Sunday, January 22, 2012

Are Device Subsidies Bad for Consumers?

Some would argue that mobile device subsidies, which require end user contracts, represent unfair competition in a market where some larger providers can afford to make the offers, while others cannot. Those subsidies are substantial. In some cases, the subsidy can run as high as $500 on some devices.

Others would argue that contracts and subsidies also are anti-competitive to the extent that use of contracts hinders consumer choice, as the contracts lock users into relationships with specific carriers.

Others would argue that device subsidies are one reason so many consumers can afford to buy and use advanced smart phones that often cost as much, if not more than a PC.

In fact, some would argue that the net present value is better, for a consumer, when choosing not to sign a contract. Yell now if you know any consumer that ever has conducted an NPV exercise before buying a device or service.

One can argue that consumers essentially are “dumb” when they choose to buy subsidized phones and sign contracts. Others would argue the behavior not only is quite rational, but provides more value.

The argument for not buying a subsidized device that comes with a contract is that there is a risk of having to pay an early termination fee, or that the recurring fees of a contract plan are higher than otherwise would be the case.

Those assumptions do not generally apply, would might argue. Not every consumer ever pays an early termination fee. Perhaps few do. For a consumer that never pays an ETF, it is not part of the value equation at all.

Nor is it the case that a month-to-month recurring fee is lower than would be the case under contract. As often as not, it will cost just the the same, either way, and could cost more, in the non-contract case.

Consumers do have the choice to buy a prepaid plan that will offer lower recurring fees. But they generally will lose access to the full range of handsets, and will have to pay the full retail price for their handsets. Figuring out the actual NPV of such deals is complex. Users pay more cash up front, but lower recurring fees

So one major variable is the cost of the device and the length of time that device is used. That generally means a tougher business case for a younger consumer than an older consumer, as younger users break or lose their phones more often than older consumers do, and younger consumers are more apt to buy a new phone for fashion or application reasons unrelated to whether the device still works.

That said, in cases where a consumer has to pay an early termination fee early in a contract (the fee is pro-rated), an argument can be made that the NPV would have been better if the contract had not been signed.

Contracts, some argue, also are “unfair” to consumers, which might not be the same thing as a less-favorable NPV. The reason is that the actual value of a handset subsidy is rarely clear to a consumer.

The device “retail” price, which is typically compared to the subsidized price, might or might not capture the actual value of the discount, since a consumer doesn’t know what a particular service provider actually paid for the devices.

The same objection can be made about early termination fees that might be likened, when imposed, to a consumer making a loan to the service provider. Some would argue that the pro-rated ETF fees are levied at rates above the simple amortization rate of the ETF over the two-year contract term.

In other words, if a consumer has to pay even the pro-rated ETF, a simple amortization rate might imply reducing the rate about $14 a month for each additional month of service. Instead, service providers reduce the rate about $10 a month for each month of contract service. That $4 a month “excess” is essentially an “interest” payment, some would argue.

Likewise, the handset subsidy might be likened to a  is a loan that is repaid over the life of the subscriber contract.

Are subsidies loans? Some might argue a handset subsidy is a loan made to a consumer that is repaid over the length of the contract term. The logic there is that the ETF should reflect the actual value of the handset subsidy.

“If the actual cash subsidy is equal to or less than the initial ETF, then the way in which ETFs are administered today produces punitive results for subscribers who terminate their subscriber contracts early,” argues Dave Selzer , JSI Capital analyst.

Some of us would argue that, in most cases, the device subsidies, with contracts, actually are positive for end users, service providers and device innovation. That is not to ignore the growing cost to service providers of providing the subsidies, the potential ETF exposure for consumers or potential danger to device suppliers if the subsidies were to go away.

The simple argument is that device subsidies allow consumers to buy advanced devices they would otherwise not be able to afford, or not want to buy. Service providers sell more data services when they sell the subsidized smart phones and reduce churn. Device manufacturers have larger markets, since consumers replace their phones at a higher rate than they would if the subsidies were not available.

All application providers win because device replacement is the primary way new app behaviors are stimulated.

Nevertheless, the subsidies cause cash flow drag for service providers, and seem to be a growing burden, in that regard.

On the other hand, subsidies and contracts do minimize churn and do support average revenue per user. Those effects are important for public companies.

Would carriers offer the subsidies without some assurance they could earn back the cost of the subsidies over time? Would carriers rather sell devices at twice current prices, or higher? Would they prefer to raise rates? You can make your own guesses in that regard.

That is not to say different packaging is inconceivable. If you assume the subsidy represents $300 to $400 of real costs to a carrier, it might be possible to offer a plan with full-price device purchase, with free service for a period of time or perhaps lower recurring prices.

The details might vary, but a revenue-neutral solution could be imagined. The downside is that predictability of revenue would decrease, since consumers could desert, without financial harm, at any point after the promotion ended

The potential changes in how service providers compete, in a regime where there are no device subsidies, is likewise unclear. All service providers prefer device exclusivity when they can afford to pay for it. That might not change.

But higher device prices would encourage more buyers to shift to prepaid plans that are far less lucrative for service providers. Fewer might buy advanced devices. So innovation would slow. That isn’t helpful for anybody in the ecosystem, as it is the promise of new services and applications that could allow service providers to keep growing revenues as demand for basic voice and messaging declines.

Device subsidies are an issue that contracts address. Contracts smooth out revenue, raise average revenue per user and reduce churn. Whether there is a way to preserve those advantages some other way is an interesting question.

So far, the largest mobile service providers, who live mostly on the strength of postpaid accounts, have been unwilling to rock the boat by switching to some packaging method that does away with the subsidies.

Whether they ought to do so also is a key question. Many business models are built on subsidizing one element of service to make money elsewhere. Amazon seems to be subsidizing devices to sell content, while Apple subsidizes content to sell devices.

Mobile service providers subsidize devices to sell recurring service. In principle, mobile service providers could offer inducements other than cheaper hardware, ranging from free domestic calling or messaging to lower recurring prices.

Whether the value of those inducements to consumers is higher than "cheaper devices" is hard to determine. Also, any other inducement would involve a revenue exposure of some size. Right now, messaging is the service with the highest profit margin and voice is the product with highest revenue contribution, though matters will change over time.

Whether prices and packaging for recurring services matter as much as cheaper phones is the issue. Also, there is no question but that devices increasingly are the value that provides the greatest demand "pull" in markets where "everybody" buys mobile service.

Nobody really "loves" their service provider, much less the ability to communicate, as much as they love their devices. Price is never unimportant. But price differentiation can only go so far, one might argue, as key competitors in each market segment pay close attention to competitor prices and offers.

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