Are Apple’s Latest Woes A Warning For All Handset Makers?

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Yesterday, in an announcement that was almost the opposite of what many investors were hoping for, a Wall Street Journal report suggested China Telecom were reducing subsidies for Apple (AAPL) handsets. This news caused AAPL to drop sharply in an otherwise buoyant market. In the short term, this news is obviously a drag on Apple stock, but does it hint at deeper problems to come in the telecom market?

As it exists now, the market is such that the telecom companies who deal directly with the public subsidize the handset manufacturers to a ridiculous degree. Newly released smart phones are generally available to US subscribers for between $99 and $199 with the signing of a two year contract, but the unsubsidized cost is significantly higher, with even the recently launched “less expensive” version of the iphone 5, the 5C, costing over $500.

This pricing model is currently very popular with consumers. So much so that when T-Mobile (TMUS) announced their JUMP program, competitors fell over themselves to follow suit. The basis of these plans is to offer more frequent upgrades to customers in return for an additional monthly fee. This is really just an extension of the current modus operandi. If we are honest, we have to admit that the majority of those subsidies are a cost that is just passed on to us, the consumers.


 The extent to which that is true can be seen by unsubsidized, pre-paid plans offered by the likes of Virgin Mobile. If, for example you stump up $550 for a 16GB iphone 5, then you can get a plan with restricted minutes but unlimited text and data for as little as $30 per month. Subsidized phones of the same model can be bought for $79-$199, but the two year contract will cost you around $20-$40 more per month. Factor in the time value of money and it can be a wash, but in most cases the subscriber ends up paying more overall when they pay out less upfront.

Consumers are used to buying this way and are used to being offered periodic phone upgrades. As it stands the model works. It is tempting to say that the rational consumer will come to the conclusion that unsubsidized phones make more sense, but consumers as a group don’t always act rationally; just ask Ron Johnson about his experience at JC Penney (JCP). The subsidy system may well continue for some time, then, but what if telecom companies were emboldened by China Telecom’s decision, and looked at reducing the payments to manufacturers and either reducing plan costs or simply keeping the increased margins?

The problem I see here is the age old one with subsidies, whether from government or private business; they distort markets. Very few people are aware of the real cost of a handset. While they hear on the launch of the 5C that it will be priced at over $500, the $199 price tag (with plan) is, to them, the cost of the phone. This means that they are not making rational decisions, but such is marketing and that will not change.

What worries me more for the future of AAPL et al is the lesson that can be drawn from this about subsidies in general. In the short term they are great for the company that receives them, but they come at a cost. What the company gives up is a degree of control over their pricing. If the consumer believes that the i-phone 5 or the Samsung Galaxy S4 Active is $199, then that is the value they place on the handset. Should subsidies be removed or reduced, the resultant sticker shock could have far reaching consequences. It is the same situation faced by green energy companies and the likes of Tesla (TSLA). At some point you have to face up to life without subsidies, but the transition can be painful.

I don’t believe this will happen overnight, but if China Telecom leads the way, it may happen gradually. If it does, the consumer will be nudged toward more rational purchase decisions, and will start to assess the potential cost of every incremental upgrade or gimmick. The resultant pressure on sales and margins would mean that any forward calculations regarding profitability are fundamentally flawed.

AAPL in particular looks great value by conventional valuation metrics, but there are assumptions involved in those calculations about some growth in revenue, margins or both. If they move in the opposite direction to that anticipated, then the current market, not the analysts have it right. If forced to choose, then I will usually take the dispassionate analysis, but this time, weight of money could be correct.

Free markets are wonderful things, but in reality they rarely operate in a textbook manner. When companies become dependent on subsidies of any form for even a portion of their profits, they place themselves in a potentially perilous position. If either service providers become emboldened by China Telecom’s actions, or the consumer begins to become more concerned about the monthly cost of a wireless plan and decides to keep their phone longer, the whole house of cards could come tumbling down.

Subsidies, QE, marketing and other distortions of markets have a purpose and are often justified, but when you mess with the “invisible hand”, whether you are a government or a private company, you had better be aware of the potential consequences. 

 



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: News Headlines , Technology , Business , Stocks

Referenced Stocks: AAPL , JCP , TMUS , TSLA

Martin Tillier


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