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Wrestling the Subsidy Challenge

Wrestling the Subsidy Challenge in Telecom

Wrestling the Subsidy Challenge in Telecom

For telecom operators chasing growth in mature markets, discount installment billing is a way to reduce subsidy budgets, expand the customer base, reduce churn, increase sales and, importantly, increase earnings.

For more than a decade now in mature wireless markets around the globe, the subsidy model has led the way to growth. Wireless operators subsidized their customers' purchase of sophisticated new smartphones in exchange for long-term service contracts—and this strategy has both attracted new subscribers and enticed them to upgrade their service plans to include data packages. It encouraged fast adoption of the mobile lifestyle, and drove operators' revenue growth.

But today the subsidy model faces challenges. A mature market—such as the United States, Europe, Japan, or Australia—faces high penetration rates, which means that operators face flattening revenues from existing subscribers, which in turn creates pressure to increase revenues by attracting new customers. The result: Subsidy budgets have grown as operators are forced to increase subsidies and swallow rising wholesale prices of iconic devices. These high sales acquisition costs are dragging down earnings.

How can operators lower costs to improve earnings without sacrificing revenues? Two alternate models are handset financing and discount installment billing. By financing rather than subsidizing handsets, operators could not only grow but also reduce the subscriber acquisition costs associated with growth. However, the problem with the financing model is that customers don't see it as a good deal. Thus to successfully move away from subsidies, operators must offer a service plan discount. Although that discount can endanger longer-term revenues, especially the widely monitored metric of average revenue per user (ARPU), it offers flexibility. If successfully executed, discount installment billing is a potentially game-changing strategy.

In our experience supporting discount installment billing programs for our clients, we have found that it is an effective strategy for many players in most geographies, but particularly for operators chasing growth in mature markets. The benefits include reducing subsidy budgets, expanding the customer base while reducing churn, and improving relationships with handset manufacturers by increasing sales of their devices. The end result can be a 3 to 5 percent increase in earnings.1 Risks do exist—both operationally and financially—but so do strategies to mitigate those risks. This paper explains that new route to growth.

The Problem: Subsidies Dragging Down Earnings

Way back in an era that may now seem prehistoric, customers used mobile devices only to talk on the phone. To spur service revenue growth, mobile operators started offering new devices at wildly discounted prices. The idea was to get people using smartphones, meanwhile locking them away from competitors through long-term service contracts. It worked beautifully: people discovered that they loved their devices, and couldn't live without a data plan. Because their data usage gave operators high ARPU, they became valuable customers.

But now that growth is slowing. In the United States, for example, operators' monthly revenue from existing subscribers has flattened: ARPU from the second quarter of 2011 through the third quarter of 2013 grew by just 1 percent CAGR.

To find growth today, operators must seek new customers. Traditionally, the way to get new customers has been through device subsidies. Yet with every recent high-end smartphone product launch, wholesale prices have increased. An iconic device may have once cost the operator $400; now it may be closer to $600 or even $700. And yet customers still expect to pay the suggested retail price (for example, just $199), which has long masked the true cost of smartphone devices from the consumer. So with the retail price point not increasing in line with wholesale prices, operators' subsidy budget has to swallow the difference—and that ultimately lowers their earnings.

The Complication: Financing Changes Aren't Enough

A potential solution to the problem is handset financing. Rather than paying up front or receiving a subsidy, the customer can finance the device over 24 monthly payments (see figure). This plan offers promise to operators because it eliminates the subsidy. The cost of the new device is now amortized across the 24-month length of the contract (in the example in the figure, at $23 per month), rather than taken all at once in the first month. So short-term margins are improved.

Discount installment billing eliminates traditional subsidies while reducing the monthly service fee

But under the financing model, the customer ends up paying more, as the middle of the figure shows. Such an offering would be attractive only to customers who couldn't afford the $199 up front. Even more than accounting concerns, the lack of customer value explains why operators have found it so hard to move away from subsidies (see sidebar: Changes in Financing Have Already Been Tried).

The Solution: Discount Installment Billing

To forego the subsidy, most customers want a discount on their monthly service. In the bottom of the figure, an illustrative $15 discount makes the cost to the customer over the 24-month period of the contract slightly less than under the subsidy model.

In short, discount installment billing is the way to make handset financing an attractive customer value proposition. For equivalent or lower cost, the customer gains transparency and simplicity. There are no hidden fees and no device-specific plans. Customers understand, and pay for, the true cost of the device. And, as explained below, they can gain better access to new technology through early upgrade programs.

Meanwhile, for the operator, discount installment billing lowers subsidy budgets, resulting in earnings improvements, while maintaining or improving the customer value proposition. The disadvantage, however, is that it reduces the monthly service revenues per consumer. That discount on the monthly service plan will lower ARPU. It may increase overall absolute revenues, if enough new customers are attracted to switch, but that increase depends on successful execution of the strategy. Furthermore, because ARPU is widely accepted as an indicator of company health, analysts may hesitate to accept even increased short-term earnings as a worthwhile tradeoff for decreased ARPU.

On the other hand, solving the subsidy problem is perhaps the paramount issue for most operators in mature markets. And although emerging markets are not yet facing it, they may well do so in the future. Discount installment billing offers the potential to solve this problem—as long as it's done correctly.

Key to Success: Full Commitment to the New Strategy

In our experience, for a discount installment billing strategy to work, the operator must whole­heartedly commit to it. The commitment may involve simplifying business models or changing internal structures, and it will almost certainly involve addressing growth and revenues through approaches such as early upgrade programs. Timid or cosmetic changes will be insufficient, because they will not be sufficiently attractive to customers, and because they fail to counteract the service revenue shortfalls, or both.

A key differentiator in successful discount installment billing plans is a well-executed early upgrade program. Because discount installment billing decouples the device from the service plan, operators can offer customers earlier upgrades. Customers aren't locked into a device for 24 months—they can trade theirs in for a better one after 12 or in some programs even after just six months. The early upgrade option is attractive to many customers, and will encourage switching from competing operators (in industry lingo, improving gross adds). It also drives increased sales of smartphones. But most importantly, early upgrades increase the number of customer touch points. Under the traditional subsidy model, the customer had little reason to talk to his or her cellular provider over the 24 months of the contract. After that long hiatus, he or she might switch to a competitor. But with meaningful early upgrade plans, operators can both upsell customers and get them to renew their subscriptions more frequently. More customer touch points provide more opportunity to manage churn.

One potential risk of early upgrade programs is increased inventory of secondhand devices.

If lots of customers upgrade after just six months, what happens to all those six-month-old smartphones? It's important for the operator to mitigate this risk through an effective secondhand-device program: after the customer trades in the device for an upgrade, the program refurbishes and redeploys the secondhand devices. Some common uses include insurance claims, resale into prepaid markets, and resale into lower-cost markets abroad. In our experience, one potential way to set up the buyback program is by coordinating with the manufacturer. Collaboration on the refurbishment and ultimate destination of the devices can help ensure the manufacturer that neither the brand reputation nor the price point for new devices is compromised. Building trust between the operator and manufacturer on this issue can pay dividends in a stronger relationship over time.

Another way discount installment billing can boost revenues is by expanding the customer pool. The subsidy model locked every customer into the same payment structure. Not only did it require the customer to pay an up-front cost for leading-edge devices, but also the operator had no way to build risk into its business model for customers with less than sterling credit. With the flexibility of discount installment billing, customers who have good credit but no cash can pay nothing up front, financing the entire cost of the device. (Those with cash can flex the up-front payment to reduce monthly fees—whichever arrangement they prefer.) Meanwhile, those with bad credit won't get rejected; they can still own a smartphone by paying more up front. The model's flexibility expands the potential customer base, thereby further enhancing growth.

Finally, the flexibility of discount installment billing can unlock expanded revenues through connected device sales. Now that the device and service plan have been decoupled, why not have multiple devices on a single account? There isn't enough evidence yet to unreservedly conclude that this new business model will help jump-start sales of phablets and wearables in the same way the subsidy model did for smartphones, but initial returns for operators in mature markets suggest that it's certainly an intriguing possibility.

Will these approaches to improving revenue be enough to counteract the drop in ARPU? The answer will depend on the situation of any given operator. But in an example we developed based on case studies in the United States and Australia, the tradeoff proves worthwhile. The financial picture for this prototypical operator after Year 1 looks like this:

  • The service fee reduction drops ARPU by 4 to 5 percent.
  • But the more attractive value proposition increases subscribers by 10 to 15 percent. Total revenue increases by 5 to 8 percent as subscriber growth outweighs ARPU reduction.
  • The savings on the subsidy budget reduces the cost of acquiring those new subscribers by 10 to 20 percent.
  • Thus earnings increase by 3 to 5 percent.

Of course, your mileage will almost certainly vary from this example—and the next section examines how.

Where It Works Best

The move to discount installment billing will have larger impacts for operators in certain situations:

1. Markets with high smartphone penetration. The subsidy's greatest value was in convincing customers to adopt higher-end devices. In markets where they have already done so, alternative payment options free customers from unpopular contracts without risking lower smartphone sales.

2. Markets with potential non-traditional customers. The subsidy model required rejecting customers with poor credit ratings. In markets with large numbers of these customers, an operator can target them for future growth.

3. Challenger operators chasing growth. For a smaller operator, growth is more important than ARPU. Yet a successful growth strategy under the subsidy model will squeeze a small operator with high subsidy costs. Thus smaller, hungrier operators will be more willing to trade lower ARPU on a small user base for earnings relief during a phase of high growth.

4. Where David can beat Goliath. Large operators likely have a high-ARPU subscriber base. For them, trading known long-term revenues for potential but uncertain growth is more risky. (We believe it's a gamble worth taking, because it's how the market is evolving—but risks are always higher for established leaders.) Thus discount installment billing can be a strategic advantage for small operators that, in the style of jujitsu, use a larger competitor's size against it.

A Final Word

Discount installment billing is here to stay. We expect that in the next two years, the majority of postpaid subscribers in mature markets worldwide will move to discount installment billing contracts. Early adopters will therefore benefit from subscriber churn away from their slower-moving competitors.

Because of this market evolution, a discount installment billing program is going to be an essential strategy for any operator. The key to success, then, is not the existence of the strategy but how well it is designed and executed. The winners will be those companies that offer customers a genuinely improved value proposition while mitigating the revenue risks.

 

1 All mentions of earnings in this paper refer to earnings before interest, taxes, depreciation, and amortization (EBITDA).

April 2014
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