Apple's carrier subsidy situation

iDevices are everywhere. None more so than the iPhone. Apple is making gobs of money selling them as fast as they are making them. It is by far the most popular single device in the last decade or so outclassing another Apple product, the iPod. Wherever I go, I have almost always spotted iPhones in people's hands. I wonder how and where Google sells its 50% marketshare worth of Android phones. Apple's iPhone juggernaut is well set to roll with the next iPhone expected to launch in the next few weeks. It is then a matter of interest to look at something or anything outside of Android competition as a potential speed breaker for Apple. And that could possibly end up being Apple's relationship with its carriers.Carrier Subsidy

What is carrier subsidy and why do we care so much about it that warrants a post?. When a user walks into an AT&T or Verizon or sprint store to buy a phone, they are given an attractive price of $0 to $199 for a phone on contract for 2 years. The phone costs much more for the carrier- typically $150-$300 for a feature phone versus $450 - $650 for a smart phone. The carrier thus is taking a hit upfront in selling it cheaper to the consumer in the hope that they will recoup the cost over the 2 years that the user will be committed to a monthly plan. Things work very differently in Europe and Asia although things are heading the US route slowly but steadily.

In EU and Asia, consumers pay full price on a phone and then change carriers as and when they desire. This is possible because all the networks are based on 3GPP standards (GSM, GPRS, WCDMA, UMTS) and changing a carrier is as simple as changing a SIM card. In the US, it is not quite as simple. Most phones that work on Verizon's CDMA based network would not work on ATT's 3GPP based network and the same goes for Sprint. So by committing to a carrier, the user is most often committing to a phone that will almost exclusively work on that carrier. Even within 3GPP, operating frequencies and bands differ between AT&T and T-Mobile resulting in 3GPP compatible phones that cant do everything they do on AT&T on T-Mobile.Hello, iPhone

The original iPhone launched as an exclusive on AT&T. At the time of its launch, AT&T Wireless was making its money on expensive contracts on feature phones. Europe was at the vanguard of mobile phone revolution with introduction of 3G networks and a new generation of phones called smartphones from Nokia. AT&T had built up a small 3G network but there were not many takers for its expensive data plans outside of business users. It was in such a world that Steve Jobs announced the iPhone. The iPhone 3G that followed created a dramatic need for a network that would handle the incredible amount of data traffic that one phone's users was generating. AT&T was caught unprepared by the surging popularity of the iPhone.

The "unlimited" data plan was causing all kinds of issues on a network that was not expecting to handle such a load. But there was a tremendous upside for AT&T in that they were adding new subscribers at a clip never before seen. And given their exclusivity with Apple, AT&T was growing at a faster rate than ever before. And Apple was well aware of the popularity of its device. So much so that it negotiated a remarkable price for its product. While most smartphones based on the Android and Windows Mobile platform were priced at $400-$500 and the carrier subsidy was anywhere from $200 to $300, the iPhone was sold at $600 or higher to the carrier resulting in a much higher subsidy.

 Verizon, Sprint and ATT

Verizon, which initiatially declined to carry the iPhone realized its folly when it saw ATT rake in the customers for the device and along with it, subscribers to its data plans. But not everything was lost. Verizon also watched as ATT struggled to meet with the explosive demand for data and coverage as created by the device's ubiquity. By the time Big Red got the iPhone 4, it had time to better suit up for the demands of the phone.

Sprint and T-Mobile were left out of the party. Sprint reportedly struck a large and expensive deal with Apple to get the iPhone 4S on its network which left T-Mobile as the only non-iPhone carrying US major operator. As Verizon and Sprint got the device, they had much more to lose than Apple in not having the device on the network (you could definitely argue that Apple dramatically expanded its audience moving into multiple carriers). The point being that Apple was able to get a good subsidy deal with every carrier negotiation.

 So what is the problem?

US carriers are adding more iPhone customers than any other smartphone. While the new subscriber additions are great, they result in lower profit margins due to the higher subsidy for the iPhone. This was fine and dandy when the iPhone was the most desired of devices (which it still is) and there was minimal to no competition. With Android devices upping the ante significantly and better Microsoft Windows Phone 8 devices on the horizon, operators have a better bargaining position with Apple save for Sprint (which is commited to Apple on an onerous and expensive long term deal rumored to be worth $20 billion). In the next year to two years, the current contracts for ATT and Verizon with Apple will come up for renewal and this could potentially lead to a subsidy face-off. One that could alter the sweetheart deal Apple enjoys and make it a more level playing field.

 Possibilities

For their part, carriers are rumored to already be pushing Android and Windows Phone devices to customers. And this will continue amidst the continuing popularity of iPhones. There are potentially 3 outcomes when the carrier contracts get renegotiated.

Option 1. Apple agrees to a lower iPhone cost to carriers. This would ensure that they get prime positioning in carrier stores. And carriers can now push iPhones over other devices. Apple will then have lower margins on iPhones than it currently enjoys.

Option 2. Apple holds its ground and given its sales clout, carriers cave in and continue to make an exception for Apple at the cost of lower profit margins. Odd as it seems for multiple corporations to enter into such a deal that would lower their margins for multiple quarters, it has happened in the past and if there is one company that they will make an exception for, that would be Apple.

Option 3. Carriers and Apple dont come to terms. Apple buys spectrum and/or Sprint/T-Mobile or both and becomes its own carrier. Intriguing as it may seem and rich as Apple is, this is farfetched. Sprint's coverage is not as comprehensive as ATT and VZ and it would be a big undertaking even by Apple standards.

Option 4. Apple tests $249 or $299 pricing on its iPhone. Verizon has had limited success pricing its flagship LTE superphones at $299 for the initial few months. Apple could definitely test the waters given its increasing fan base which is willing to pay top dollar for having every Apple product on Day 1.

We will not know what comes of all this until a good two years from now. The giveaway would not be a public announcement but the quarterly numbers from the carriers and Apple indicating their margins. But given the intense scrutiny on the matter and its close link to the share price of the most valuable company in the world, we will definitely hear about it. Until then, lets patiently wait and watch.