Don't Cry For Wireless Carriers

By Chad Henage - February 16, 2012 | Tickers: AAPL, T | 0 Comments

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I recently read an article saying that mobile is doomed, because wireless carriers are subsidizing the cost of the latest and greatest phones. Everyone replaces their phones every 2 years or so, and the carriers are paying for the handsets. This article basically assumes that carriers are dim witted accomplices to handset makers. Let's use AT&T (NYSE: T) as an example and see if the carriers are really being taken for a ride. Something tells me that the carriers know what they are doing.

We'll use one of the most popular carriers and one of the most popular handsets to run our numbers. Let's assume you are an individual who wants a smartphone. You've never had service before and you've been thinking about getting an Apple (NASDAQ: AAPL) iPhone 4S. You walk into a local AT&T store, Best Buy, or other store, and you sign up for service. There is a big difference between what happens that you see, and what is going on behind the scenes.

Here is what you see:

You choose the iPhone 4S with 16 GB memory. You're told if you sign up for a 2 year contract with AT&T that you can have this phone for $199. You agree and sign up. You hand whomever you bought the phone from the $199 plus tax. You choose the cheapest individual plan at $39.99 a month. You also have to sign up for a data plan, since it's an iPhone, so you sign up for the 3GB plan which is $30 additional a month. You want to be able to send unlimited text messages, so you sign up for the $20 a month unlimited messaging. This seems like a good deal because with this unlimited messaging you can call any mobile phone without using your minutes. In most cases you are told there will be a $35 activation fee on your first bill. You get everything set up, and walk out the proud owner of a brand new iPhone 4S. You're expecting that monthly charges without taxes and fees is going to be $89.99.

Going on behind the scenes:

Now behind the scenes there is a lot going on. First, it costs Apple reportedly about $200 to make the 16 GB iPhone 4S. Apple sells these to stores and carriers reportedly for about $650. This means the carrier has to make up the difference. So up front, it costs the carrier about $450 just to subsidize the phone. In addition, the carrier normally pays a commission to whomever signed you up. For sake of argument let's say the carrier pays $300 to the store that sold you the phone. The carrier is already out $750 and they only have 1 new customer. Is the carrier being taken for a ride?

To understand the economics, understand that wireless carriers have to have 100% up time on their networks. It doesn't matter whether there are 10 million people using the network or 1. This is truly an example of the more customers the more profitable the carrier can be. It's the same concept that airlines use. If a plane is flying a route and is full the airline is more profitable. If it's half full the airline is making less money. Think of cell towers like that plane. The more people using the tower the more cost effective it is for the carrier. Understanding all of this is key to knowing why a carrier would subsidize a new phone.

The carrier in our example, now has a customer that is paying $89.99 per month for the next 2 years. If that person cancels, their cancellation fee on a smartphone is $325. Each additional subscriber adds incremental income to the bottom line. Here is the math the carrier is looking at:

Month 1 = Carrier cost $750 - $89.99 monthly charges - $35 activation fee = $625 negative

Month 2 = Carrier cost $625 - $89.99 monthly charges = $535.01 negative

Month 3 = Carrier cost $535.01 - $89.99 monthly charges = $445.01 negative

etc. until Month 8 = $4.94 profit

For most carriers I would venture to say they become incrementally profitable around month 8 – 10. Since this is a 2 year contract, the carrier makes money over the next 14 – 16 months at $89.99 a month. This works out to a profit of about $1,259 - $1,439 per new 16 GB iPhone 4S customer.

Now I realize that all carriers have expenses like sending out bills, processing payments, upgrading their network, etc. Yes the math above is a little simplistic, but it shows that carriers can be profitable even if the customer chooses an expensive smartphone and upgrades every 2 years. The reason I'm comfortable with the above math, is not everyone on the network buys a smartphone every two years. There are a lot of customers that have been with the same carrier for years and they still pay $39.99 a month or more. The truth is, the less frequently people upgrade the more profitable the carrier is. However, if they upgrade to most phones, the carrier can require a data plan which adds to the carriers incremental profit.

I think you can see that we shouldn't be too concerned about the carriers in this situation. This is also the reason that I think investing in certain carriers can be profitable. A company like AT&T does have to pay quite a bit to get that new iPhone customer. They know that within the first year they have recovered their cost and turned profitable. Keep these numbers in mind the next time you hear how mobile is doomed. Based on what we have seen, it seems like the carriers will do just fine.

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