How Carriers’ Move Away From Phone Subsidies Could Hurt Them

on March 13, 2014

Over the last several months, we’ve seen moves by the US carriers to introduce a new model for paying for devices in addition to the traditional subsidy model. The new model allows customers to pay for their devices over a period of time in monthly installments. It began at T-Mobile in May 2013, and the other carriers quickly followed over the course of the ensuing months. There are still significant differences in the details of these plans: T-Mobile has done away with service contracts (though you’ll still sign one for the installment plan), and T-Mobile, Sprint and AT&T offer service discounts for customers who are paying for their own device either outright or through installments, whereas Verizon Wireless stubbornly charges the same service fees regardless of whether it is subsidizing the device.

What the T-Mobile, Sprint and AT&T plans have in common is they separate two things that have historically been intertwined: service fees and device payments. Carriers traditionally charged about a third of the retail price of high-cost devices up front, recouping the rest through service fees over the course of a two-year contract. Many customers didn’t really understand the true cost of the device as a result, and the model also meant customers who held onto a device beyond the standard upgrade cycle were paying the carrier far more than the cost of the device. As such, the switch to installment plans is a good thing for consumers, because it introduces transparency over the relative costs of service and hardware.

It’s also good for the carriers, because they can slowly reduce the costs of subsidizing handsets while being more competitive on service pricing. Sprint is the only carrier that’s really broken out its costs of subsidy explicitly, and the impact in the first few months was significant, as shown in the chart below, which illustrates the cost of subsidies (i.e. the cost of equipment not paid for explicitly by customers) and the percentage of the total cost of equipment sold that’s covered by equipment payments from customers.

Sprint subsidy costs

As you can see, the total subsidy cost, which normally spikes hugely in Q4, when carriers sell many more handsets than in the other three quarters, didn’t spike nearly as much in Q4 2013, partly because Sprint sold fewer smartphones than it usually does in Q4. But the key thing to note is the line, which shows 41% of Sprint’s cost of equipment was paid for by customers, significantly up from 34% a year earlier, and also significantly higher than in any other recent quarter. The strategy worked, reducing subsidy costs and passing more of the cost directly on to consumers. It’s likely other carriers, especially those actively pushing customers towards the installment model, are seeing similar or even greater positive results. So this shift is good for carriers too.

What are the other implications of this move? Well, one that I’ve already mentioned is consumers will become much more aware of the true cost of a device (i.e. $649 for an iPhone 5S 16GB, and not just the $199 most carriers charge up front on a two-year contract). But to me the bigger implication is consumers will start to wonder why they should pay the carrier for a device at all. If the service fees and hardware fees are separate, even though the service fees are logically paid to the service provider, why shouldn’t the hardware fees go to the hardware vendor?

The answer today, of course, is carriers are offering zero percent financing on these devices – there’s no additional cost to paying for a device in installments over a period of 12-24 months instead of up front, and that’s a lot easier to swallow for most consumers. But what if hardware vendors started offering interest-free financing too?

The challenge to the direct sales model for hardware has always been multi-faceted. For example, hardware vendors lacked direct distribution in the form of retail stores where consumers could try out devices. But the biggest challenge was consumers in most countries simply aren’t accustomed to paying up front for devices, and even if they did, the service fees they paid to carriers would still implicitly include subsidy repayments, making it a really unattractive proposition. But now that three of the big four carriers are pushing reduced service fees in return for consumers paying for their own devices, that equation changes. And if hardware vendors started offering installment plans instead of forcing consumers to pay up front, that would be pretty attractive. If the hardware vendors threw in free annual upgrades too in return for giving back the old device (as some carriers do), that might make it even more attractive.

Consider this: Samsung offers you the option of always owning the latest member of the Galaxy S family for a flat monthly fee of $30. For consumers, this would offer far greater flexibility in their choice of carriers. Instead of being forced to stick with a carrier until their device was paid off, they could switch whenever they wanted to, using either contract-free postpaid plans or even prepaid plans. Their loyalty would be to the device vendor and not the carrier (though they might choose to stick with a carrier that worked for them). Device vendors would enjoy the benefits of eliminating the carrier middle-man, which would give them the option of reducing the price of devices on these installment plans, and develop direct relationships with their customers.

What are the downsides here? Well, for the carriers, this would be a step in the wrong direction: they’d lose the direct relationship with a consumer around their device, and potentially become much more expendable. At present, the device and service contract cycles, often out of sync especially within a family plan, create a perpetual lock-in which helps keep churn low. Remove the device upgrade cycle from the equation and suddenly it becomes much easier to switch when the contract is up (or at any time, if there is no contract).

What’s the downside for vendors? Well, the obvious answer is that, instead of getting a big payment up front they’d get the payments spread out over a period of time. That’s much less attractive from a revenue recognition perspective. And it also creates a massive potential bad debt problem, in that customers might fail to make their payments. This risk is one of the reasons for Verizon’s caution on installment plans, and it would be a big risk for any device vendor adopting this approach, without the benefits of a service contract to hold over the customer as leverage.

Which vendors would be most likely to take this approach? Well, since many device vendors struggle to make money as things stand, most of them are not likely to pursue this strategy. Those best placed are those which already dominate the market, namely Apple and Samsung. Both make very healthy profits from smartphones and have deep pockets to fund such an initiative. Both also have something of a retail presence, Apple a significant one with its retail stores, and Samsung a small but growing one with its stores-within-a-store at Best Buy and some standalone retail outlets. Two other players who don’t currently make smartphones but could afford to do something interesting with this approach are Google and Microsoft. Microsoft, of course, is acquiring Nokia, and so will shortly be in the handset business, and given its struggles to get carriers to support Windows Phone it might find the direct route appealing. Google already sells phones direct through the Google Play online store, and this might finally offer a way to get mass-market interest in Nexus and Play Edition phones, something it hoped (but failed) to stimulate when the first Nexus phone launched.

Beyond these big players, the Chinese vendors might also find the approach attractive. They have struggled to get tier 1 carriers in major western market to carry their devices under their own brands, but might use the installment approach as an alternative route to those markets, improving their name recognition and perhaps helping to bring the carriers around too.

There are significant barriers to this approach, but thanks to the carriers’ moves to get out from under the burden of subsidies, several of the barriers that existed in the past are slowly being removed. I would expect at least one phone maker to begin experimenting with this model in the coming months, and I wouldn’t be surprised if others followed.