How Prepaid iPhones Will Remake the Mobile Market

Apple has lots of big iPhone news today , but last week’s announcement that Sprint Nextel and Leap Wireless will begin offering iPhones without a contract could actually be just as significant – starting a massive change in how Americans buy and use mobile phones.

Up till now, if you wanted an iPhone, you signed a two-year service contract with a carrier like AT&T, Verizon Wireless or Sprint, and got a big discount on the price of the phone. But under this new model you would buy the phone at full price, but pay less for service and avoid getting locked into a contract. Over two years, the prepaid model comes out to be significantly cheaper.

The new approach won’t change everything overnight. The upfront price of the iPhone 4 and iPhone 4s in the carriers’ pay-as-you-go plans will be too high to have an immediate impact. Sprint’s Virgin Mobile USA will sell the Apple smartphones for $549 and $649 respectively, with a no-contract plan that costs as little as $35 a month. Leap’s Cricket Wireless will sell the phones for $399 and $499 respectively, and provide a voice and data plan for $55 a month.

Verizon Wireless and AT&T, meanwhile, sell the latest iPhone for just $200 – albeit with a two-year contract that carries significantly higher monthly costs. These types of plans are what people are used to in the U.S. (though not in most of the rest of the world), and sticker shock for unsubsidized phones will likely keep most people from switching – at least right away. “There will be some impact, but it’s not going to be large-scale or widespread,” said Weston Henderek, an analyst for Current Analysis .

Psychological Barriers Remain

Given the total price difference over the course of a two-year contract, though, the reluctance to switch is partly psychological. But there is a practical reason, too. Prepaid plans offered by smaller carriers typically come with less nationwide coverage than what’s provided by the tier-one carriers.

The first carrier expected to feel some pain would be T-Mobile, which doesn’t sell the iPhone but encourages people with unlocked phones to come to them for a cheaper service plan. That strategy may no longer be as attractive, now that Virgin and Cricket are also offering relatively inexpensive plans, along with device warranties.

The real disruption will take longer. If Apple continues to drastically reduce the price of older iPhones every time it releases a new model, it’s likely to create a robust market of slightly out-of-date iPhones used on second-tier carriers. For example, when the current iPhone 4S was released, the price of the iPhone 4 fell low enough for carriers to sell it for $100 with a two-year contract. The iPhone 3GS cost nothing with a similar plan.

If carriers selling prepaid plans can get the price of older iPhones closer to the $200 mark, many people may find those deals attractive enough to switch from the contract plans offered by Verizon and AT&T. The shift will happen gradually, as current two-year contracts run out and consumers start looking for options. “It’s going to be a gradual trickle, rather than people just all of a sudden dumping their carrier and going over,” Henderek predicted.

As that option becomes more mainstream, it’s likely to put price pressure on AT&T and Verizon for both service and the devices.

What About Android?

Android phone manufacturers won’t be spared from changes caused by the prepaid iPhone. The impact will be felt in the high end of the Android market where phones cost anywhere from roughly $250 to $350. To compete with the iPhone, carriers will likely boost the number of high-end Android phones sold with prepaid plans. “You’re going to have a much wider range of devices available,” Henderek said. At the same time, older prepaid iPhones will put price pressure on the mid-range of the Android market.

Impact on AT&T, Verizon Wireless

How these changes will affect the market for the latest iPhones is more complicated.

It’s no secret that AT&T and Verizon would like to reduce the size of the average iPhone subsidy – now running $400 to $450, some $100 to $150 more than for a high-end Android smartphone.

If Americans suddenly decided they’d rather pay full price for an iPhone with no contract, then the carriers would be off the hook. However, they might also have to deal with a higher churn rate, since customers without contracts could switch to a competitor whenever they wanted. To hold onto customers, carriers would have to compete on the price of services, which could have an even greater impact on the bottom line than current iPhone subsidies.

To get a sense of the market impact of prepaid phones, U.S. carriers and wireless analysts are looking to the Iberian Peninsula, where Telefónica Spain and Vodafone Spain ended subsidies for all phones earlier this year. Orange, the third major carrier in Spain, is continuing to subsidize phones.

“It is too early to determine what affect the elimination of subsidies will have on the net add dynamics of the Spanish wireless industry, though if Orange gains meaningful share, it could pressure the decision of the other two,” William Power, wireless analyst for R.W. Baird, said in a note to clients, according to Barron’s.

It will take time for all of these effects to play out, but if Telefónica and Vodafone are successful in Spain, expect carriers around the world to take a long, hard look at paying smartphone subsidies.

Finally, if and when we get to a market where upgrading your smartphone costs $500 instead of $200 (or $200 instead of free), many people may suddenly be willing to hold onto their current devices another year or two. As the U.S. smartphone market becomes increasingly saturated, there may not be enough new smartphone customers to maintain growth rates.