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Will unlocked cell phones free consumers?

Handset makers in the U.S. are dabbling in selling phones directly to consumers, but will the model be attractive enough to consumers?

The major cell phone operators' hold on which devices U.S. consumers can use on their networks may be slipping as large manufacturers like Motorola and Nokia dabble in selling unlocked phones.

Up until recently, unlocked phones--handsets that can be used on multiple carrier networks--have been available only in "gray" markets where Americans have bought phones from overseas. Now manufacturers are selling them on their Web sites and through certain retail channels.

"Cell phones rank just behind keys when it comes to items that Americans don't leave home without," said Albert Lin, an analyst with American Technology Research. "And as cell phones become the most important thing people carry with them through their day, they will look for products that fit their lifestyles better. And believe me, they will want more than 5 to 20 choices. They'll want hundreds of options."

"In general, phone makers do better in markets where the handset purchase is separate from the service purchase."
--Albert Lin, analyst with American Technology Research

Walk into any supermarket in the U.S. and it's easy to see that Americans have more choices in terms of products they can buy than most people in the world. But when it comes to choosing a cell phone, consumers in the U.S. are limited to a handful of devices offered by a few manufacturers, and those devices are sold solely through a single service provider.

This means that Verizon Wireless subscribers are limited to phones sold specifically for the Verizon network. And Cingular Wireless subscribers are limited to handsets that Cingular sells. It also means that when subscribers switch from one service provider to another, they are unable to take their phones with them.

This is true even if the carrier they are switching to offers the same phone made by the same manufacturer. For example, a Motorola Razr sold for Cingular's network won't work on T-Mobile's network, even though both Cingular and T-Mobile use the same underlying network technology, GSM.

Worldwide, the cell phone market is split about 50-50 between phones sold through carriers and phones sold through other channels directly to consumers, says Lin. In Asia, about 80 percent of cell phones are sold independently of a carrier. And in Europe, roughly 70 percent of cell phones are sold unlocked. But in the U.S., between 90 percent and 95 percent of cell phones are sold through a mobile service provider.

The subsidy game
The driving force behind the carriers' control in North America is the fact that they subsidize the cost of the handsets. Typically, for customers signing a two-year service contract, operators knock off $50 to $80 from the cost of the phone. As a result, some consumers get phones for free instead of paying $100 or more for a device.

This has greatly expanded the market by making phones more affordable, but it's also given mobile operators complete control over the relationship with consumers. The carriers decide which cell phone manufacturers they will work with and which devices they will sell. They also decide which features can be activated on their network.

As a result, only a fraction of a manufacturers' total line of products is offered. For example, even though Nokia introduced roughly 50 new products into the market last year, only a handful were offered by operators in the U.S.

"In general, phone makers do better in markets where the handset purchase is separate from the service purchase," Lin said. "More brands compete in lower concentration, which means more suppliers are competing in the market. It's also good for consumers because, in these markets, products come in a wider range of prices with a lot more feature variation."

Last year, Nokia opened several of its own retail stores in the United States, including its flagship store in Chicago. In these stores, Nokia is pushing unlocked versions of its high-end, smart phones. It also sells its fashion phones unlocked through retailers like Neiman Marcus.

Stores such as CompUSA are also buying unlocked Motorola, Nokia and Sony Ericsson phones from distributors and selling them.

While it's clear that phone manufacturers are testing the waters in the U.S. market, the companies are reluctant to make a major push that might upset carriers they do business with.

"We would welcome a path that provides more direct sales access to consumers, so we can promote our brand," said Bruce Brda, a vice president at Motorola. "But today the carrier subsidizes the phones, and that's great because it makes our phones more affordable to more people. Until that goes away, I see unlocked phones being a very small piece of our business in North America."

Indeed, price is the major barrier for cell phone makers looking to sell directly to consumers. It makes little sense for someone to buy an unlocked Motorola Krzr, which costs $330 from Motorola's Web site, when Cingular offers it for $200 with a two-year contract and a $50 mail-in rebate.

What's more, unlocked phones require much more programming and manual updating by users than phones purchased through a carrier. For example, an unlocked Krzr that is used on Cingular's network won't get the automatic over-the-air updates that the same device would get if it was purchased through Cingular. This means features like voice mail or the mobile Internet might work one day on an unlocked phone, but not the next.

"It's not clear if the carriers will make money from these value-added services. So if the economic model is still unclear, why give away more control earlier than you have to?"
--Andrei Jezierski, a partner at i2 Partners

Unlocked phones are also available only for GSM networks. In the U.S. market, that means they can be used on two of the four large nationwide carriers, Cingular and T-Mobile. Major phone makers today do not offer unlocked versions of their phones for networks based on CDMA, which include national carriers Verizon Wireless and Sprint Nextel.

In Asia and Europe, all the operators use GSM technology. They have built their networks using standardized equipment and software, making it very easy for cell phone manufacturers to sell devices that can be used on all networks.

Because of network differences, operators in the U.S. claim it is important for them to certify phones used on their networks to ensure quality.

"We only allow devices on our network that have been approved," said Jeffrey Nelson, a spokesman for Verizon Wireless. "People come to Verizon Wireless and stay with our service because of the quality of the experience. And that includes the network and the quality of devices used on the network."

The current business model in the U.S. also gives mobile operators tremendous control over which features and services can be accessed from the handsets. The phones and new multimedia services that consumers most often see are branded by the carrier. In this way, Verizon is able to offer its V Cast video and music service and Sprint can offer its PowerVision service.

"If I were a carrier, I would drag my heels too," said Andrei Jezierski, a partner at the consultancy i2 Partners. "It's not clear if the carriers will make money from these value-added services. So if the economic model is still unclear, why give away more control earlier than you have to?"

But experts say tiny cracks are forming in the current model that could challenge mobile operators' dominance whether they like it or not. Apple, with its iPhone, has the brand recognition and established retail channel to easily sell millions of devices on its own. Initially, that device, whose price starts at $499, will be sold exclusively through Cingular. But experts say it's possible that Apple may eventually sell it directly to consumers.

"I think the first time there will be a threat will be if Apple unlocks the iPhone and sells it in its stores," said Lin. "It's already priced near the high end, so subsidies won't make much difference, and Apple already has such good brand recognition."

Experts also see smaller carriers and handset manufacturers potentially upsetting the status quo. For example, regional carrier Metro PCS came out of the Federal Communications Commission spectrum auction last year with more licenses that could help the company build a nationwide network. Metro PCS has already been competing against the big four national carriers in some regions of the country with low-cost prepaid services. And in those markets, it's been able to garner 15 percent of the market in as little as 18 months, Jezierski said. It could compete with bigger carriers by allowing subscribers to bring their own devices and then offer them a lower cost pre- or post-paid service without a service contract.

New hybrid services that combine cellular, Wi-Fi and eventually WiMax services could also put pressure on mobile phone operators to change their business models. Consumers could download music or videos, use Google or Yahoo for messaging and search, or even use voice over IP applications such as Skype to talk over a Wi-Fi network and completely bypass the carrier's cellular network.

"Once one carrier breaks ranks or hybrid Wi-Fi services start skimming away customers who might use advanced services, then I think we could see the market becoming more open," Jezierski said.

He conceded that the path to a truly open market will be a slow and steady one with real change at least three to five years away.

"I don't see major changes anytime soon," he said. "The subsidy offered by the carriers will definitely have to go away for it to make economic sense to consumers."