Smartphone subsidies problematic for Sprint

Subsidies are here to stay, and they are getting more problematic for some given the fact that smartphones are expensive to build but consumers expect them to cost $200 or less.

For a company like AT&T, which continues to ride high on iPhone sales, subsidies have generated new customers, new cash flows and positive net present value. Now that the subsidy has been paid back by a number of iPhone customers, AT&T is reaping the benefits of higher ARPU and lower churn. Those things offset the higher acquisition costs associated with the device.

For a company like Sprint Nextel, which continued to bleed subscribers in the third quarter, subsidies are making a comeback all the more difficult. Goldman Sachs analyst Jason Armstrong said in a research note that Sprint's wireless adjusted EBITDA was 10 percent below the consensus level. He noted that the improvement in gross customer adds during the quarter mostly reflected increased handset subsidies and more expensive promotional activity. "We believe any marked improvements in the postpaid trajectory will come at a heavy cost," Armstrong said.

During Sprint's conference call with analysts last week, Sprint CEO Dan Hesse noted that smartphone subsidies are the new norm. "It does hit you in the short-term when your gross adds go up in particular," he said.

It looks like any recovery in net adds will indeed come at a heavy cost. Sprint is banking on WiMAX to drive subscriber adds next year, and Hesse promised that the 3G/4G devices it offers "will carry some significant subsidies with them as well." The company needs a differentiated product as its aggressive moves around pricing plans and devices, such as the Palm Pre, haven't made enough of a dent in subscriber additions to date.

It won't be easy given the competition from Sprint's healthier operator competitors that have the financial wherewithal to send prices down even further in the smartphone subsidy game. Moreover, these 3G/4G device subsidies must be pretty steep given the fact that 3G smartphone pricing is falling. ABI Research said 27 percent of smartphones offered so far this year were sold for under $200. Of course, 3G/4G devices should be able to garner somewhat of a premium--but not much given a relatively small WiMAX footprint and the intense need Sprint has to add subscribers.

Investors don't like to see a margin decline nor do they like to see customer acquisition costs rise. But this is the new reality of the smartphone game. The question is: Will investors have the confidence in Sprint to see the payoff in the long run? --Lynnette