Handset Subsidies and the Consumer Conundrum – Part 4

What’s It All Mean?

If you’ve been following our series on handset subsidies and the consumer conundrum, you know by now that I believe that the market power concentrated in the hands of AT&T Mobility (NYSE:T, “AT&T”) and Verizon Wireless (NYSE:VZ, “VzW”) gives them unregulated market control.  You’ve also read my analysis of the practice of subsidizing handsets, requiring a contract for same, and charging an Early Termination Fee (ETF) when a subscriber breaks his contract.  You also understand that I view the handset subsidy as a loan to the customer and the construction of the ETF has a built-in form of interest expense. In this last installment, I’ll explain why I believe these things are truly bad for both the industry and consumers.

First, the actual amount of the cash subsidy matters, and that’s the one piece of information that consumers don’t have. Knowing the actual cash subsidy amount is the single most important piece of information needed to truly understand the total financial impact of the purchase. The large wireless carriers would likely point out that the full retail price represents what the actual market price would be in the absence of the subscriber contract system.  This is a hollow answer; the fact is that the contract system does exist and carriers set the full retail price at levels which virtually guarantee that transactions involving wireless devices end with the consumer signing a 24-month service commitment.

Furthermore, the cash incentives provided by carriers aren't subsidies at all, they are loans that are repaid by the consumer over the life of the subscriber contract; 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. This means that payments made to wireless carriers which are now called Early Termination Fees, are in fact Early Termination Penalties. These penalties represent yet another hurdle to consumer choice with regard to wireless services. So why does this confusing system of hidden handset subsidies and penalties exist? 

The answer is that the subscriber contract is a significant brick in the foundation that supports the entire wireless industry. The subscriber contract ties the consumer to the wireless provider for up to 24 months at a guaranteed minimum ARPU, meaning that the contract system provides a means by which wireless carriers regulate both subscriber churn and service revenue. Churn and ARPU are two metrics that are closely tracked by financial analysts as indicators of future earning; if either of these metric were allowed to fluctuate unpredictably, the equity prices for both AT&T and VzW would become more volatile. Uncertainty is not viewed positively by large investors and is ultimately a threat to senior management. Therefore, the need to maintain the subscriber contract system as a means of controlling these two metric is paramount, even if it comes with great financial costs.

Elimination of handset subsidies and its implications for the all-important subscriber contract represents a significant threat to the status quo and would be fiercely opposed by the major wireless carriers.  In all likelihood, AT&T and VzW would proclaim that handset subsidies are pro-competitive and good for consumers. Practically speaking, the notion of AT&T and VzW as consumer advocates does not compute and claims made by either company that purport to be pro-consumer should be viewed with a high degree of skepticism.

The reality is that even if the use of handset subsidies were eliminated, it would not spell the end of the subscriber contract; subsidy dollars would simply be reallocated. Depending on the timetable under which the current system could be replaced, the impact to wireless carriers would be a net cash savings based on the fact that they would no longer be making large outlays to subsidize the purchase of wireless devices. The cash savings would be enormous, but these savings would come at the cost of having to forgo the use of subscriber contracts. Giving up the use of subscriber contracts means ending the primary ARPU and churn controls now in existence; this, in turn, would make senior managers at both AT&T and VzW less certain of their future financial performance.

Because of the increased uncertainty that would be created, the likely response would be for service providers to find new subsidies to exchange for subscriber contracts. The most obvious scheme would be for carriers to offer consumers promotional/ introductory pricing such as two or three months of free or reduced pricing for wireless service. 

In my view, if wireless carriers were effectively eliminated from the supply chain for wireless devices, the most likely result would be that prices for wireless service go down. How far prices for service would drop is unclear but the fact is that prices would not fall below the amount of the actual cash subsidies that are offered today and would make the entire system function with significantly more transparency. Under the scenario envisioned here the consumer is provided with far better information about the exchange between service provider and consumer allowing for the use of subscriber contracts under conditions that are less compulsory than they are now.

A second, less likely outcome would be that wireless providers accept the elimination of subscriber contracts. Under this scenario consumers may not pay lower prices for wireless service but then service providers would need to compete for subscribers based on some form of product differentiation. Achieving that differentiated status is extraordinarily difficult to do with a product such as wireless service. Carriers would need to commit to a level of capital investment, which could be funded from the savings described above to raise the customer experience to the point where very high levels of customer satisfaction would create product loyalty. The issue is that the success of any service improvement program is far from guaranteed and corporate entities such as AT&T and VzW are reluctant to invest capital in programs that can’t guarantee a return.

Lastly – yes, absolutely without a doubt, consumers would pay higher prices for wireless devices. The question is, will prices for devices be as high, or higher, than the full retail prices that exist today? If the answer to this question is no, which I think is likely, then net, net the industry and the consumer would be much better off without the convoluted system of handset subsidies and contracts that exists today.

Richelle Elberg contributed to this series of articles.