Cut in handset subsidies would be positive for operators

Telecom operators would benefit from a market-wide cut in handset subsidies because the cost and quality of the network would become the driving force in customers’ buying decisions, rather than the desire for a new phone, Fitch Ratings says.

A split of the handset from the tariff would give pricing power back to the telecom operators and allow them to focus their capex on improving the quality of the network. Investment in the network would lead to service competition and coverage improvements, which would become the primary influence for customers when buying.

Operators spend approximately 15% of their revenues on handset subsidies to attract and retain customers. This erodes profitability and credit profiles. The introduction of improved smart phones such as Apple’s iPhone4S and Samsung’s Galaxy S has made subsidies so expensive that they are unsustainable in the fragmented European market.

In the US, operators have cut the net cost of the subsidy by introducing handset upgrade fees of USD30-35.

This has slowed the rate at which subscribers are upgrading their phones.

Any move away from handset subsidies will be hardest in Europe where the number of competitors makes maintaining market share a priority.

In Europe there are approximately 45 mobile networks compared with only four to five in the US. The competition means that if one network cuts subsidies, while others do not, they will lose business in the short term and may not survive to see long-term gains.

The current weakness of European consumer spending may prove an opportune time to reduce or eliminate subsidies as people look to cut the cost of their mobile phone subscription rather than upgrade to a new phone. Vodafone and Telefonica recently cut subsidies in Spain where consumer demand is particularly weak. The latest retail index data shows nationwide sales dropping 4.1% in the first quarter of the year compared with the same period in 2011.

Other operators in Spain, including Orange, have not followed Vodafone and Telefonica’s lead, and it is too early to see the effect on market share and margins. If this strategy is successful, we would expect to see other operators cut handset subsidies in other markets.

A cut in handset subsidies across the whole industry would result in people upgrading their phones less frequently.

This could reduce the operators’ growth rates because new phones typically lead to higher data plans. However, we believe the net result on operators’ credit profiles would still be positive as lower growth would be more than offset by reduced customer churn and lower acquisition and retention costs.

The impact of the reduction in handset subsidies could be mitigated by operators offering consumer finance, via leasing or hire purchase.

This would reduce the upfront cost of the phone, albeit not to existing levels, by spreading the costs across the life of the contract. There is already an established market for consumer finance in many similarly priced products and therefore, although volumes will inevitably fall, many consumers will continue to upgrade their phones regularly.