June 6th was the launch date for the Palm Pre, the heavily hyped new smartphone from Palm and Sprint.  What I really want in a phone is something that matches the elegance and simplicity of the user interface on Apple’s iPhone, but still includes a physical keyboard and multitasking capabilities.  The Pre appears to be a very close fit, almost certainly much better than the Windows-mobile based HTC Touch Pro that I bought last year.

I definitely tend to be an early-adopter on new gadgets, so it certainly wouldn’t have been surprising if I had run out to buy a Pre last weekend.  In fact, I would have very much liked to have made that purchase.  Unfortunately, I’m already a Sprint customer and, as I mentioned earlier, I purchased a new phone last year.  Because of this, I am not currently eligible for upgrade pricing, which means that any phone purchased now would cost me considerably higher than the new or upgrade eligible customer pricing, which, of course, is the pricing that Sprint and Palm are advertising publicly.

I am, of course, under a 2-year contract with Sprint that was a necessary condition for the purchase of my last phone.  I completely recognize the validity and legality of that contract and that it is the underlying reason why I am not eligible for upgrading without a price penalty.  My purpose in this post is not to argue that my situation is somehow unfair or that I am being denied an entitlement.  I never had any expectation of being able to upgrade early and I don’t believe that there is anything unethical, much less illegal, about the system.

What I do question pretty strongly is whether or not the current business model used by the cell phone industry is a correct one in today’s marketplace.  Particularly since Apple has turned the smartphone into a much more mainstream product with the iPhone, the industry has entered a phase of extremely rapid growth and enhanced competition with frequent introduction of new models with desirable new features.  I strongly question whether customers are going to continue to be willing to accept a system that requires a 2 year wait between upgrades.

I had initially started thinking about this as subject for a blog post after getting into a Twitter discussion of it during the day of the Pre launch.  I got busy with other things and didn’t find time to start working on it until later.  In the meantime, this became a very hot subject generating a lot of coverage both in blogs and the mainstream press after Apple announced the third-generation version of the iPhone and AT&T revealed that the lower pricing would not be available to current iPhone owners that are still under contract.  This is a change from the approach taken with the last version of the iPhone, which was offered at the new-customer price to owners of the previous version, regardless of contract status.

The central idea behind current business model used by the cell phone industry is that the carriers subsidize a portion of the purchase price for the phone in exchange for the customer committing to a service contract, generally for 2 years.  If the customer chooses to switch carriers before the contract is up, he/she is obligated to pay a fairly substantial fee to buy out the contract.  Most carriers offer the customer the option of a smaller discount on an a new phone half way through the contract.  After the contract expires, the customer is generally eligible to again get the same subsidy offered to a new subscriber.

The contract system eliminates a lot of the need for carriers to expend much effort in customer retention, outside of the discounted phones offered at the end of the contract.  This likely saves the companies a lot of money, but is also almost certainly the biggest contributor to the industry’s reputation for poor customer service.  I have found that no matter which of the big cell phone carriers is mentioned, it doesn’t take long for someone to start telling stories about their horrible experiences.

It is in the best interest of the cellular carriers for most phones to have non-subsidized prices that are prohibitively high for most people since, otherwise, it is a safe bet that most people would forgo the contract.  This would make it much easier for customers to switch carriers at will and, thus, would greatly increase the cost and effort that the companies would have to expend towards retention.  I have little doubt that this would dramatically improve the quality of the customer experience, but it might or might not have a negative impact on profitability.

The big question is whether or not the non-subsidized prices really reflect the true cost of a cell phone or if they are kept artificially inflated by the cell phone manufacturers as a result of the subsidy-based sales model.  I admit that I have no direct knowledge, but my educated speculation is that the subsidized prices are probably more realistic.  The non-subsidized prices for phones (especially smartphones) simply seem way out of proportion with the pricing for other portable electronics.  In most cases, those prices are pretty close to what you would pay for a full-featured laptop computer and considerably higher than netbooks, stand-alone PDAs, or portable media players, any of which would seem more comparable technology.

The most obvious direct comparison would really be between the iPhone and the iPod Touch, which is basically an iPhone without the cellular radio or camera.  The pricing information for the 16GB version of the new iPhone 3GS has indicated that it costs $199 fully-subsidized (the price widely advertised), $399 for customers 1-year into their 2-year contract, or $599 un-subsidized.  The suggested retail price of the 16GB iPod Touch is $299 and it can be found in the $260-$275 range if you shop around.  I can certainly see where the added features of the iPhone would justify a higher price, but does it really make sense that they would double it?

In all fairness, my instinct looking at those numbers is that the $399 price offered after 1-year is probably the most realistic one.  While I suspect the price on the iPod Touch is also a bit inflated (it doesn’t really have direct competitors), it really does look like the $199 price probably brings in a pretty thin profit margin, if there is any at all.  The same is probably true with the similarly priced Palm Pre, although it does also have somewhat lighter specs, including only 8GB of memory. Even if the subsidies do push the prices down below the actual cost of the phone, I can still see justification for why the carriers might want to subsidize even for existing customers still under contract in order to prolong their contract and help to ensure loyalty.

I think that they might want to look to the satellite TV business as a possible example.  I’ve been a DirecTV customer for a number of years and they also use a system of contracts and subsidized equipment.  The big difference from the cellular business, though, is that DirecTV lets current customers upgrade their equipment (such as going to a DVR or hi-definition) at the fully subsidized price no matter how far they are into a contract.  The one catch is that doing so will reset their contractual start date to the date of the upgrade.  This helps to accommodate any need that the customer might have to move up to something better or different, while also pushing further back the date at which he/she might be able to switch to a competitor.

I do imagine that the cellular industry would probably prefer to stick with the current fairly customer-unfriendly system for as long as possible, but I do seem some recent signs that they may very well be changing their approach.  The recent publicity over AT&T’s prices for iPhone upgrades hasn’t been very good for them, even if they are pretty clearly within their rights.  A fan base as loyal as the more vocal iPhone owners, particularly when they are so willing to spend more money to make sure they have the latest and greatest, really does need to be cultivated and protected.  Policies that seem to directly target those loyal customers may not be in the company’s best interest, even if they appear to be the most financially prudent on the surface.

Another interesting development is Sprint’s recent introduction of the Sprint Premier loyalty program.  Customers that have achieved high longevity (10 years or more) or have one of the higher-end service plans (priced over $69.99/month, a fairly common price point for a smartphone with both a voice and data plan) are automatically enrolled in that program.  While the program offers a number of smaller benefits, the big one is that those customers are eligible for the fully-subsidized upgrade price at the end of the first year of a 2-year contract.  While Sprint’s recent issues with customer retention probably made this more necessary for them, it still is a pretty clear acknowledgement that higher-end customers are increasingly unwilling to wait 2 years between upgrades.