Over at tech uber-blog Engadget, there is an interesting story that Sprint/Nextel waived early-termination fees (the other ETF) for Government employees/agencies. This is especially interesting, since Kevin Martin, chairman of the FCC is trying to push the mobile carriers to come to some sort of agreement to chill out with the ridiculous ETFs.
Thats all well-and-good, and I'm sure theres some yet-to-be-explored angle there, but I'm more interested in the discussion that followed in the comments section on Engadget. As could be expected, many decried the CRAZY early termination fees as usurious extortion by the carriers. Some tried (and failed) to kind-of explain, but even the most 1/2 hearted attempts fell on deaf ears. I also tried (and failed) to lend some reason to the debate, but the kind folks at Engadget refuse to recognize my logon/password, even though I copied it directly off the automated confirm sent to my email when I first signed up. Alas, I shall not be ignored!
I put together a quick & dirty (spreadsheet ) to illustrate a simple example of the cell phone retail business model, but to summarize, it goes something like this:
- Step 1. Subsidize cost of phone (i.e. sell as loss-leader)
- Step 2. Amortize the loss/make $$ by locking customers into long-term contracts.
- Step 2.5. Charge mucho dinero to customers for walking away from said contracts.
Now, some people have a hard time with these fees, which can be as much as $250 (if not more). My first reaction is generally somewhere along the lines of, "READ THE CONTRACT BEFORE YOU SIGN (idiot)." Of course, we all know the average person's ability to read (nay, comprehend) contracts is not so good ("hey, who wants a no-doc, stated-income jumbo option arm mortgage?"), so this response is pretty much a waste of breath.
In reality, people need to understand that they simply cannot have their cake (i.e. affordable handsets) and eat it too (no/low early termination fees). Thats just how the world works. Deal with it.
In this example, I assumed a 2-year contract period, on which the carrier takes a loss (subsidy) of $200 on the handset at purchase, a contract costing $50 monthly, and an annual interest rate of 9% (semi-arbitrary). The NPV to the carrier over the life of the contract is about $900. However, if there we assume a hypothetical situation where there is no early-termination fee and the customer were to cancel after only 12 months, the NPV drops down to about $375, almost a 60% drop in profit. To the layman, this may seem silly, as the company is still 'making a profit', but that only captures a small part of the picture, running a mobile communications company is an awfully expensive proposition. Thus, the "profit" generated by long-term mobile contracts enables the company to conduct business, that is, it doesn't simply trickle down to the bottom line uninterrupted.
We'd be delusional, of course, to expect every Joe and Jane Doe understand the complex business model of a wireless carrier, and we'd be similarly delusional to expect the fervor surrounding early-termination fees to die down any time soon.
Lets assume that the FCC and the carriers come to some sort of agreement limiting the ETFs, avoiding the possibility that Cox & Crew will bow to the anti-capitalist cries from the masses and mandate they be eliminated entirely. How, then, will the carriers account for the increased uncertainty of future cash flows from service contracts? One thing is certain: The carriers are absolutely not going to roll over and play dead. I'd imagine they'll play ball, so-to-speak, and give up some restrictions on early-termination, but where they're losing money (and the attendant certainty of that money) they'll make up for it elsewhere. I'd expect they'll keep up with the practice of heavily subsidizing handsets as their main sales driver, and reducing ETFs should definitely increase sales, as people can upgrade their phones more often.
Its important to keep in mind that not only are the carriers losing out on previously-certain future cash flows, but they'll also suffer a hit to their gross margins as higher handset sales directly increase their CoGS. To offset this, I'd expect the carriers will increase the cost of service contracts to even-out the PV calculation, and changing the structure (i.e. tenor) of the service contracts they offer. I think the most obvious solution is that there will be a shift towards 1-year contracts, reducing the likelihood that a customer will switch carriers or upgrade their phone before the contract expires.
Of course, the trade off is that the shorter-duration contracts will most likely cost more per month than the traditional 2-year variety, but as I said, you can't have your cake, and eat it too.