T-Mobile US Inc.s John Legere Needs to Learn This Economic Game

By Markets Fool.com

Continue Reading Below

T-Mobile's John Legere. Source: Wikimedia Commons

Over the last year, there's been no company that's led the wireless industry quite like T-Mobile's John Legere. After scrapping device subsidies in 2013, T-Mobile successfully used this as a competitive advantage by instituting its Un-carrier initiatives: The elimination of the 2-year contract, domestic overages, and free streaming music. For perspective, the company added 8.3 million net customers while competitor Sprint appears to have lost subscribers in 2014. In the end, T-Mobile is picking up subscribers by intense discounting and customer-friendly policies.

So you'd figure shareholders would benefit as well ... and you'd be wrong. Matter of fact, T-Mobile has consistently lost money over the last six quarters, and 2014's second-quarter profit was heavily aided by a sale of spectrum. Recently, parent Deutsche Telekom CEO Tim Hoettges cast doubt on Legere's business model by stating, "The question is always economics in the long term...and earning appropriate money. You have to earn your money back at one point in time."

And that makes sense, considering each customer-friendly policy and Un-carrier initiative essentially amounts to lower revenue and/or profit per subscriber for John Legere's company. Essentially, T-Mobile John Legere could learn from an economic principle based in game theory best known as "The Prisoner's Dilemma."

The game and principles
The game has been modified to suit each reciter's purpose, but the underlying theme is to expose the phenomenon where rational actors may not cooperate -- even when it is in their best interest to do so. Assume two bank robbery suspects are arrested for a bank robbery and unlicensed firearm possession. The police don't have enough evidence to charge for the more-serious crime of bank robbery so they need to elicit a confession from the now-separated duo.

Continue Reading Below

For the suspects, the following choices are given:

  • You must serve one year for the illegal firearm possession.
  • Unless you betray your partner and testify against him for both counts, then he will get a 20-year sentence but you'll go free.
  • We're giving him the same opportunity.
  • If you both talk you'll each get a five-year sentence.

For a visual representation, please see below:

Source: Encyclopedia Britannica. Confess means betray in this example

And as you may have guessed, although it is better for all parties to cooperate by remaining silent, most actors will betray the other and end up with a prison sentence five-times the length of the lowest sentence. The reason why this happens is the asymmetric risk/reward scenario of remaining silent if the other suspect betrays you.

And how does this relate to T-Mobile?
In a way, this game describes the oligopolistic nature of the U.S. wireless industry. Although there are more actors -- four major companies instead of two -- the underlying premise of cooperation being better for all actors applies. Broaden and modify the game to include wireless pricing and one can see how T-Mobile's aggressive price cutting and customer givebacks could hurt the company and the wireless industry in the end.

To be clear, I'm not advocating the illegal act of price collusion, but it appears T-Mobile is engaging in a rather unnecessary price war. Investors should ask Legere what his end goal is with this strategy. Of course, T-Mobile could finish off the best if other wireless companies fail to match its price-cutting initiatives, and the company continues to pick up subscribers (aka making it up on volume), but that doesn't seem to be the case. Instead, it appears competing carriers are joining T-Mobile in a price war.

Recently, Sprint started its "Cut your bill in half" initiative and it appears to be paying off by adding 1 million subscribers in the third quarter -- its most successful gross postpaid customer quarter in three years. And although it appears Sprint is the most aggressive in matching T-Mobile's initiatives, even AT&T and Verizon mentioned promotional discounts for recent margin compression.

Let me repeat, T-Mobile is unprofitable
Again, it is important to mention that T-Mobile is still unprofitable. When presenting its financial reports, the company tends to focus on its adjusted EBITDA figure, which isn't the same as earnings, and was interestingly flat year over year last quarter although service revenues grew 10.6% -- the reason being the lack of EBITDA growth was customer additions. Considering T-Mobile doesn't give device subsidies, that's an interesting reason given.

Not to mention that Deutsche Telekom CEO estimated T-Mobile will need to invest between $4 billion-$5 billion in its networks just to keep up. Over the last four quarters, T-Mobile's Adjusted EBITDA has been slightly over $5 billion.

And while T-Mobile's customers love Legere's consumer-friendly policies, they could find themselves worse off in the event T-Mobile scrimps on building out its network or exits the business due to an unsustainable business model. In the short run, T-Mobile's moves are exciting, but they could cost shareholders and subscribers dearly in the long run.

The article T-Mobile US Inc.s John Legere Needs to Learn This Economic Game originally appeared on Fool.com.

Jamal Carnette owns shares of Verizon Communications and AT&T. The Motley Fool recommends Verizon Communications. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.