"AT&T 's iPhone model is a prime example of the negative effects of the subsidization model," Castonguay said. "It shows that an AT&T iPhone account with high data usage doesn't break even until month 17 of a 24-month contract."

A Lengthy ROI Window

The late 2008 burst of sales for the iPhone made global headlines despite being a relative drop in the bucket for an industry that sold 1.25 billion handsets last year, Castonguay observed. "The danger of this early success is that operators, OEMs and other companies can quickly become enamored with the titillating burst of media attention and begin to lose sight of the longer-term ramifications of their decisions -- namely, shrinking profitability," Castonguay said.

The estimated financial burden on AT&T for acquiring a new iPhone user on a two-year contract is a staggering $859. "Assuming that an iPhone user maintains voice usage comparable to AT&T's average customer and data usage of 5GB per month, Yankee Group estimates that AT&T would achieve an operating margin per account of approximately 47 percent, leading to a total profit margin of 16.1 percent per user," Castonguay said.

Eliminating the subsidy on the iPhone would generate a total return for AT&T of 33.4 percent over two years and shrink the time to break-even status on the account to eight months, Castonguay observed. "With this dynamic change, AT&T could begin to offer more flexible contracts to its customers, designing the total cost of ownership structure to reward specific behaviors such as long-term loyalty with better monthly terms," he said.

What's more, the subsidization model's shortcomings aren't limited to handsets. Negative experiences also pose significant risks for the carriers subsidizing netbooks, noted Joshua Holbrook of the Yankee Group.

"A 30 percent return rate for netbooks demonstrates that consumers don't understand the limitations of their functionality," Holbrook said. "Wireless operators that subsidize netbooks in conjunction with wireless data contracts run the risk of consumers confusing poor netbook performance with poor network performance, thereby compromising an operator's brand and profits."

A Wake-Up Call

The popularity of the iPhone and its users' ravenous appetite for mobile data has created other headaches for AT&T, which saw its data traffic increase 5,000 percent between April and August this year. At the same time, AT&T has received complaints about poor network performance.

"Certainly the data congestion is going to be a negative pressure on their brand as well as the service quality they can offer their customers," Castonguay said. "Obviously, when you have the explosive data demand we are seeing, it really does impinge on your network performance and creates a 'be careful what you ask for' scenario."

Carriers would clearly become more profitable more quickly if they stopped subsidizing the devices that run on their networks -- freeing up more resources for improving network quality, Castonguay said. "They need to reconfigure their distribution model so that the cost of those devices doesn't impact their own bottom line," he said.

Recent legal challenges to the early termination fee (ETF) policies of network operators also should be a wake-up call. "The early termination fee offsets the financial risk that the carriers take when they subsidize their handsets," Castonguay said. Without it, he said, subsidization becomes too risky.