T-Mobile Drops Subsidies: What Does it Mean for the Smartphone Market?

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In a few months, T-Mobile USA (a unit of Deutsche Telekom (NASDAQOTH: DTEGY)) will no longer offer subsidies in return for customers committing to two-year contracts.  Phone subsidies have long been a major feature of the U.S. wireless market, particularly for smartphones.  An unlocked base-model iPhone 5 from Apple (NASDAQ: AAPL) retails for $649, but can be purchased for just $199 along with a two-year contract from AT&T (NYSE: T), Verizon, or Sprint Nextel Corp.

These subsidies are a win-win for customers, carriers, and high-end smartphone manufacturers.  Customers clearly value the upfront savings, and are willing to pay significantly higher monthly costs in order to upgrade their phones frequently.  Wireless carriers also benefit, because they can keep postpaid customers locked into their networks.  The postpaid/subsidy model generates higher margins for wireless carriers than lower-cost prepaid plans.  High-end smartphone manufacturers also benefit, because the subsidy model relieves pricing pressure.  Apple's cheapest phone (presently the iPhone 4) costs more than $400, but is available free of charge with a two-year contract at the top three U.S. carriers.  Since consumers do not directly see the cost of high-end smartphones, there is little pressure to lower prices.  Since each party sees some benefit from the continuation of subsidies, I do not expect this practice to disappear anytime soon.

Nevertheless, T-Mobile USA CEO John Legere thinks T-Mobile could gain significant market share by focusing on lower-cost plans without phone subsidies.  At first, it would seem that this strategy is bound to fail.  After all, prepaid plans already exist, but customers have increasingly abandoned them for more expensive postpaid plans that offer phone subsidies.   Relatively few customers will be willing to shell out $649 up-front for an unlocked 16GB iPhone 5 on T-Mobile.  For that reason, the company will be offering "installment plans," whereby customers can amortize the cost of a new phone over 20 months.  This will result in a similar cash flow profile between T-Mobile's plans and the rest of the industry's subsidized plans.

Moreover, T-Mobile could gain additional subscribers through market segmentation.  Users who already have a smartphone could save a lot of money by upgrading less frequently while enjoying the lower monthly rates at T-Mobile.  T-Mobile particularly has AT&T in its crosshairs, since the two carriers have compatible GSM networks.  As a result, AT&T smartphone users can (relatively) seamlessly move to T-Mobile when their contracts end, while keeping their existing phones.  Alternatively, customers could buy used GSM smartphones for much less than the cost of a brand new phone.  While many people want the latest and greatest phone, for others, a 2 or 3 year old phone is still "good enough."  With most AT&T customers upgrading every 2 years, there is a steady stream of used phones of that age range becoming available.

What does this mean for Apple?  Apple bears have long been worried about the potential demise of the subsidy model.  Without subsidies, Apple could face pricing pressure that would severely dilute its margins and cut into its better than 70% share of smartphone profits.  However, I think the current situation is much more benign than bears fear.  First, T-Mobile's installment plans will keep the upfront cost of new iPhones very manageable.  Second, while some users may hold onto their iPhones longer before upgrading, thus dampening demand, higher demand for used iPhones could boost resale values.  This would actually lower the cost of ownership for AT&T iPhone users who plan to upgrade every two years anyway.  With more T-Mobile customers looking to save some money by buying an older iPhone, AT&T customers should have no problem selling their 2-year-old iPhones for $200-$300 to cover the upgrade fee.

Conclusion

It will be interesting to see how T-Mobile's move away from phone subsides plays out over the next year or two.  Consumer behavior to date suggests that most people prefer the subsidy model.  That said, as a smaller carrier than the "Big Three," T-Mobile may be better off trying to differentiate itself and targeting price sensitive smartphone users through this strategy.  Most customers of AT&T, Verizon, and Sprint will continue to accept 2-year contracts in order to receive subsidized phones, while those who do not see much value in upgrading their phones will be more likely to switch to T-Mobile.  The "Big Three" carriers could always offer competing unsubsidized plans if they started to see significantly higher churn, so they face relatively moderate risks.

As for Apple, the real driver of iPhone sales is high user satisfaction and a continuing stream of improvements to the hardware and software.  The iPhone 5 is already a very high-quality device, so we are likely to see fewer radical innovations in future models.  However, it should be easy (for the foreseeable future) for Apple to add a few new features and additional processing power each year.  Considering how much time a typical iPhone user spends with his/her phone, the iPhone experience offers very good value for the price.  This should drive robust upgrade demand regardless of the popularity of T-Mobile's unsubsidized plans.  Moreover, the subsidy model offered by the Big Three has a lot of life left in it, and should also allow Apple to maintain its market-leading position in the U.S.


Adam Levine-Weinberg is long AAPL. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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