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Are Mobile Device Makers Finally Ready To Swear Off Carrier Subsidies?

We’re beginning to see hints that mobile-device makers may be prepared to start weaning themselves off carriers handouts and pricing their products based on what they actually cost. What’s less clear is whether everyone-not just Apple-can be truly competitive and make enough money in the market without those juicy subsidies.

Back in 2007, Apple (NSDQ: AAPL) tried to drive a new pricing model into the smartphone market. It priced the original iPhone at $599, betting that it was attractive enough at that price to forgo carrier subsidies that would artificially reduce the cost of the phone. It wasn’t: Apple cut the price of the first iPhone just a few months after it was launched, and then cut it further in 2008 upon the launch of the iPhone 3G, when it accepted carrier subsidies to get the price down to $199. After that, Apple never looked back, as iPhone sales skyrocketed at the lower subsidized price.

But just three years later in 2010, Apple was able to generate demand for the original iPad at unsubsidized prices, which allowed its customers forgo a two-year wireless contract for their tablets. The same thing happened this year, as the iPad 2 went on sale at both AT&T (NYSE: T) and Verizon Wireless (NYSE: VZ) without a wireless contract at the same price as the original iPad. Those prices range from $499 to $699 for various configurations of the Wi-Fi-only models, and $629 to $829 for 3G-capable models, yet it seems the vast amount of interest is in the Wi-Fi only models.

So now, as challengers get ready to try and dent Apple’s runaway lead, do they need to accept heavy subsidies on 3G and 4G products in order to compete? We’ve already seen Motorola (NYSE: MMI), which accepted carrier subsidies for its Xoom launch, blunt its chances at picking up any ground by coming in too high both with and without the subsidy, forcing it to offer a Wi-Fi only version. The real question is what type of gross margin are those competitors willing to accept as they acknowledge that the amazing mobile growth of the past several years simply would not have happened without generous carrier subsidies that reduced the opening price of their wares, not to mention the heavy promotion as those carriers went about recouping their investment.

At the moment, Apple’s challengers are trying to have it both ways. We got a good look at the short-term strategy Tuesday at CTIA Wireless, when both Samsung and Research in Motion (NSDQ: RIMM) announced plans to ship Wi-Fi only versions of their tablets running the Android and QNX operating systems, respectively, for identical prices to the iPad 2. But they conspicuously avoided details as to how they plan on pricing the versions of their tablets that can connect to wireless carrier data networks, and a decision to undercut Apple’s unsubsidized prices could make this market more interesting at the expense of once again forcing mobile customers to shoulder multiyear contracts.

A tale of two devices: Tablets are different than smartphones in a few ways. Smartphones, the ultimate mobile device, really require cellular data connections to be truly useful. Apple may sell a lot of iPod Touches, which is basically a Wi-Fi-only iPhone, but overall the smart mobile device market is tilted heavily in favor of phones that can get online just about anywhere.

Tablets, on the other hand, are in a period of flux as device makers and carriers try to figure out exactly how people want to use the devices. Today Wi-Fi-only tablets make an awful lot of sense as coffee-table computers that are substantially less expensive than 3G or 4G-enabled tablets, especially since most tablet owners still carry a phone to make voice calls and in some cases can tether their tablets to their phone’s data connection. However, Wi-Fi is limiting and seems unlikely to be the long-term method of connecting to the Internet for the tablet market, especially as fast wide-area 4G connections become more and more pervasive. In addition, hooking up with carriers allows tablet makers to take advantage of the huge promotional and distribution budget that wireless carriers can tap when they are motivated.

That means that while Wi-Fi-only tablets might be popular in 2011, carriers will eventually be involved in the tablet market. Right now, they’re playing a very passive role when it comes to the iPad, and even when it comes to other devices carrier subsidies aren’t huge: a Verizon-subsidized Motorola Xoom costs $599, as opposed to $799. By contrast, the unsubsidized price of the iPhone 4 is either $499 or $599 depending on the storage, while the subsidized price is either $199 or $299.

Sprint (NYSE: S) CEO Dan Hesse, speaking on stage at CTIA yesterday, acknowledged that “subsidies are going to increase as a combination of devices get more powerful,” citing the move to dual-core processors and sophisticated cameras inside tablets and phones. At the same time, he said carriers like Sprint also are “going to try to pass more of that cost onto the end user” even though as device costs get higher, carriers tend to make more money per subscriber from increase data usage.

The duality of that statement–that carriers are going to spend more money while also trying to pass more cost onto the user–underscores that carriers would very much like to convince device makers they need subsidies while maintaining their own profit margins. It’s been a little easier for Apple to avoid that oversight so far based on the favor associated with its brand, its early entry into the market and its laundry list of cost advantages: favorable component supplier deals cut years ago, a wholly owned retail network, and the inherent advantage in designing hardware and software within a single organization.

Cost of doing business: Have hardware costs reached a point where other tablet makers can offer their products at competitive prices without help from their carrier friends? When it comes to Wi-Fi-only models it seems like device makers are willing to suck it up and match Apple, but we don’t know the full story until their 3G and 4G pricing is revealed. The problem is that iPad challengers may have to get even more competitive on price as opposed to merely meeting Apple’s price, and whether or not they can actually do that at the moment and make money is far from certain: for example, price wars, while good for consumers, did not make the PC market a better place to be.

After all, carrier subsidies on smartphones became a standard practice for a reason: just ask Nokia (NYSE: NOK) how easy it is to sell a smartphone in the U.S. without carrier aid. Savvy customers do the math over two years and know they might be better off getting service without the contract, but an awful lot of people think in terms of the upfront price, figuring they’re going to have to get data service for the thing anyway. Tablets are a little different, since people can understand that they should cost more than phones, but neither are they PCs that can simply plug into any Internet service provider’s modem.

Tablet makers face a decision: do they take the carrier money for cheap 3G tablets and run, knowing they’ll have a better chance competing against Apple on price? Or do they try and compete against Apple on relative pricing while taking on much of the burden of promoting and distributing their own products and betting on Wi-Fi-only models? The problem for those folks is that Apple, sitting on a ton of iPad demand and a pile of cash, can match their moves and once again suck the profit out of another mobile segment. But there’s also upside either way: either tablet customers learn to pay true prices for products that allow device makers to escape the carrier yoke, or those friendly subsidies introduce them to a whole new generation of customers without having to sacrifice profits.

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