Look out Major Carriers: Innovator's Dilemma Coming Soon!

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Have you ever read The Innovator’s Dilemma by Harvard professor Clay Christensen?  The book is a masterpiece, explaining how incumbents in strong industries become complacent with their huge margins and fat profits.  To prove its point, the book walks readers through a number of actual examples occurring over the past few decades. 

The cycle often looks like this:

  1. Incumbent earns huge margins from its products and services
  2. New entrant enters market and provides bare-bones products for bare-bones pricing
  3. The entrant’s product gets better over time, and the price is still significantly less than the incumbent’s price
  4. The incumbent cannot respond quickly enough because its cost structure and R&D are too centralized and bulky
  5. The new entrant dethrones the incumbent

The major Telco companies are in the earliest stages of the dilemma.  Here’s why.

Culture Shock

In Europe, Free Mobile forced competitors into a deadly pricing war by offering pricing far below competitors.  In the U.S., Skype co-founder Niklas Zennstrom had a similar goal – and he built FreedomPop to accomplish it. 

FreedomPop offers cheaper, no-contract plans through Sprint’s (NYSE: S) Virgin Mobile.  Through Sprint, it charges just $10 per gigabyte, and up to 500 megabytes are free.  Currently the company does not yet offer talk or text services, but plans to just enter the market by revamping how consumers pay for data.

The firm’s model is unique.  Most of its revenues will not come from data, but rather from three other areas.  First, it sells services like Turboboost, which will “guarantee the fastest speeds available to a user even when on a congested network,” The Wall Street Journal reports.  Second, it sells a mandatory $99 sleeve that wraps around cell phones, and finally, it requires a deposit of $89 for portable Wi-Fi hot spots.

For the networking end of the deal, FreedomPop connects to the network offered by Clearwire Corp. (NASDAQ: CLWR), a company that offers networks covering 136 million Americans.  Clearwire is a gamble, however.  Clearwire, which does everything from buying network space to selling directly to consumers, has been experiencing major losses – to the tune of -$5.72 per share last quarter.

Partnering with Clearwire is risky.  Google (NASDAQ: GOOG) and Intel have invested in the company, but the investment has turned bust.  Google hoped to have a large stake in a growing network company, which holds large quantities of spectrum, or air wave space.  However, Google’s $500 million investment has turned into just $66.5 million, where the company sold its shares.  Google Ventures acquires companies at a feverish pace, so this investment is just one flop in a giant pool of acquisitions.  But moving forward, Google will have to deal with the ramifications of this written-off investment and must recoup its losses in other ways.  (If you are long Google, I highly recommend looking at the Google Ventures link above.)

To compensate for the rest of America not covered by Clearwire, FreedomPop has inked a deal with Sprint to cover the remaining users in the U.S.

FreedomPop’s foray into the space has implications for Verizon (NYSE: VZ) and AT&T (NYSE: T), as well. The danger is that consumers will begin to grow tired of paying fees of up to $100 per month for a smartphone, and they will gravitate to the no-contract, cheaper service offered by the new entrant. 

Such a thundering consumer shift would force the two large Telco companies to quickly revamp their firms to cut costs and to reorganize themselves into more nimble units that can embrace change more quickly.  Such a change is very possible, but it will not be happening soon.

Verizon and AT&T are experiencing their lowest attrition rates in the past eight years, with AT&T losing just .97% of users and Verizon losing a mere .84%.  The average for all carriers is 1.23%.  Likely the small changeover is due to the 88% of users who are on family and business plans, making it harder for them to switch carriers.

Short Term, OK - Long Term, Questionable

To inflict major damage, FreedomPop would have to add voice and text services to complement its free data usage service.  Building the infrastructure – or forming a deal – would take time.

However, a joint venture with Sprint could turn the industry on its head.  FreedomPop would steal away market share, and Sprint would be in the strong position of managing a new portfolio of businesses, a must if it hopes to take down Verizon and AT&T.

FreedomPop’s entry could mark a turning point in the telecommunication space where prices are lowered to entice consumers.  The situation is a classic case of Innovator’s Dilemma; that’s the downside for the big Telcos.  However, they can fight back.

To take down the ex-Skype entrepreneur, the big firms have a strong tool at their disposal – a book.  Luckily, Christensen laid out a plan for them also in his sequel: The Innovator’s Solution

ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Google. Motley Fool newsletter services recommend Google. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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