AT&T’s Read of FCC’s 15^th Annual Report on CMRS Competition Doesn’t Tell the Whole Story

On Tuesday the FCC issued its 15^th annual report on wireless competition.  On Wednesday AT&T (NYSE:T) proclaimed the FCC’s report clearly showed that the market for wireless services was robust and highly competitive (so it should, of course, be allowed to acquire T-Mobile).   The basis for AT&T’s claims is a chart showing that the percentage of Americans served by five or more wireless service providers rose from 74% in 2009 to almost 90% in 2010, an increase of nearly 44m people.  But does this fact, which the FCC caveats by saying that its estimates are overstated, mean that the market for wireless services is really competitive?

The answer to this question is largely a function of how you define the word ‘competitive.’  Implicit in AT&T’s statement is that competition is determined solely by the number of players in the game.  Count the number of companies offering service to a large percentage of the population and when that figure exceeds a certain threshold, in this case five, the market is competitive.  But the word competition implies something more than a simple number, it also implies something about quality play.  To have true competition each player must have at least a marginal chance of victory. 

The FCC’s report contains information beyond what AT&T has gleaned, though it does take slightly more work to unearth it.  For example, the report contains a wealth of information about net subscriber additions.  First, there are estimates of the total number of net subscriber additions realized by the wireless industry as a whole. Using this information we can construct a good view of how the market for wireless services has been changing with regard to customer acquisition.

According the information supplied in the FCC report, between 2006 and 2009 the combined share of net subscriber additions for AT&T and Verizon Wireless (NYSE:VZ) rose from 59% to 92%, implying a compound annual growth rate of 16% in net subscriber additions, and over the four years analyzed, the top-two carriers accounted for 71% of total net additions.  Figures like these speak for themselves.

This is just one example of many that contradictions found in AT&T’s hyperbolic statements about the nature of competition in the wireless industry.  Factoring in spectrum holdings, the ability to offer advanced 3G and 4G services and device availability only further dilute AT&T’s claims.  The fact is that the wireless industry is a practical duopoly and nothing AT&T or its numerous surrogates say can change that basic fact.   

What’s It All Mean?

If you’ve been following our series on handset subsidies and the consumer conundrum, you know by now that I believe that the market power concentrated in the hands of AT&T Mobility (NYSE:T, “AT&T”) and Verizon Wireless (NYSE:VZ, “VzW”) gives them unregulated market control.  You’ve also read my analysis of the practice of subsidizing handsets, requiring a contract for same, and charging an Early Termination Fee (ETF) when a subscriber breaks his contract.  You also understand that I view the handset subsidy as a loan to the customer and the construction of the ETF has a built-in form of interest expense. In this last installment, I’ll explain why I believe these things are truly bad for both the industry and consumers.

First, the actual amount of the cash subsidy matters, and that’s the one piece of information that consumers don’t have. Knowing the actual cash subsidy amount is the single most important piece of information needed to truly understand the total financial impact of the purchase. The large wireless carriers would likely point out that the full retail price represents what the actual market price would be in the absence of the subscriber contract system.  This is a hollow answer; the fact is that the contract system does exist and carriers set the full retail price at levels which virtually guarantee that transactions involving wireless devices end with the consumer signing a 24-month service commitment.

Furthermore, the cash incentives provided by carriers aren't subsidies at all, they are loans that are repaid by the consumer over the life of the subscriber contract; 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. This means that payments made to wireless carriers which are now called Early Termination Fees, are in fact Early Termination Penalties. These penalties represent yet another hurdle to consumer choice with regard to wireless services. So why does this confusing system of hidden handset subsidies and penalties exist? 

The answer is that the subscriber contract is a significant brick in the foundation that supports the entire wireless industry. The subscriber contract ties the consumer to the wireless provider for up to 24 months at a guaranteed minimum ARPU, meaning that the contract system provides a means by which wireless carriers regulate both subscriber churn and service revenue. Churn and ARPU are two metrics that are closely tracked by financial analysts as indicators of future earning; if either of these metric were allowed to fluctuate unpredictably, the equity prices for both AT&T and VzW would become more volatile. Uncertainty is not viewed positively by large investors and is ultimately a threat to senior management. Therefore, the need to maintain the subscriber contract system as a means of controlling these two metric is paramount, even if it comes with great financial costs.

Elimination of handset subsidies and its implications for the all-important subscriber contract represents a significant threat to the status quo and would be fiercely opposed by the major wireless carriers.  In all likelihood, AT&T and VzW would proclaim that handset subsidies are pro-competitive and good for consumers. Practically speaking, the notion of AT&T and VzW as consumer advocates does not compute and claims made by either company that purport to be pro-consumer should be viewed with a high degree of skepticism.

The reality is that even if the use of handset subsidies were eliminated, it would not spell the end of the subscriber contract; subsidy dollars would simply be reallocated. Depending on the timetable under which the current system could be replaced, the impact to wireless carriers would be a net cash savings based on the fact that they would no longer be making large outlays to subsidize the purchase of wireless devices. The cash savings would be enormous, but these savings would come at the cost of having to forgo the use of subscriber contracts. Giving up the use of subscriber contracts means ending the primary ARPU and churn controls now in existence; this, in turn, would make senior managers at both AT&T and VzW less certain of their future financial performance.

Because of the increased uncertainty that would be created, the likely response would be for service providers to find new subsidies to exchange for subscriber contracts. The most obvious scheme would be for carriers to offer consumers promotional/ introductory pricing such as two or three months of free or reduced pricing for wireless service. 

In my view, if wireless carriers were effectively eliminated from the supply chain for wireless devices, the most likely result would be that prices for wireless service go down. How far prices for service would drop is unclear but the fact is that prices would not fall below the amount of the actual cash subsidies that are offered today and would make the entire system function with significantly more transparency. Under the scenario envisioned here the consumer is provided with far better information about the exchange between service provider and consumer allowing for the use of subscriber contracts under conditions that are less compulsory than they are now.

A second, less likely outcome would be that wireless providers accept the elimination of subscriber contracts. Under this scenario consumers may not pay lower prices for wireless service but then service providers would need to compete for subscribers based on some form of product differentiation. Achieving that differentiated status is extraordinarily difficult to do with a product such as wireless service. Carriers would need to commit to a level of capital investment, which could be funded from the savings described above to raise the customer experience to the point where very high levels of customer satisfaction would create product loyalty. The issue is that the success of any service improvement program is far from guaranteed and corporate entities such as AT&T and VzW are reluctant to invest capital in programs that can’t guarantee a return.

Lastly – yes, absolutely without a doubt, consumers would pay higher prices for wireless devices. The question is, will prices for devices be as high, or higher, than the full retail prices that exist today? If the answer to this question is no, which I think is likely, then net, net the industry and the consumer would be much better off without the convoluted system of handset subsidies and contracts that exists today.

Richelle Elberg contributed to this series of articles.

Subscribers Are Paying Hefty Interest on the Handset “Loan”

In Part 1 of this series, I described how Verizon Wireless (NYSE:VZ, “VzW”) and AT&T Mobility (NYSE:T, “AT&T”) are acting as unregulated market makers within the handset market, because of their overwhelming dominance, market share and resulting sway with equipment vendors. 

Part 2 showed the calculation of the net present values of a hypothetical AT&T subscriber and a hypothetical VzW subscriber, under a scenario where the subscriber accepts a handset subsidy in exchange for signing a contract and alternatively, where the subscriber pays the advertised retail price. Not surprisingly, the NPV of each subscriber is sharply higher under the unsubsidized scenario than under the subsidized scenario; the difference between the two scenarios is supposedly explained by the out-of-pocket expense that wireless carriers incur to offer the discounted device to their customers.  It is also used to rationalize the Early Termination Fee (ETF) that subscribers incur if they terminate service before fulfilling their contract. Now I will explain why I think this system is unfair to the consumer.

The following is a hypothetical situation that is faced by U.S. consumers every day.  Consumer X arrives at the local ValueZone Wireless store to buy the new CoolPhone, which is manufactured by Apricot Electronics Company; the full retail price is $499.99 and the contract price is 199.99, implying a total subsidy of $300.00. 

The consumer doesn’t like the idea of signing a contract and he takes issue with the fact that the implied subsidy is less than the ETF, which is $350.00.  When the consumer points out this inconsistency (the ETF is greater than the subsidy), he is told that there is an additional discount available in the amount of $100.00, making the contract price $99.99.  This brings the implied subsidy to a total of $400.00—this is beginning to look like a good deal.  Still being uncomfortable with notion of signing a contract, the consumer asks if the additional discount can be applied to the full retail price.  The answer is no, the additional discount is only applicable to the contract price and in order to get the additional discount, Consumer X must signup online.

Now things have become more confusing.  There are three prices instead of two and two different implied levels of subsidy: there is the full retail price of $499.99, the contract price which is $199.99, implying a subsidy of $300.00 and the online contract price of $99.99, which implies a $400.00 subsidy. 

But what if the real price paid to Apricot Electronics was really $100.00 less than the full retail price and that ValueZone Wireless had chosen to only pass those savings on to consumers who purchase the CoolPhone at the online contract price?  For the consumer willing to forego the additional discount, the implied subsidy is $300.00 and the actual cash subsidy is $200.00.  A similar situation hold true for the subscriber who signed up on line; the implied subsidy is $400.00 but the actual cash subsidy was really $300.00.  Does this really happen? The answer is that I don’t know; none of the information that is needed to answer this question is ever disclosed.

The next issue that must be tackled is the interaction between the implied cash subsidy, the actual cash subsidy, the initial ETF and the ETF amortization.  This task is difficult because the information provided in the subscriber contract, while seemingly simple, is in truth very confusing.  Nevertheless, if we begin with the assumption that the inclusion of the ETF in the subscriber contract is a fair proposition, that the wireless carrier incurs an out-of-pocket expense at the time the wireless devices is sold and should be allowed to recoup that expense if the subscriber terminates the contract early, then we can proceed.

But what is the proper amount that should be paid for early termination?  This is where the issue becomes murky and determining the amount is made particularly difficult because the actual amount of the cash subsidy is an unknown quantity.

The ETF policies for AT&T and VzW as it relates to smartphones are the following:  AT&T sets the initial ETF at $325.00, for each full month during which the subscriber remains active on AT&T’s service, the ETF is reduced by $10.00.  VzW, starts its ETF at $350.00 and, like AT&T, for each full month of service the ETF is reduced by $10.00.  By dividing the initial ETF by the monthly reduction of $10.00, the total life of the ETF is 32.5 months for AT&T and 35 months for VzW.  These implied ETF lives are at odds with the fact that the term of the typical subscriber contract is 24 months.

Recalculating the monthly ETF amortization based on a life of 24 months yields amortization rates of $13.54 for AT&T and $14.58 for VzW.  In my view, the differences between the recalculated ETF amortization rate and the actual amortization rate, which are $3.54 ($13.54 less $10.00) and $4.58 ($14.58 less $10.00), constitute an interest payment.  Furthermore, I see the device subsidy as nothing more than a loan made by the carrier to the consumer for the purchase of the wireless device.  The handset subsidy is a loan that is repaid over the life of the subscriber contract.  If the contract isn’t terminated, then intuition would tell us that the implied annual interest rate on the loan should be zero percent. 

Shown in Table 4 is the financial impact and implied annual rate of interest that is experienced by an AT&T subscriber choosing to terminate service early, under the terms and conditions described in the subscriber contract currently used by AT&T today (For the purpose of establishing a reference point for comparison, I also provide the calculation showing the financial impact if the subscriber contract is not terminated early.) 

Table 5 presents the same calculation, which I call the JSICA Calculation, assuming that the subsidy is actually a loan. Under this scenario I add the amount of the difference between the recalculated amortization rate and the actual amortization rate in the form of interest payments.

Looking back at the implied subsidies I calculated in Part 2 of this series, AT&T and VzW would like consumers to think that the subsidies are generous and in many cases exceed the amount of the ETF.  While subsidies are large, it is unlikely that on average, actual cash subsidies exceed the ETF for either company.  Because of this, I calculate the implied interest rates assuming actual cash subsidies that revolve closely around the AT&T and VzW initial ETF amounts, rather than using the implied subsidy numbers found in Table 1 of Part 2 in this series.

Tables 6 and 7 show the same set of calculations as in Tables 4 and 5 but using the terms and conditions found in the VzW subscriber contract.

AT&T and VzW would probably disagree strongly with the analysis but I think this methodology is sound.  The reason for this belief is that the JSI calculations pass the “aw, shucks” test.  The results of the AT&T and VzW math produce nonsensical answers, whereas the JSICA calculations produce results that are predictable and just seem to make common sense.  The best example of the difference between the two sets of calculations is the scenario where the actual cash subsidy matches the ETF.  If the contract runs to term intuition tells us that the implied annual interest should be zero percent; this is exactly the result found in both sets of JSICA calculations.  On the other hand, the AT&T and VzW calculations produce annual interest rates of negative 14 and negative 17 percent.  Unless you believe in the tooth fairy, Santa Claus and that there really is such a thing as a free lunch, these results simply don’t hold water.  In Part 4 of this series on Handset Subsidies and the Consumer Conundrum, I’ll explain why.

What’s A Wireless Subscriber Worth, With and Without a Handset Subsidy?

In the first installment of this series on handset subsidies, I described how AT&T (NYSE:T) and Verizon Wireless (NYSE:VZ) have excessive control over the market for devices.

Part 2 addresses the long-time industry practice of subsidizing wireless devices and why it’s a net negative, for the industry and for consumers.  The insidious nature of the device subsidy is very complex.  Consumers generally like paying less than the perceived market price for their device but the questions is, what are consumers giving up when they accept a device subsidy?  The fact is that it is virtually impossible for consumers to determine what their opportunity costs are in these transactions.

For example, wireless providers never tell the prospective subscriber the actual cash amount of the device subsidy that is being provided.  Instead carriers provide information that is meant to suggest the value of the subsidy without being specific.  Consumers are given a minimum of three pieces information from which they can then use to estimate, imprecisely I might add, the value of the subsidy. 

First, consumers are told what is generally known as the “full retail” price; this is the cost of the device under which the consumer will not be required to sign a subscriber contract in order to initiate or continue service with the carrier.  Second, there is the “contract” price.  The contract price is deeply discounted relative to the full retail price, but in order to obtain the discount the consumer is required to sign a contract.  The subscriber contract outlines the terms and conditions associated with the acceptance of the device subsidy, and usually obligates the consumer to abide by those terms for 24 months.  Third, consumers are told that if they should choose to terminate the contract before the end of its term, they must pay what is referred to as an Early Termination Fee (“ETF”).  By subtracting the contract price from the full retail price and then comparing that result to the initial amount of the ETF that is disclosed in the subscriber contract, the consumer is expected to triangulate the actual amount of the subsidy.  Generally speaking, this process is supposed to, and usually does, end with the consumer choosing the contract price and signing the contract.

Table 1, shows the full retail and the contract prices for a large number of the smartphones currently available from AT&T and VzW.  Additionally I have included the amount of any additional discounts that may be available related to these devices.  This information is used to calculate the implied subsidy figures that are presented.

Using the implied subsidy data collected in Table 1, I conducted a detailed financial analysis examining various aspects of the current system of subsidized distribution.  The financial benefit experienced by the consumer is derived by comparing the Net Present Value (“NPV”) of a single subscriber under two scenarios: In scenario 1, the consumer purchases his device at the full retail price and in Scenario 2 the consumer chooses to purchase the device at the contract price.  I conducted this analysis for each of the smartphones listed in Table 1.  The NPV for each scenario was derived through the use of a 24 month Discounted Cash Flow (“DCF”) model and an 8.5 percent annual discount rate.  This model was also used to simulate the financial impact of early termination under both scenarios described above.

Table 2 lists the major assumptions that were used to compute our NPV results: the Cash Costs per User (“CCPU”) is the estimated amount of cash outlaid on operating expenses associated with a single subscriber for each month of service.  The Activation Fee is the cash payment made by the consumer to the carrier at the time service is initiated.  The ETF is the initial amount of the of the termination payment that a subscriber must pay to terminate service prior to the end of the term of the subscriber contract.  The ETF Monthly Reduction is the amount by which the ETF is reduced or amortized for each month that the subscriber remains a subscriber.  Lastly, the Monthly Capital Expenditure is an estimate of cash that is deployed in new capital to support a single subscriber for both AT&T and VzW for each month of service.

Table 3 details a typical service plan associated with a smartphone user for both AT&T and VzW.  I used the figures presented to develop our estimate of monthly recurring revenue that would be generated by AT&T and VzW.

With these assumptions along with the implied subsidy amounts from Table 1, I found that on average, the NPV for subscribers choosing the contract price was about $700 for AT&T and $820 for VzW, while the value of a subscriber choosing to pay the full retail price and forego the subscriber contract was about $1,075 for AT&T and $1,180 for VzW.  The implication is that under normal circumstances, the average consumer electing to take the contract price was financially better off than those choosing to pay the full retail price.  Generally, these results held true even under various early termination conditions.

The outcomes described above are not a shocking result.  In spite of these results, it is my firm belief that the current subsidized distribution of wireless devices is a practice that is anticompetitive and bad for the average consumer in the longer-run.  In the final two installments of this series on Handset Subsidies and the Consumer Conundrum, I’ll explain why.

AT&T and Verizon Wireless are Acting as Unregulated Market Makers

Ever since Apple (Nasdaq:AAPL) let the genie out of the bottle with the release of the iPhone, the wireless device has become one of the most important tools that a wireless carrier has for attracting and retaining high value subscribers. In their never ending quest for total market domination, AT&T Mobility (NYSE:T, “AT&T”) and Verizon Wireless (NYSE:VZ, “VzW”) have driven device manufacturers to produce powerful and dynamic phones, tablets and other wireless gadgets. For wireless carriers of all stripes, the ability to purchase these devices on reasonable economic terms is now table stakes in the struggle for long-term survival in the industry. But the control wielded by the Dynamic Duopolists results in negative ramifications for both competitive service providers and consumers.

Tactically, AT&T and VzW are using the wireless device to strip subscribers away from smaller carriers in two ways: first, many of the most technically advanced devices are distributed under exclusive distribution agreements; the most widely publicized example of this was the Apple/AT&T agreement for the iPhone. 

Second, wireless carriers provide large cash incentives to entice consumers into signing subscriber contracts. These cash incentives take the form of a substantial price reduction on the purchase of the devices. A consumer accepting this price cut is then required to sign a subscriber contract, which specifies minimum levels of service to be purchased and the length of time, usually two years, that the consumer will remain a subscriber.

I believe that both of these tactics are unhealthy for the industry, but in this series of articles I will focus on the impacts of the incentive system used to distribute wireless devices—the handset subsidy. I believe that the anticompetitive impact of the handset subsidy touches all aspects of the wireless industry, from consumer choice and service pricing to the overall level of consumer satisfaction. I have come to the conclusion that the only meaningful way to address the market disruption created by the handset subsidy is to remove wireless carriers from their role as device distributors. 

This would not only resolve many of the problems I see, but should also result in the elimination of exclusive distribution agreements, which would be good for all carriers (except AT&T and VzW). I’m aware that such a sweeping change to the business model is not likely in the near future, but I do believe that it is beneficial to discuss the many issues related to wireless devices and subsidies, and how they impact the industry today.

AT&T and VzW are Setting Handset Prices

The first problem related to the way in which wireless devices are distributed in the U.S. is the fact that AT&T and VzW now have far too much vertical control of the supply chain. It has reached the point where one could say that AT&T and VzW are acting as market-makers for the wireless device segment.

Market-makers are firms which are allowed to make both buy side and sell side offers in the commodities markets or for specific financial securities traded on financial exchanges. This ability allows market-makers to set prices and wield power in the marketplace; if this practice went unchecked, these firms could easily manipulate the market for these products to their financial advantage. Because of this, market-makers are highly regulated by the SEC and are subject to stringent reporting requirements. 

AT&T and VzW now capture enough gross flow share that practically speaking they are setting both the price floor for what manufactures are paid for wireless devices and the price ceiling for the price that consumers are willing to pay the wireless carrier for those devices.

AT&T and VzW are Deciding Which Devices Get Made

But the control these carriers have goes beyond the just the pricing issue. VzW and AT&T are also overly influential when it comes to form, functionality and the overall number of wireless devices supplied to the market each year.

An example of the market control exerted by the largest wireless carriers in the equipment arena relates to as-of-yet undeveloped handsets for newer spectrum bands. It is common knowledge that carriers who purchased lower 700 MHz A-Block spectrum in the last auction are finding it difficult to locate manufacturers willing to supply LTE handsets that are capable of broadcasting on Band Class 12.  Band Class 12 is a well defined 3GPP standard (3GPP is the internationally recognized standard setting board for both 3G and 4G LTE telephony) which  has been in place for several years. 

But VzW and Motorola recently announced that VzW has the ability to distribute devices capable of operating on the upper 700 MHz C and D-Blocks. As of now, 3GPP has not yet even published a standard for this exact spectrum configuration.  There are individual, stand alone 3GPP standards for the Upper C and D-Blocks but obviously Motorola is more motivated to cater to the device needs of VzW than it is to fill the niche market related to Band Class 12. It’s no wonder the Band Class 12 community is up in arms when it comes to the issue of device interoperability! Market forces and the duopoly carriers determine vendor decisions regarding development of equipment; the smaller players simply have no leverage.

In addition to the issues mentioned above, device manufactures are not prohibited from engaging in price discrimination. Each contract for the supply of wireless devices is individually negotiated and contains pricing provisions which are unique and specific to that contract. Because smaller carriers are not capable of delivering significant volume commitments, they are usually paying higher prices than either AT&T or VzW for their devices. This exposes them to greater financial pressure because AT&T and VzW have already set the ceiling for the prices that consumers are willing to pay, thus diluting operating margins for smaller carriers.

In the next three installments of my series on Handset Subsidies and the Consumer Conundrum, I’ll explain why handset subsidies are punitive for consumers and a net negative for the industry.