The One Unexpected Threat To Mobile Carriers

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 (NAS: 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 (NYS: S) was so desperate to join Verizon and AT&T (NYS: 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 (NAS: MSFT) Windows Phone operating system that runs Nokia's (NYS: 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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At the time thisarticle was published Fool contributor Dan Radovsky owns shares of AT&T and Nokia. The Motley Fool owns shares of Apple and Microsoft.Motley Fool newsletter serviceshave 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 servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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