July 11, 2013

Verizon Could Face $14B iPhone Shortfall; Disclosure Sets Off Firestorm


We all know that it only takes one spark to ignite a fire that can become an uncontrollable inferno. It appears that a posting by Caroline Gabriel on RethinkWireless, “Verizon could face $14bn iPhone shortfall,” may turn out to be just such a spark. 

What Ms. Gabriel was reporting on (previously covered by Bloomberg) was a recent Moffett Research report where noted industry analyst Craig Moffett delved into the dark world of mobile service providers’ commitments to Apple in terms of promised sales. As the article points out, several months ago, as what was at the time called a “Hail Mary pass” of desperation, Sprint agreed to $15.5B in Apple smartphone sales over four years hoping to pin its survival on the continued popularity of Apple products. The Moffett analysis says that Verizon’s risks could be much larger with a possible $14B exposure this year alone.

Moffett says Verizon is on the hook to purchase $23.4B worth of iPhones this year. He speculates that given Apple’s fall from grace to Samsung in particular but the rest of the Android community in general, Verizon is in jeopardy of the huge loss which equates to roughly $4 to $5 per share. If even remotely on target, this is a number that obviously cannot be made up via up-selling of mobile services to existing customers. In fact, exacerbating the situation is that Verizon has a very large number of existing customers coming off their current subscriptions, and competitive pressures are going to make what is a commodity service with lowering margins and falling ARPU a very tough row to hoe.

What’s Going on Here?

Here at TMC, we have engaged in a spirited in-house debate about what all of this means. I leave my colleagues to weigh in with their thoughts, but suffice it to say the juices are flowing. The first, big question being kicked around is whether this signifies the beginning of the end of subsidized phones by service providers, or the beginning of an era where the customer is going to dictate the rules—device options, data plans, service bundles, ecosystems, etc. I happen to believe it is an interesting mixture of both. 


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The history of the communications industry going back to before there were mobile devices was that the service providers could dictate what phone people had. The old saying about the original AT&T was that their idea of marketing was, “any phone you want so long as it is black.” Competition created choice and the Interconnect industry was born and flourished. However, it was not without bumps in the road as PBX and Key system manufacturers looking for distribution channels cut deals with phone companies whose onerous terms and conditions along with a propensity to use customer premise equipment (CPE) as a loss leader, caused market chaos for a time. The manufacturers learned the hard way they could not make it up in volume. 

What the service providers have learned, in large measure due to their initial decisions to “subsidize the razors and make it up on the blades” and unlimited usage plans in the U.S., was the flip side of the above. They bet their futures on consumer products being a service attraction, i.e., people would gravitate to your service if you had exclusivity to “hot products,” forgetting that such items come in and out of style. Ask Sony for example about how far and how fast you can fall from favor.

The fact of the matter is that the notion of there being a powerful tie-in between network services and the things that hang off of them might hold when there is a monopoly or duopoly, but not when there is choice. Market realities right now are that while the service providers would like everyone to believe that there is choice when it comes to which service, the differences are incremental as the rush to deploy 4G LTE is on and coverage is likely to go away as an issue and pricing will be in a zone of reasonableness. 

That leaves the devices as a determinant of major proportions when it comes to which service to get. However, with so many out there that look an act the same at the end of the day, this comes down to something more than a choice of a physical device and more of one about picking an ecosystem. The Apple Store just celebrated its fifth birthday. It disintermediated markets and transformed the world, but it got caught and seemingly passed, not just by Google but by the hundreds of Android-friendly app stores that can now be accessed. Betting on the iPhone is also betting on the Apple ecosystem, and in a world where change is the only constant along with the speed at which it is accelerating, and where customers are increasingly disloyal, getting literally locked-in can be bad for business.

On a grander scale, what all of this highlights is a monumental shift in the balance of power in the communications industry. It used to be that the service providers got their way because of their financial strength. However, they have been eclipsed by the likes of Google and Apple on that front. 

It also used to be that they owned the customer relationship. What has happened is they may own the billing relationship but they do not own the customer experience -- which is owned by ecosystems based on operating systems and app stores as well as the content like social media, video and gaming entities -- all looking for value-added wallet and mind share.

The facts are that the customer now owns their own experience, and as Verizon and others who met Apple’s demands are discovering, the market can be a cruel task-master.

Does all of this mean the end of phone subsidization by the carriers? If, like T-Mobile, they decide to experiment with retailing devices rather than subsidize them, and are smart in handling a myriad of tricky transition issues, the service providers can and I believe should wean us from an expectation of getting full-feature phones for inexpensive prices in return for long-term service loyalty.

While I have already been challenged on my views with some interesting arguments, I believe subsidization of phones based on market trends and consumer behavior is unsustainable over time, and that time may be short. Verizon is a harbinger of why this is the case. It is consistently said that content is king, but it is actually the consumer who’s in charge. The real revolution brought about by the Internet was that the balance of power between buyers and sellers – which consistently had been controlled by the sellers -- was overthrown. This is just the latest manifestation of that revolution.

Now that the spark has been lit, it will be interesting to see how the fire is contained. My suspicion is it is going to spread fast and whether the existing players have the ability and agility to handle it is going to be fascinating. Indeed, now that the discussion has gone viral, how investors digest all of this in the next few days is going to be a leading indicator of things to come.




Edited by Rory J. Thompson



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