Smartphone subsidies and telco profitability

• Smartphone subsidies are spreading South-East Asian markets, exerting pressure on telco bottom lines
• Delta Partners here presents new and trialed measures that could be used to mitigate the impact

THE increasingly contentious issue of smartphone subsidies is rapidly ascending to the top of CEO agendas, not only because they present a means of tapping much-anticipated yet unrealized data revenues, but more worryingly because widespread use of such incentives is exerting pressure on the bottom lines of telcos – at the very least, over the short term.
 
The issue, which initially hit US and European telcos, is now spreading to emerging markets and is becoming progressively more relevant across South-East Asian markets. As a market matures, carriers shift their operational focus from acquisition to loyalty and retention, and progressively incentivize their customers to shift from prepaid to post-paid tariff plans as a mean to lock in their high-value subscribers. This immediately translates into increased subsidy costs.
 
For instance, to serve its post-paid base, M1 in Singapore increased its subsidy expenditure by more than 60% in the first half of 2012 year-on-year; and Globe, the challenger in the Philippines, almost doubled the subscriber acquisition costs in Q3 2012 compared to the previous year.
 
A similar phenomenon can affect Maxis in Malaysia, which in the recently released financial results saw its EBITDA (earnings before interest, taxes, depreciation and amortization) margin eroded by higher device sales.
 
However, the impact of subsidies on a telco’s financial performance cannot be assessed by simply extrapolating short-term implications.
 
First of all, while the cost occurs at the time of subscription, the revenue will accrue over the contract period; subsidies stimulate smartphone penetration, which translates into higher mobile data adoption, thereby lifting ARPU (average revenue per user); a shift towards post-paid improves retention (lowering churn rates); and additionally, if exclusivity agreements are reached, being the sole provider of certain devices models may also improve an operator’s positioning.
 
The objective of this article, in this light, is to examine a selection of new and trialed measures that could be used to mitigate the impact of handset subsidies on operators’ bottom line, and are particularly relevant for operators across South-East Asia.

1) Carefully segment the customer base: smartphones are not for everyone (yet)

A blanket subsidy model that does not differentiate customer needs would over-deliver, resulting in value destruction.
 
Predictive tools cross-factoring customer locations, current EDGE/3G/HSPA data usage, ARPU levels, current device usage, social circles, propensity to spend/ upgrade and so on, can be developed to estimate future value-generation and extrapolate subsidy levels that maximize value-creation over the long term.
 
Below-the-Line (BTL) upgrades should be preferred to a one size fit all approach in order to maximize the return on investment on subsidy costs. Operators should define their device portfolios with additional care to ensure an effective mix of high- and low-end smartphones as well as cheaper data-enabled feature handsets for those who are not ready or for whom subsidies do not pay off.

2) Recover part of the subscriber acquisition cost: the leasing model

Under the leasing model customers lease a device for the duration of the contract and either return it at the end or pay a marginal price for it. In this way, operators can recover a portion of their handset costs by refurbishing and selling devices to the secondary market or by selling them for spare parts.
 
This model has been applied by several operators across the globe, amongst which M1 in Singapore under the Take3 umbrella plan.

3) Introduce the SIM-only proposition

Incentives can also be provided to new customers willing to forfeit a new phone for lifetime Monthly Subscription Fee (MSF) discounts.
 
For example SMART, the market leader in the Philippines, recently introduced Postpaid Freedom Plans, a SIM-only option which mirrors the prepaid offers without adding additional service charges and forgoing a minimum monthly commitment.
 
This model has the added benefit of linking costs to the revenue a customer generates, reducing the short-term impact of subsidies as well as the risks associated with early contract termination churn.

4) Lengthen customer lifetime

Operators could proactively offer discounts on subscription fees for each additional month a customer is willing to wait for renewal. Several operators offer competitively priced refurbishing services that allow customers to extend the lifetime of their mobile phones, even smartphones.

5) Decrease the cash risk: the reverse subsidies model

The traditional subsidy model trades today’s cash-out for tomorrow’s cash-in, with the risk entirely borne by the operator. Reverse subsidies do not offer an incentive on the market price of a mobile handset at the beginning of the contract, but offer discounts on the Monthly Subscription Fee.
 
They not only reduce the cash risk for operators but also generate stickiness through the monthly discounts they offer.
 
Reverse subsidies are now being offered by a growing number of operators, including Bharti Airtel and China Mobile.
 
In the same context, operators can cooperate with consumer credit providers to offer interest-free credit lines for smartphone purchases (see SingTel in Singapore).

6) Share subsidy costs with third parties 

Operators could leverage their direct relationships with the end consumer to create innovative business models in conjunction with third parties and Over-the-Top (OTT) players, thus sharing subsidy costs.
 
So far, operators have viewed OTT players as a “frienemy”; a friend but also a known and necessary evil. Facebook shortcuts pre-installed on feature phones (for free) by vendors or operators are an obvious example.
 
But the balance of power could shift to the benefit of operators if they or smartphone manufacturers call on OTT players to share the cost of subsidies, bringing an end to their free ride.
 
In conclusion

Operators are increasingly feeling the pinch of device subsidies on their bottom lines and are therefore seeking workable solutions that alleviate the pressure without negatively impacting their competitiveness.
 
Despite the fact that subsidy costs are still under control in most South-East Asian markets due to a still limited share of postpaid subscribers, this is a call to action for operators to re-examine and rethink subsidy strategies as a matter of priority; to start educating the market before they find themselves sacrificing EBITDA.
 
Anna Arlorio is a Senior Associate in Delta Partners based in Singapore. Delta Partners is a management advisory and investment firm specialized in telecoms, media and technology within the Middle East, Africa, Eastern Europe, Emerging Asia and Latin America.

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