Subsidies Verizon Wireless is paying to entice consumers to buy Apple iPhones might also be penalizing Android devices and users, some now argue. Though top Android devices cost as much as Apple iPhones, high-end Android devices often sell for prices $100 to $200 higher than the iPhone.

In other words, Verizon is trying to recoup some of its cash flow and operating margin by making Android handset users pay more for their devices than Apple iPhone users.

Verizon is betting that buyers who want the high-end Android phones will pay, so they’re marking those models up.

John Hodulik, an analyst at UBS AG has estimated that the iPhone subsidy could be as high as $400 per iPhone customer. If 13 million of the devices get sold in a year that implies a which $5.2 billion hit to earnings. Some argue that devices should not be subsidized, since doing so means consumers have to sign contracts. But iPhone subsidies are quite a big expense for firms such as Verizon Wireless.

From at least one perspective, contracts and subsidies offer value for consumers and service providers, with users getting devices they want at $400 lower prices, while service providers can smooth out recurring service revenues and reduce customer churn.

Apple has set a standard entry price of its newest smartphones at $199, with higher end models available with more storage. This year however, Verizon has set a new contract price for its high end Android phones at $299.

The implications are clear enough. If you like high-end Android devices, do not buy them from Verizon.

Both the Motorola Droid RAZR and the just released Google-branded Samsung Galaxy Nexus are $299 with a two year Verizon contract, and both are listed as costing $649 without a contract.

In contrast, Apple’s 16GB iPhone 4S is offered for only $199, even though it costs the same $649 without a contact. Apple is getting a $450 subsidy, compared to just $350 for Android licensees Motorola and Samsung.

Verizon’s $199 Android phones, including the Samsung Droid Charge, Motorola Droid 3 and Droid Bionic, cost $499, $459 and $589 respectively without a contract, making their subsidies worth just $300 to $390, or $150 to $60 lower than Apple’s, one might note.

The closest Verizon’s phones currently come to an iPhone subsidy appears to be the HTC Thunderbolt, which is being offered for $149, a $420 subsidy compared to its $569 full retail price. However, this involves a special promotional discount of $100, making the “sale” price of Android models still higher than regular price of any of Verizon’s iPhones. Verizon Wireless can do what it wants, of course. But consumers should also do what they want.

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.

Handset subsidies largely are responsible for rapidly increasing smart phone penetration. On the other hand, the subsidies put pressure on service provider profit margins. Assume a service provider subsidies a device at about 50 percent of its actual cost, in exchange for a two-year service contract.

A device that costs the service provider $400 might be sold for $200, with the subsidy value recouped over the life of the service contract.

One might say handset subsidies are a necessary evil, allowing service providers to more easily acquire new customers, reduce churn and increase sales of smart phone data plans.

Typically, smart phone users commit to new multi-year-term contracts and generate average revenue per unit nearly twice that of voice-only consumers.

But handset prices are a major issue for consumers, in China and elsewhere.

But there is a price: the subsidies are a real cost of acquiring customers and reduce both cash flow and operating margins.

“In Canada, operators are seeing the benefits of higher sales and upgrade volumes largely wiped out by the impact of discounted handset pricing,” says Joss Gillet, Wireless Intelligence senior analyst.

The acquisition cost handset subsidies represent is in the range of $350 to $400 per new subscriber in Canada, and about the same amount in the U.S. market.

Nevertheless, Canadian operators value these costs as positive investments since they help to acquire and retain higher ARPU, lower-churning customers on longer-term contracts.

In markets that are saturated, there now are pressures to reduce subsidies. But nobody really can predict what will happen if service providers do so. One has to think (economics suggests higher prices for any product people want will lead to lower demand; while lower prices lead to higher consumption) much-higher handset prices will reduce purchases of new handsets.

At the very least, that will reduce the rate of innovation in devices, as users will refresh their devices at a slower rate, and it is device innovation that drives change in the mobile business.

Lower subsidies also will drive consumers to buy less-expensive devices, as well. On the other hand, at least some might argue that service providers should “double down” by extending contracts and refresh cycles, essentially gaining longer contract terms at the price of more-rapid refresh rates.

Some might say the solution is simply to provide more prepaid options for consumers. Such plans require that users buy their phones at full retail prices. But that also means there is no need for an operator subsidy.

But service providers also differentiate postpaid service from prepaid by the selection of devices. Typically, the hot new devices only are available on postpaid plans, in part to encourage purchase of the higher-margin postpaid plans.

If for no other reason than the differences in average revenue per user and profit margin, it seems unlikely service providers will want to shift too far in the direction of greater sales of prepaid plans.

Another tactic, namely making less costly phones available, will likely be preferred. But some of that potential also depends on supplier ability to create attractive devices at lower cost, as well as user willingness to buy those devices.

So far, no service provider has been willing to take the risk of selling even the most highly desired Apple iPhone without a subsidy. Whether a workable solution can be found–allowing service providers to reduce subsidies without losing customers–remains to be seen.

Some might say the consumer net present value actually is higher when users do not buy on contract, the logic being the early termination charge that could apply. But consumers do not perform an NPV calculations when shopping for a new phone or new service provider.

Also, one might argue that the potential payment of an early termination fee is about the same as the incremental cost of a full-price phone, so that in most cases there is not much difference between buying a subsidized phone under contract, and paying full price for the device to avoid the contract.

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