May 24, 2012 11:16 AM EDT
(Reuters) - Save up now for that new iPhone: the era of free or cut-price phones when signing a new mobile phone contract may be soon be over in Europe.
Telecom companies, facing a profit squeeze from fierce competition and regulatory pressures, are taking the knife to the generous subsidies that allow new mobile customers to get the latest smartphones on the cheap.
Two of Europe's biggest telecom operators, Vodafone and Telefonica , are using Spain as a testing ground for this big change in their business model, while in France a new ultra-low cost mobile player Iliad won clients with a no-subsidy approach.
It's a gamble that could boost telcos' bottom lines but could also lose them customers in recession-hit Europe. And it is likely to hurt mobile phone makers if people hold back from buying the latest smartphone, which at 600 euros-plus often costs more than a flat screen television.
In Europe, telecoms companies' spending on phones more than doubled to 13 billion euros ($16.36 billion) last year, meaning more was spent on phones than on upgrading mobile networks, according to Bernstein Research. Globally, phone subsidies climbed more than 40 percent from 2009 to 2011 to reach $48.5 billion.
"There is a sense of uneasiness about very heavy subsidies and a realization that they are not good for the industry," said Telecom Italia Chief Executive Franco Bernabe at a conference.
Vodafone Chief Executive Vittorio Colao said that operators could now scale back their spending since consumers were addicted to smartphones. "There are now very good Android smartphones available with mid-to-low end pricing, so there is much less need today to heavily subsidize handsets to just fuel data growth," he said on an investor call.
Traditionally, mobile operators buy phones in bulk from manufacturers like Apple or Nokia and then offer them for free or a low upfront cost to customers when they sign a new one or two-year contract.
Although they usually recoup the subsidy during the contract, some firms are concerned that the approach saps profits, especially as the cost of smartphones creeps up and tech-savvy consumers expect upgrades every year.
In Spain, where one in four people are unemployed, market leader Telefonica dropped subsidized mobiles for new customers in March and offered payment plans instead so they can buy them themselves. Vodafone soon followed suit.
Both say they will focus their marketing dollars instead on keeping their customers they already have.
In France, new mobile player Iliad launched its 'Free Mobile' service in mid-January with no phone subsidies whatsoever and rapidly attracted 2.6 million customers, prompting all of its larger rivals to match the model despite initially deriding it.
The marketing chief of Vivendi's SFR Frank Cadoret predicted up to 30 percent of the French would soon buy mobile services this way.
U.S. phone companies, including AT&T and Verizon , are watching developments in Europe closely. They are managing to prosper from the smartphone boom because of better pricing power, and have so far adopted less dramatic measures like delaying phone upgrades and imposing fees of $30 when people get a new mobile.
Sprint Chief Executive Daniel Hesse told Reuters that it was too early to tell whether further measures would be needed. "Obviously the subsidies we pay have been going up, up, up... carriers have to take actions."
Cutting mobile subsidies is not without risk, analysts say, and it's far from certain it will become the norm. They have helped lock-in customers via long-term contracts. Eliminating them means people can leave when they want.
There is always the risk that some companies will stick with subsidies to entice customers. In Spain, third-place player France Telecom is playing the spoiler to Vodafone and Telefonica by keeping subsidies to boost market share.
And by severing the link between the phone and service, telecom operators are also opening the door for smartphone makers to bypass them to market.
"The single biggest card the operators have to play in negotiations with smartphone makers especially Apple is that they control distribution of the phones," said Thomas Wehmeier, telecom analyst at consultancy Informa.
"If they stop subsidizing them, more phone makers could just start selling to customers directly and operators will have even less bargaining power."
Apple already does this discreetly in its U.S. and U.K. stores in partnership with Barclays , offering 6 to 12-month financing for iPhones. Retailers could also jump into the fray. Tesco ran a full-page ad in a London newspaper to tout its financing plans to customers buying iPads.
APPLE, SAMSUNG HIT
But the shift could also hurt phone makers, especially Apple and Samsung <005930.KS>, which make the most expensive smartphones.
Asian brokerage CLSA estimates that 42 percent of Apple's revenue last year came from telecom companies' mobile subsidies.
Nokia, trying to make a comeback in smartphones, will need marketing and distribution support from telecoms companies if its new Lumia phones are ever to rival the iPhone.
People also might trade down to cheaper models, such as the emerging crop of Chinese-made Android smartphones that cost $150-300 instead of $600-800 for an Apple or Samsung. Or they might just keep the one they have for longer, depressing sales.
In France, phone sales are set to fall from 24 million last year to less than 20 million this year due to Free Mobile's effect, said an executive who declined to be named.
In a worst case scenario where all operators kill subsidies, some $24 billion would be wiped out of the mobile phone market, said Pierre Ferragu, analyst at Bernstein Research.
"We don't think that is likely to happen though," said Ferragu. "Operators in Europe aren't getting rid of subsidies but just offloading them to partner banks via financing plans, so we think consumer behavior won't be affected too much."
How it all plays out will depend on how consumers react and how telecom operators position themselves in each market.
In France, 25 year-old Natalie Reynaud says she recently bought her own iPhone 4S and signed up for Free Mobile. "I like that I can switch operators freely and not be tied into a long contract," she said, adding that mobile subsidies offered by France Telecom or SFR didn't tempt her. Reynaud also passed up a consumer loan offered by Free Mobile in partnership with a local bank because she didn't want to pay interest.
France's established firms, France Telecom, SFR, and Bouygues Telecom plan to keep subsidies for their mainstream business as a way to attract clients.
"People have finally realized that premium smartphones cost the same price as a television! Few people want to lay out that sum at the beginning of their contracts," said Olivier Roussat, who heads Bouygues Telecom.
But he admits firms will probably have to cut subsidies over time. "If the French market heads to average monthly bill around 20 or 30 euros a month, it's obvious that we won't be able to subsidize mobiles."
In Spain, it's too early to tell how the three-month old subsidy shift will evolve. In the first quarter, which included only March under the new policy, Telefonica lost 170,000 mobile subscribers, Vodafone lost 90,000, while France Telecom gained 130,000 subscribers.
José María Álvarez-Pallete López, who heads Telefonica's European businesses, told investors that the company knew it would lose customers initially but felt this was the right thing to do to keep its most valuable subscribers and improve profits.
"We think this is a change that is needed at a sector level," he said.
A Bernstein analysis predicted that Telefonica and Vodafone could potentially add 25 percent to operating profit in Spain.
But a sales clerk at a Phone House store in Madrid said that she had seen more customers opting for Orange since Vodafone and Telefonica got rid of subsidies. "People are in a hurry to pick up the iPhone from Orange, because they are afraid that Orange will also cut the subsidies in a near future," she said.