subsidies. While much of the market dismissed it as a stunt by a struggling carrier, T-Mobile could be on to something as Verizon (NYSE:VZ) and AT&T (NYSE:T) have expressed curiosity regarding how T-Mobile’s strategy plays out. Carriers have long subsidized handsets in their quest to gain market share at the expense of margins. However, with a struggling economy and the increasing popularity of no contract plans, more value-seeking American consumers may opt for the no subsidy, no contract system.
The above chart shows the long-term cost advantage of a T-Mobile unsubsidized smartphone (assuming a handset cost of $650, about what the iPhone costs) versus a subsidized phone from the other major carriers. For an average data user, the savings over 2 years is $510. However, the savings increase to $1700 and $1200 for a heavy data user (10 GB per month) over AT&T and Verizon users, respectively.
While many articles have been written on the cost-effectiveness of unsubsidized plans, they have all questioned the ability and willingness of consumers to make a huge payment upfront. While that is a genuine concern, we believe that handset manufacturers can afford to absorb some of the subsidy costs. Apple (NASDAQ:AAPL) has enjoyed gross margins of over 60% on the iPhone, and we estimate that Samsung and other high end phone manufacturers to have attained similar figures as well. Meanwhile, carriers like AT&T, Sprint (NYSE: S) and Verizon, have been fighting to capture market share while experiencing significant margin pressures. We believe there is plenty of room for handset manufacturers to make their models affordable to prepaid consumers (see AT&T’s Challenges In Innovation And Competition).
How The Subsidy Model Works
An entry level iPhone without a subsidy costs around $650, while U.S. carriers sell the same for $200 under a two-year contract, which translates to a $450 subsidy. Apple is estimated to have sold around 100 million handsets in the U.S. since 2007, leading to a total subsidy of about $45 billion to date. This is just one manufacturer, and if you throw in Samsung, Nokia (NYSE:NOK) and Research in Motion (NASDAQ:RIMM), the number is staggering.
Carriers are counting on recovering this investment over the two-year contract period through higher internet revenue per subscriber. However, in a tough economic environment, the risk of lower customer spending is higher. The pressure on margins will continue as manufacturers are in a race to launch higher end smartphone models, forcing carriers to subsidize these at their risk. The subsidy model is one of the reasons iPhone sales were not affected by lower discretionary spending during the worst recession after 2008 financial crisis.
The New Model
We expect that carriers will eventually push back against the subsidy model, which was started when the average phone retailed at around $100 and subsidies were a way to get users to switch networks when their contracts ended. With popular smartphones retailing at upwards of $500 and phone manufacturers making huge profits, carriers will likely argue that it is time for them to share the margin pressure.
We believe that carriers would like the handset market to evolve to a model whereby companies like Apple or Samsung offer payment plans to customers in order to reduce the upfront commitment. Apple recently announced a similar payment scheme in China through which consumers can buy an iPhone or iPad online and choose a payment plan ranging from 6 months to 24 months . We could eventually see a similar model in the U.S. as the fight for smartphone market share intensifies. However, much of this hinges on the success (or lack thereof) of T-Mobile’s recent move.Notes:
- Apple Lets Buyers on China Web Pay in 2-Year Installments, Bloomberg, 16th Jan 2013 [↩]