23 Nov 2012

Google as a Wireless Carrier: Potential Impact on Subsidies & Smartphone Margins

Google Wireless Network

According to a recent report in the Wall Street Journal, Google and Dish network are in talks to partner on a new wireless service. A follow-up report on 9to5Google confirmed these developments and stated that Google will be ready to roll out the service by mid-late 2013. While talks are at a very early stage, Google's primary motive may be lowering the cost of data usage while bringing down smartphone prices and their associated subsidies.

These reports state that Google could benefit from control of a wireless network, as many carriers have attempted to stonewall Google's Voice and Wallet services. Wireless carriers have also restricted capacity, limiting the amount of access users have to Google's services. Control of a wireless network would allow Google to give users access to cheaper bandwidth with fewer constraints. This was also the primary motive behind the roll-out of Google Fiber.

Lower Carrier Subsidies to Drive Lower Data Rates

While the concept of cheaper data connectivity would be very appealing to Google, there is a reason why carriers have chosen to limit bandwidth. In addition to expensive wireless infrastructure, carriers also have to pay smartphone manufacturers huge subsidies on smartphone sales. As a result, carriers have to restrict bandwidth and charge higher rates on data usage to increase profitability. Clearly, if Google wants to offer cheaper data rates, it must cut down on subsidies. But for most carriers, that would increase smartphone prices beyond the reach of the average consumer. This dynamic has held back the growth of pre-paid carriers in the US.

What does Google have to say about this? John Lagerling, the director of business development for Android, had this to say in an interview with the NY Times:
Basically we felt that we wanted to prove you don’t have to charge $600 to deliver a phone that has the latest-generation technologies. Simply that level of margin is sometimes even unreasonable, and we believed that we could do this. 
There are players in the industry who were unhappy about more competitive pricing for the consumers. They want to keep the prices high, they want to force the price to be so high that operators have to subsidize the devices very highly. That’s not only the Cupertino guys but also for the guys up in Seattle. They want higher margins, they want to charge more for software. 
Google clearly feels that margins on high-end smartphones are much higher than they should be. Normally, as competition increases, pricing pressure forces margins to come down. This is already happening in the tablet market, but the smartphone market has been largely insulated (especially at the high-end). For example, the iPhone 5 is said to have a gross margin above 70%, while iPad margins are in the range of about 40%. While smartphone and tablet margins across other OEMs are lower, they show a similar gap between the two product categories even though sales & distribution costs aren't wildly different. This is one of the reasons why the smartphone market is a duopoly, as pricing pressures have been artificially neutralized through subsidies.

Ripple Effect - Hardware Margins Decline

With the launch of the Nexus 4, Google has been trying to drive down prices and subsidies, but it has not received much co-operation from OEMs (at least in non-Play Store markets). Control of a wireless network would give Google the freedom to control the level of subsidies and hence, enable lower data usage rates for consumers. If consumers find this option appealing, the resulting subscriber churn among other carriers could also pressurize them to cut data rates and hence, demand lower subsidies from smartphone OEMs. This ripple effect could cause margins on high-end smartphones to drop to more realistic levels. This could also help improve the popularity of pre-paid carriers in the US.

Since the margin decline on smartphone sales would not be directly driven by Google, but by a ripple effect via other carriers, it should have little to no impact on the Open Handset Alliance. This move would allow Google to improve the bandwidth availability, drive quicker smartphone adoption and also getting a leg up on the competition to solidify Android's status as the leading smartphone platform.

Of course, this is a very long-term view of the industry and Google would face significant challenges related to infrastructure and marketing (not one of Google's core strengths). But it does seem to be the ultimate goal of their potential entry into wireless services.