S is for Service

One of the enduring mysteries of the iPhone has been its lack of a portfolio. After six years it seems that Apple has finally acquiesced that there should be one, albeit currently limited to two items. The second enigma is related to the price, namely why does Apple ask so much for its phones? At an average sales price of $600 it’s a shocking premium to the average phone, and with a six year run, a shocking resistance to the corrosive effects of competition.

The obvious answer to why Apple asks so much is because it can. Anybody would if they could. That’s a poor question. So the right question should be: why does anybody pay this much? One could answer that few do and it’s not a mystery that some feel better paying more simply because they can. But those who pay Apple’s prices are, mainly, not consumers. They are operators. Exactly 270 of them.

So then let’s re-ask the question: Why do so many operators pay so much for Apple’s phones? We can’t answer that with the psychological slurs usually directed at the brand. Surely Operators aren’t competing in beauty contests or need to soothe their collective egos. The decisions operators make on whether to range a phone are driven by hard economic realities: ARPU, churn, network costs, depreciation, ROI, etc. Some clearly can’t make the iPhone fit their economic models and indeed about two thirds of them don’t. But the most prominent1 do. DoCoMo, the largest in Japan just did after holding out for five years. Verizon held out for years, as did T-Mobile. China Mobile’s acceptance also seems imminent.

But that still leaves the question of why are those operators who do carry the iPhone willing to pay so much for it? I only assume that their decision process is likely to be rational. Mainly because we have a large enough sample but also because there is a lot of money at stake requiring quite a bit of internal consensus and vetting before committment. We have to conclude that operators place the orders because they obtain value from the iPhone even when it’s priced at a premium to the average alternative.

The question which follows then is how do they obtain value? I’ve argued that this follow-the-money process leads one to conclude that the iPhone helps in moving users to higher revenue data services. These are more profitable services for operators and the subsidy model creates more loyalty and thus reduces churn and creates a stable cash flow which can then be leveraged through debt to upgrade networks and attract yet more loyal iPhone users.

Therefore the iPhone is “a data service salesperson” receiving a large commission (in the form of a price- and hence margin premium) for doing what few others can do. In that sense the iPhone is hired by the operator to do a unique and valuable job and is paid well for doing it.

This answers the question of why Apple can get away with charging so much for its phone: because operators love it. The entire product depends on a reward system and for years we’ve heard fears that it’s going to end. But it hasn’t. Operators love subsidies and they’ve been honing them for long before the iPhone showed up.2

But this is not the end of the money trail. The premium is initially paid by the operator but they tend to get most of that payment back from the consumer. In other words the subsidy that inflates the iPhone price is at least partly if not mostly paid by the consumer in the form of a higher phone bill.

You won’t see it itemized on your bill, but it’s likely that $10 to $15/month from a subsidized phone service plan goes toward paying for your phone.

So in a way, Apple has managed to place itself on many people’s monthly phone bills. It’s a nice place to be. It’s nice for the same reasons operators like post-paid customers: predictability. It’s also nice because recurring services are a better business model than products; they have higher levels of loyalty and are more “sticky”.

But this placement is not transparent. It smacks of misdirection. The link is not made in the mind of the consumer that they are paying for a phone through their service plan and many see it as a thinly veiled con. The value of the iPhone to the user may be evident through its use but the payment for that value is not.

But in many ways this is similar to how many services are valued: through bundling. We pay for the value of a great retail experience through a higher price on items purchased. But we still associate that price with the good sold not with the place where it was bought. We get great value from Google’s services but don’t know how to quantify the cost of their peering into our minds. In fact the whole Internet and all business plans that are built on it depend on a subtle “something for nothing” type of misdirection. The Internet runs on the arbitrage between a consumer service market where everybody consumes but nobody pays and a separate data market where nobody consumes and everybody pays.

The iPhone could thus be finally understood as a complex service business. It captures value through the phone bill but delivers value through a screen. A misdirection magic trick which many have tried to pull off. It’s essentially tapping into the $1.3 trillion communications market, skimming profits by delivering the “content” which lights up the wires.

It’s great except it does not work everywhere. Not yet at least. The complexity of services means that they are usually found in more advanced so-called service economies and rare in less developed so-called goods economies.

Economists have observed this process and even have a name for it: servitization: The process whereby almost all sufficiently advanced products are indistinguishable from services.

As a service, the iPhone’s strengths are easier to understand. Its weaknesses as well. Services simply don’t work in economies which don’t have robust institutions of credit, capital intensive infrastructure and distribution networks.

It’s also the reason why Apple is so slow to penetrate all markets. It’s not in the business of selling phones. It’s in the business of enabling and creating services.

1. Arguably the most important [↩]
2. Recall that the first iPhone was sold without subsidy and with a separate, secret revenue sharing plan. It did not last because it was cumbersome and because operators convinced Steve Jobs that their way was better. [↩]