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So Long Fat Cell-Phone Subsidies?

In January, gadget-lover Ezra Goldman scored a great deal on a cell phone. The angel investor from Chicago no longer needs to drag his mobile along when he walks from his computer to, say, the printer or the coffee room. Goldman's new Nokia 6310i, equipped with Bluetooth technology, allows for wireless communications between his headset and the phone, which now remains by his computer. Better yet, Goldman got the cutting-edge device, which normally retails at AT&T Wireless for $139.99, for free. He half expected a good deal since the latest and greatest phones sell for little nowadays.

Indeed, wireless carriers have been doubling for Santa Claus. During Christmas, the nation's sixth-largest wireless-service provider, T-Mobile, sold Sony-Ericsson's T300 phones, with a color screen and an embedded camera, for $99 -- probably at half its actual cost. And in December, the largest U.S. mobile-service provider, Verizon Wireless, sold Motorola's color-screen T720 flip phone for $149 with a two-year contract. It originally sold for $299, but consumers wound up paying just $49 after a $100 manufacturer's rebate.

These bargains are turning into a costly headache for service providers, which subsidize the bulk of each phone's cost. From 2001 to 2002, wireless carriers' cell-phone subsidies in the U.S. rose 18%, from $3.8 billion to $4.5 billion, estimates Martin Dunsby, a vice-president at wireless consultancy InCode Telecom in La Jolla, Calif. Handset subsidies are actually the largest single cost -- about one-third of the $350 carriers spend on average -- to sign up each new subscriber. That expense will likely rise again this year because the newest phones, many of which had debuted last holiday season, have higher price tags, says Dunsby.

GROWTH BY GRABBING. Most carriers can ill afford the increase since their revenues per subscriber are falling. No. 3 carrier AT&T Wireless (AWE) collected an average of $60.20 per subscriber in 2002, vs. $62.60 in 2001, a decline of 3.8%. And from 2001 to 2002, total revenues of the U.S. top-three wireless-service providers -- Verizon Wireless, Cingular, and AT&T Wireless -- rose by only 10%.

This year won't be much different. Now that nearly 60% of the U.S. population already owns cell phones, wireless companies are pretty much stuck with growing only by snatching each other's customers. As a result, per-minute -- as well as handset -- prices are under pressure. Carriers already lose money on subsidizing the phones for some customers, such as those on prepaid calling plans, which don't require long-term contracts, says Dunsby.

Their profitability will be challenged further starting this fall, when the Federal Communications Commission is expected to mandate so-called wireless number portability, allowing cell-phone users to keep their numbers when switching carriers. Today, many remain with the same service provider just to avoid the hassle of notifying friends and colleagues of a number change. Because it usually takes carriers two years to recoup that $350 customer-acquisition cost, their profits could fall off a cliff. The industry's Cellular Telecommunications & Internet Assn. says the law will cost carriers $500 million a year.

ALTERED POLICIES. One response: slashing the phone subsidies, something the carriers' European counterparts began doing about two years ago. Lower subsidies are one reasons European carriers' margins increased by about 5% in the past year, estimates Mark James, an analyst with investment bank Nomura in London. U.S. carriers could enjoy even more pronounced results since their subsidies are so much higher. Companies such as No. 4 U.S. carrier Sprint PCS (PCS) achieve operating margins that are less than half of what some European providers get.

Many U.S. wireless companies will drastically alter their subsidy policies in the next six months, says Andrew Cole, an analyst with wireless consultancy Adventis who is developing new subsidy strategies for several major carriers.

Some of the likely changes: The subsidies will decrease or disappear on prepaid plans, which generate the least amount of revenue per user. When British service providers stopped subsidizing prepaid phones a year ago, handset prices doubled to around $113, says Nomura's James. U.S. operators might also start allocating subsidies to customers based on their lifetime value. Finally, carriers will crank up the heat on cell-phone makers to cut prices.

WILLING TO PAY. Because revenue per customer is directly linked to how long a carrier keeps a user, service providers have to start offering the biggest subsidies to their best existing customers to hang onto them after number portability goes into effect, says Cole. Besides, spending lots of money on attracting new users doesn't make much sense now that the wireless market is saturated and new customers aren't as profitable and loyal, he explains. Thus, AT&T Wireless made a good decision by offering a new handset to Goldman, an AT&T customer for more than a decade who has recently purchased four phones for his children.

Carriers should also offer subsidies only to new customers who need them, says Cole. Goldman, for instance, doesn't look for the cheapest phone. Rather, he's interested in the latest gadgets and features. It seems he has lots of company: Already, Verizon Wireless sells its Audiovox Thera personal digital assistant (PDA), the most expensive device it has ever offered, to business users for $599 with no subsidies. And it sells well, says a Verizon spokesperson. No. 5 carrier Nextel (NXTL) has discovered that its business users are happy to pay more than $200 for mobile phones with new features.

Sony-Ericsson research "shows that as soon as customers look at products that make more than voice calls, they expect them to cost hundreds of dollars," says Suzanne Cross, product marketing manager for the phone maker. When they find out about the promotions, "they're pleasantly surprised," she adds. So, it might actually make more financial sense for carriers to sift out customers who aren't willing to pay what a phone is worth.

Any misstep, however, could cost dearly. When subsidy policies weren't done right in Europe and Australia, wireless-service providers suffered from stalled subscriber growth and customer attrition. Still, U.S. carriers will almost surely stop selling expensive phones for a pittance. "I hope our competition maintains some pricing discipline," says Kevin Beebe, president of the communications group at No. 7 wireless provider, Alltel (AT). Chances are they'll have no other choice. By Olga Kharif in Portland, Ore.

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