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Should Apple Fear a Smartphone Subsidy Revolt?

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Earlier this week Walter Piecyk of BTIG Research made headlines by cutting his rating on Apple (NASDAQ: AAPL) from “buy” to “neutral.” The call attracted lots of attention being one of the only negative calls on Apple. Last week an analyst gave Apple a $1,001 price target; this week Piecyk is forecasting a revenue miss driven by a subsidy revolt, which is a bold call indeed. His reasoning is straightforward:

  • The iPhone is expensive
  • Wireless carriers have propped sales by subsidizing
  • Subsidies have been good for growth, but are becoming a burden
  • Some carriers are already moving to slow upgrade cycle, others may follow
  • iPhone sales will fall with subsidies

How much of an effect is Piecyk anticipating? Assuming other companies follow AT&T’s (NYSE: T) lead, quite a big one. According to AllThingsD Piecyk had this to say: “We expect Apple’s iPhone sales to drop to 27.5 million units in Fiscal Q3, resulting in a revenue estimate that is $1 billion below consensus.” Quite a bold call, particularly since it hinges on a subsidy revolt.

How likely is a subsidy revolt? Almost guaranteed at this point, and even if subsidies aren’t dropped altogether, resistance will still have a toll on domestic upgrade sales. Carriers are already pushing against the upgrade cycle -- AT&T is a great example of this. Prior to the launch of the iPhone 4S, AT&T routinely waived the two-year upgrade commitment to allow iPhone users to upgrade after a year, but that is no longer the case. Now users have to wait 20 months to be eligible for an upgrade, tacking eight more months on to the upgrade cycle.

Even worse, the carriers are becoming increasingly more outspoken against subsidies, with some going so far as to blame device subsidies for industry woes. Last month T-Mobile’s Chief Marketing Officer Cole Brodman spoke at the GeekWire Summit in Seattle and lamented the distortion caused by subsidies. Internationally subsidies have been even more unwelcome, with several carriers opting to drop subsidies and others speaking publicly about their sustainability.

In much of the world subsidies are less common, particularly in southern Europe and developing markets like China. Unsurprisingly, Google’s (NASDAQ: GOOG) Android OS outperforms iOS by a wide margin in these areas, which was recently highlighted by a report from Chinese research firm Analysys International.

<img src="/media/images/user_92/chinesesmartphone2011q1-q4_large.jpg" />

As demonstrated by the chart above in just the past year Android has grown significantly, moving from 33.6% of the market in Q1 to 68.4% by the end of Q4. Without subsidies Apple’s device is much more expensive than Android competitors and developing consumers are much more sensitive to price. Because Google freely licenses their OS to handset makers, there is a variety of Android devices, including ones specifically targeted for the low-end. Also worth noting is the presence of Nokia’s (NYSE: NOK) Symbian OS, which despite losing ground still held a respectable 18.7% of the market in Q4. In developing markets Nokia embraces a low-cost, high-volume approach that is likely one of the reasons for its continuing market share in China.

Nokia is also embracing the low-cost strategy in the US, though it remains to be seen whether its latest attempt puts pricing pressure on other manufacturers. Nokia launched their first high-end Windows Phone and potentially a price war this week, but so far the Lumia 900 hasn’t made much of an impact despite its $100 price tag.

Piecyk is right in suggesting a move from subsidies will hurt the iPhone and Apple, but I think he’s neglecting other factors in his projected results. A drop in iPhone sales would clearly hurt Apple; the iPhone remains Apple’s biggest contributor to net sales by product.

<img src="/media/images/user_92/applesales06to11_large.jpg" />

Even with carriers moving to lengthen the upgrade cycle, subsidies still remain. And more importantly, even with its record sales, Apple has yet to reach market saturation and is continuing to add new distribution channels. Just this past year Sprint-Nextel (NYSE: S) locked itself in to buying at least 30.5 million iPhones over the next four years, to the tune of $20 billion. Sprint’s CEO Dan Hesse seems happy with the deal, pointing to the big boost in new customers that came with the addition of the iPhone 4S to its product line even after paying $1.7 billion in subsidies during Q4. Smaller U.S. carriers are getting in on the act too, with recent reports pointing to the iPhone being launched April 20 at various regional carriers.

Another big factor is international growth. Apple has made a big push into China, which should offer significant growth. Even though pre-paid phones are the norm in China, companies have experimented with subsidies and post-paid phone plans. China’s second largest mobile operator, China Unicom (NYSE: CHU), has subsidized the iPhone for the past three years and competitor China Telecom (NYSE: CHA) has recently begun to do so as well. Subsidies in China are particularly important given that Apple devices are still prohibitively expensive without them.

In the end, there is some merit to Piecyk’s position, but I think he’s painting an overly grim picture. Apple should fear the loss of subsidies, but it is long-term issue. Apple has also been keeping older models of the iPhone around, priced competitively, so it isn’t a stretch for the company to start adopting a two-pronged model with a high-end and low-end offering. That being said, I salute Piecyk for his bold call, but I remain an Apple bull.

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