## Thursday, November 24, 2011

### iPhone micro: How SMS pricing is accelerating the smartphone transition

I've been playing with a simplified model of the carrier-locked AT&T American 2011 iPhone marketplace. I think it makes some interesting predictions.

For the purpose of this discussion we'll assume that a minimal phone must include both:

• phone system compliant voice services
• text messaging: either SMS or non-SMS (example: Facebook Messenger, WhatsApp, etc)

We further assume that voice services cost the same for all phones, that iPhones are assigned AT&T's minimal \$15/month [1] data plan and that SMS and non-SMS text messaging are equally valuable [2]

In this model there are only 3 phones:

• A: iPhone optimal - today that's the 32GB 4S.
• B: iPhone minimal - today the 3GS 8GB. This is similar to the 'A' phone of 2 years ago.
• C: pPhone: Plain Phone. Includes SMS and Voice but does not trigger AT&T's

So how do prices and lifespans break down, assuming phones are purchases with a 2 year contract, we get a new contract q 2 years, and the iPhones use non-SMS messaging (\$15/month [3]) but the Plain Phone (pPhone) uses SMS (\$20/month)?

• A: \$300 + (\$15 * 24) = \$660.
• B: \$0 + (\$15*24) = \$360.
• C: \$0 + (\$20*24) = \$480.

Based on this simple model what can we say will happen to pPhones? Assuming a healthy iPhone can run for four years [4], then at the end of the 2 year contract, what is the rational selling price of a used phone?

Clearly, the pPhone should disappear immediately. It costs 30% more than the minimal iPhone, and it doesn't have apps, wifi browsing, video, calendar, pen light, quality camera, etc, etc. It has no resale value. (A bizarre conclusion, but it follows from the extraordinary high price of SMS services.)

Less obviously, the resale value of 2 year old iPhone is also quite low [6]. A formerly class B phone iPhone is probably no longer supported by Apple at that point and the formerly Class A devices set a low ceiling (below).

The formerly Class A iPhone at age 2 is a 'Class B' phone, but for a new-contract customer it has NO price advantage over a current generation Class B device. Both will cost \$360 over two years. The only market for an out of contract 2 year old carrier-locked 'Class A' iPhone is to replace a lost or broken contracted phone.

That's worth something -- but there are a LOT of those 2 year old former Class A iPhones on the market. After all, in this model there's no rational reason to not have a data plan, and since a data plan pays most of the cost of a phone, everyone in this model gets a new phone every two years [5]. That means there's a glut of post-prime iPhones on the market.

If I new Class A iPhone has an initial purchase price of \$300, I expect its value after two years to fall to about \$70. Indeed, the primary market may be persons wanting a very cheap iPod Touch. Effectively the price difference between the Class B and Class A iPhones over two years is \$660-\$360-\$70 or \$230 -- which is what we pay for the storage capacity and features of the Class A device (well worthwhile for most of us).

In this simple model then, it's deeply irrational to buy a pPhone, one should not fear loss or breakage of an iPhone as there will be a glut of affordable used phones on the market, the value of an out of contract iPhone is going to fall, and there are good reasons to buy either a Class B iPhone (save \$230) or a Class A iPhone (features, performance).

The real world is a bit more complex - but not much more complex. Data network based texting is not yet a full replacement for SMS texting for example. However, the future of SMS is very limited. An unintended consequence of carrier's addiction to SMS margins is that they're ferociously accelerating the transition to smartphones that will destroy those margins.

- fn -

[1] Note we're talking contract, so this is fair -- unlike AT&T's mandatory smartphone data plan for non-contract phones.
[2] Clearly SMS is superior at the moment, but this is going to change quickly.
[3] I'm assigning the FULL cost of the data plan to non-SMS messaging.
[4] Based on our experience, assuming even minimal care.
[5] That's probably too simplistic. A two year old former-Class A device may be superior to a new Class B device -- though not by much.
[6] Today businesses that buy used 3GSs are offering only \$100 - for a device with an unsubsidized purchase cost of perhaps \$300.  That's a very low price for a device that may be only two years old and can run iOS 5. It's so low because the primary market is small -- people who need to replace a lost contract phone or who want a 2nd rate iPod Touch (troublesome to activate, flaky iMessage performance, not truly supported by Apple). The market would be much larger if not for AT&T's carrier lock and mandatory data plan policies, and the price would be higher.

Update 11/26/11: A Felix Salmon Reuters post is a good complement to this article. It's a sign that the marketplace is beginning to think through the weird consequences of AT&T's contracts, all-smartphone-data-plan-mandate,  and SMS pricing.

Update 11/30/2011: added footnote [6] to clarify.