This Bandwagon is Missing a Wheel
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I've read multiple articles that wireless carriers are looking to establish a third ecosystem to challenge Apple's (NASDAQ: AAPL) iOS and Google's (NASDAQ: GOOG) Android OS for market leadership. With Research in Motion (NASDAQ: BBRY) apparently all but forgotten, the most likely third ecosystem could come from Microsoft (NASDAQ: MSFT).
This is the thought process behind a recent article by the Fool's Dan Radovsky. In his article, "More Carriers Jumping on Windows Phone 8 Bandwagon," Dan outlines some of the comments and arguments for establishing a new competitor in the mobile operating industry. In short, the idea is that a third ecosystem could put more “competitive pricing pressure on smartphone producers,” and could be a big win for Microsoft at the same time. While that sounds good on paper, and wireless carriers may actually believe it, there are a few questions left unanswered.
Why Establish a Third Ecosystem at All?
In his article, Dan pointed out that executives from each of the major carriers were "almost falling over themselves... to offer praise and support for Microsoft mobile operating system." In addition, he said that Glenn Lurie from AT&T said he is, "bullish on Windows 8... it's hard to bet against a tablet that does what your PC and desktop will do."
Meaning no disrespect to the large wireless carriers, having three different systems won't necessarily change anything about their current predicament—and that's not a terrible thing. In theory, a third ecosystem that has strong support might lead to better smartphone prices and lower subsidies for the carrier. However, in the real world this might not occur at all.
Case Study: Research in Motion
If you want an example of why a third ecosystem makes no difference, you only have to look at Research in Motion. The company was once a darling of the smartphone industry. Users were so hooked on the devices that the name CrackBerry was born. However, as iOS and Android came on the scene, customers chose these two new operating systems over the well-established BlackBerry system.
In theory, this competitive force from Apple and Google should have put pricing pressure on all three companies. However, what actually happened is the pricing pressure only affected Research in Motion. The most popular iOS and Android devices actually have seen an increase in their profitability for their respective companies. The point is, just having another option doesn't automatically mean increased pricing pressure.
What's Wrong with Current Subsidies?
While the mobile carriers probably would hate to hear me say this, there really is nothing wrong with the current subsidy system. I've written about this before—wireless carriers are tremendously profitable even when they subsidize the most expensive smartphones, because their network is one of almost 100% incremental profit. For point of comparison, let's use the Samsung Galaxy S3 16 GB smartphone as an example.
We will use Verizon's (NYSE: VZ) pricing to keep things consistent. Without a two-year contract the price is $599.99; with a two-year contract the price is $199. This tells us the carrier is subsidizing just over $400 worth (or 66.83%) of the retail price in exchange for a two-year agreement. The carrier usually pays somewhere around $300 for the acquisition of a new customer sign-up, which brings their total cost upfront to roughly $700.
Since every smartphone requires a data plan that nets out to around $30 per month, and most require a minimum voice plan that averages $50 per month, the carrier gets roughly $80 per month from this customer for the next 24 months. With $80 per month in incremental income, the carrier breaks even on the phone subsidy and acquisition commission in just under nine months of a 24-month contract. This leaves the remaining months as almost pure profit. With 15 months at an average price of $80 per month, this is equivalent to a $1,200 profit over the course of the contract. Granted this is a very simplistic example, but the point is carriers are not losing their shirts like many have been led to believe.
Does Competition Lower Subsidies?
I hate to be the bearer of bad news to mobile phone providers, but there doesn't appear to be strong evidence that competition lowers subsidies across the board. In fact, it might surprise some to know that the Verizon subsidy for an iPhone 5 is exactly the same as for the Motorola RAZR MAXX 16 GB. Both phones have a retail price of $649.99, but with a two-year contract you pay $199.99. This means whether you buy the iPhone 5 or the Motorola, Verizon subsidizes 69.23% of the retail price.
If you can believe it, the subsidy for the Droid Incredible 4G LTE by HTC is actually a bit higher at 70% of the retail price. Without a contract this phone costs $499.99, but with a two-year contract the price drops to $149.99. Even customers considering a BlackBerry Bold 9930 end up with a subsidy of almost 55%.
Three different phones with three different operating systems have different subsidy levels, but the most popular phones are subsidized at the highest amount. What's to say that an equally popular Windows 8 phone wouldn't gain the same type of subsidy requirement that the Samsung Galaxy S3, the Motorola RAZR MAXX, or the iPhone 5 get? The obvious answer is there's no reason to believe an equally popular third operating system phone would be subsidized differently.
Conclusion
While mobile carriers might believe developing a third ecosystem will change their costs, there isn't any reason to believe Microsoft or smartphone manufacturers will accept less in subsidies. It's very likely if Windows 8 does generate a lot of customer interest that the carriers will be required to subsidize these phones at an equivalent rate to existing iOS and Android devices.
Mobile carriers might be upset that smartphone subsidies are expensive, but the reality is smartphones are here to stay, and are gaining in popularity. This dynamic won't change, and any carrier that lowers its subsidies will feel the wrath of customers. Pricing in the market is fairly well established, and $199.99 seems to be the top line for a highly desired smartphone.
If AT&T decided to change its subsidy level while Verizon stayed the same, customers would flock to Verizon because they would be getting the same phone for a lower price. While it will be months before anyone knows if Windows Phone 8 will take off, this potential big win for Microsoft probably isn't a big win for carriers like they might expect.
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MHenage owns shares of Apple and Verizon Communications. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend Apple and 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.
