As customers hold onto smartphones longer, Apple, Samsung could challenge carriers with upgrade programs

U.S. consumers are upgrading their handsets less frequently as carriers move away from two-year contracts and toward leasing programs and equipment installment plans. The decoupling of those contracts with the price of the phone itself has provided consumers with added transparency about what they're really paying for their phones, so they're often holding on to them longer.

In response, operators and smartphone vendors are increasingly turning to device upgrade plans in an effort to boost hardware sales. And that gives smartphone companies an opportunity to capitalize on what has traditionally been a crucial customer touch point for network operators.

Verizon (NYSE: VZ) last week expanded its upgrade program to include the Samsung Galaxy S7 and S7 Edge, enabling users to switch to any new smartphone once a year when they return their old device that has been at least 50 percent paid off. The carrier launched its upgrade program last September for customers who purchased Apple's (NASDAQ: AAPL) iPhone 6s or 6s Plus.

The nation's largest carrier introduced its upgrade offering within weeks of the launch of Apple's own iPhone Upgrade Program, which starts at $32 a month and allows users to switch to a new iPhone every year. And Samsung, the world's largest smartphone vendor, recently launched its own upgrade program for users in its home market of South Korea, charging them $6.35 in addition to their phone payments to allow them to move to a new Galaxy S or Galaxy Note device every year.

Upgrade programs are perhaps an obvious strategy in an era where handset replacement lifecycles are becoming significantly lengthier. Postpaid subscribers now keep their devices for an average of 3.3 years, according to a recent report from UBS analysts, up from 2.8 years in 2011. Roughly 30 percent of the phone base upgraded in 2015, UBS said, and the market research firm predicted a record low 6.2 percent of the postpaid subscribers of major U.S. carriers to upgrade during the current quarter, down from 7.2 percent during the same period in 2015.

And multiple U.S. operators have witnessed the trend.

The handset upgrade cycle is "shifting out and getting longer," said John Stankey, CEO of AT&T's Entertainment Group, during a recent investor event. "It's not a trend that is unique to AT&T."

Slowing replacement cycles aren't entirely bad news for carriers, of course. Carriers foot the upfront bill for the phones they sell through EIPs (as opposed to full retail purchases), so the trend has resulted in improved industry profitability as device expenses decrease. And customers often don't switch carriers until they buy a new handset, so churn rates have waned and grow subscriber adds have slowed.

"Subscribers are electing to hold their devices longer and save money once the handset is fully paid off," UBS analysts wrote last week in a research note. "This is putting pressure on upgrade rates, which in turn is driving lower churn as handset sales are the main trigger for customer activity and movement among the carriers. Lower churn also puts pressure on gross adds."

And the emergence of upgrade programs by handset vendors is quickly emerging as a threat to network operators that continue to dominate the smartphone retail space. A survey last year from Consumer Intelligence Research Partners found that carriers claimed 55 percent of smartphone sales during the fourth quarter of 2014; no other channel accounted for more than 12 percent of sales. Customers who walk into their carrier's store or visit online to buy a new phone will almost surely stick with their operator, obviously. Those who upgrade through other channels are more likely to switch.

Thus, Apple's substantial retail presence online and in brick-and-mortar locations gives it an opportunity to position itself in front of consumers when they upgrade their handsets, potentially replacing their carrier partners at a time when users are most likely to consider switching operators. Meanwhile, Samsung is looking to increase its physical presence in the U.S. with the opening of a swanky "technology playground and cultural destination" in New York, and the company likely has designs on expanding its new upgrade program to other markets eventually.

So as carriers monitor the upgrade programs of their manufacturer partners, they shouldn't be concerned only about losing out on winnowing device revenues. They should also be worried about losing subscribers in the process. --Colin