This article is the second part of a series discussing the mobile hardware market and its major players. Part I provided the crucial background that most manufacturers are losing money on hardware, even if financially supported by a software vendor. Part III will examine Apple's (AAPL) ability to extract excellent profit from its relatively modest slice of the overall mobile market. This part examines Samsung (SSNLF.PK) - which makes the second-most money in mobile hardware - and illustrates Samsung's substantial differences from the unprofitable but high-volume Nokia (NOK), which Samsung recently unseated as the world's leader by handset sales volume.
In connection with an earlier two-part article on the mobile platform war (Part One and Part Two), this article offers readers a view of the mobile battlefield not simply by focusing of platform differences, but by looking into the complete product to illuminate which competitors are in a position to achieve what kind of result from what portion of the mobile gadget market. Although this article seeks to discuss hardware rather than platforms, the connection of some hardware vendors to particular platforms prevents complete separation of the two.
Nokia Is Doing Something Wrong
It's not enough that the Guardian's chart of Nokia share (from IDC data) show Nokia's share of the smartphone market steadily sagging:
Nokia's slumping sales clobbered Nokia harder than suggested by the slope of its unit sales, because profit isn't purely a function of units: it's also a function of margin. As Nokia's product differentiation has evaporated, its margins have collapsed, rendering its huge unit volumes impotent to float the foundering craft. As discussed in the prior segment of this article, Nokia's earnings have taken the following plunge despite a ten-figure subsidy from its platform partner Microsoft (MSFT):
How did this happen? Let's look at some of the basics of Nokia products. During 2011, Nokia inked a pact with Microsoft to shift its smartphones to Microsoft's operating system. The fairly high-volume but declining Symbian OS was effectively given an End-Of-Life announcement. Nevertheless, Nokia was not only a global leader in handsets, Nokia was a top contender in smartphones. In a global market that moved 428 million mobile devices in the first quarter of 2011, Nokia enjoyed 25% of overall share (and Samsung, 16%) but 27% in smartphone share. The only platform outselling Symbian in the quarter was Android, sales of which were distributed across multiple manufacturers. With world-leading unit volumes, the problem at Nokia has never been its ability to sell units, or its economies of scale in assembling handsets. What is the mysterious problem plaguing Nokia where it counts?
How Money Is Made in Mobile
It's difficult to look at the fact that Apple and Samsung take 106% of all smartphone profits (the other manufacturers' losses bring the whole pie down to 100%) without stopping to ask: what is it about Apple and Samsung that separate them from their competitors? Two things spring to mind. The obvious one is volume: last quarter, Samsung (56.3 million units) and Apple (26.9 million units) crushed their next-nearest competitor's unit sales (Research In Motion, with 7.7 million units). Volume hardware production means volume parts purchasing, and Apple is the world's largest buyer of semiconductors (at least in 2010, 2011, and 2012). But recently-leading Nokia proves that volume is by itself utterly incapable of upsetting competitors' plans to poach profit. Moreover, crushing the competition on share is not a key component of the profit calculus: Apple and Samsung together sold less than half of all smartphones in 3Q 2012. This means that quite a bit of market share is available to competitors - enough share, in fact, to eclipse either Apple or Samsung in sales. The obvious conclusion is that the advantage of volume isn't an advantage of network effect, but an advantage of scale: big producers have better margins. (If network effect improved the prospects of large vendors, the upset of Nokia wouldn't have gone as it did; its products would have been more valuable, and competitors would have been fighting uphill to compete.)
The second thing Apple and Samsung share may be the real secret: production. Apple and Samsung each produce more of their hardware than typical competitors. That is, each operates with a great degree of vertical integration. Instead of buying all their parts from third parties - paying a premium for others' design work - they do much of the costliest work in-house, and own the technology involved in those aspects of their product in order to retain the margin associated with it.
For example, Apple and Samsung both design their own processors in-house. That means that instead of paying a premium to Intel (INTC), Qualcomm (QCOM), Texas Instruments (TXN), NVidia (NVDA), or others for complete processors or graphics hardware, Apple and Samsung pay less for mere manufacture of their own designs (in Samsung's case, they fabricate many key parts as well). Other hardware manufacturers are dependent on third-party designs, and pay a premium for finished processor pieces to go into each phone. Nokia's Lumia 920, for example, relies on a Microsoft-approved CPU, designed by Qualcomm, and reportedly manufactured in Taiwan by UMC (or, the rumors suggest, maybe Samsung). Paying for pieces of someone else's system-on-a-chip processor design not only lowers margins, but decreases differentiation: anyone can buy the part. If the part is the best, it can be adopted by any willing OEM, killing differentiation. If the part isn't the best, being unable to do better is a competitive disaster. One simple truth governs OEM parts: manufacturers using dominantly commodity parts have a harder time making their products' performance so different from competitors' as to command a premium price.
This doesn't mean that non-differentiating commodity parts have no place in high-end devices. Apple is, after all, the world's largest chip buyer. What other company has made ten-fugure OEM parts prepayments on mobile device components? With buying power like that, the largest-volume vendors must have some of the best price-negotiating power on the planet. And that means that at similar retail prices, Apple earns more profit on a re-sold part than a manufacturer that buys less memory.
In some instances, however, Samsung is even more vertically integrated than Apple. Samsung makes its own LCD screens (and Apple's), it makes many of its own processors (and at least until sometime in 2013, Apple's too), and as a major global producer of Flash RAM, Samsung makes much of its own memory (of which Apple is trying to buy less). On the other hand, Samsung sources some high-end mobile processors from Qualcomm, whose dual-core Snapdragon is the only processor currently supported by Microsoft's Windows Phone 8, which Samsung sells alongside Android-driven handsets using Samsung's in-house chips. Everybody selling Windows Phone 8 must - at present - buy the exact same CPU component from the same manufacturer. But the fact Samsung buys Qualcomm's chips for a few phones doesn't mean Samsung isn't making much more on its more common products. It just means Samsung won't allow competitors to seek profit in a Windows Phone market segment without margins-compressing competition.
This is why Apple and Samsung are capturing more of the profit in 2012 than they did in 2011 (when they shared the profit with HTC), and why competing with either of them is going to require willingness to lose a lot of money in the hope of approaching them in sales volumes sufficient to make margins manageable. Apple and Samsung aren't merely assembling others' parts like many of their competitors; they lower their cost of production by owning more of the IP in each device and thereby increase their margins on every device. Apple and Samsung can profit more at the same price points on similar hardware than others, and as the hardware market heads toward commoditization, competitors face a dangerous game of chicken with these behemoths' beefy balance sheets.
Sadly for the U.S. investor, Samsung isn't listed on a U.S. exchange and doesn't make regular SEC filings. It can be traded, but pink sheet stocks' data doesn't show up in lots of stock screening tools. One thing definitely does show up in the U.S.: Samsung's products.
Samsung sells vastly more cell phones than Apple. In fact, Samsung currently sells more cell phones than anyone, having just this year ended Nokia's 14-year reign as the global volume leader. Most of those handsets aren't smartphones, of course, but even there Samsung is no slouch. At nearly half of all Android sales, Samsung doubled its share of Android devices in 2012. While Samsung historically experienced sales volumes dominated by low-end devices - most of which weren't smartphones at all - Samsung's efforts in the high end have enjoyed recent success. Sales volumes of the Galaxy SIII passed the iPhone 4S in the quarter the iPhone 4S was replaced by the iPhone 5 as Apple's flagship phone. Samsung has grown sales volume in the high-end market and now has substantial share of the segment.
Samsung's sales gains haven't come from buying share: it's making a profit on those smartphones. Since Samsung designs the Exnos 4 processor in the Galaxy SIII and builds the chip itself, Samsung has the best possible pricing on the parts. Moreover, as volumes increase, the per-unit cost will drop as fixed costs become a smaller and smaller contributor to per-unit costs. Volumes are a great friend to margins, and Samsung has them. The benefit of volume in risk reduction is evident when one reviews the reports surrounding Apple's predicted shift of A-series chip fabrication to Taiwan Semiconductor Mfg. Co. Following reports that Apple's chip fab business would move from Samsung in the wake of the companies' ongoing litigation, Samsung mothballed an improved fab plant that was part of a billion-dollar semiconductor manufacturing investment. Why? Without the guaranteed volume of Apple's high-end product consumption, the investment may have represented an unacceptable risk. Firms with less sales than Samsung have greater risks, and less willingness to invest. (Apple and Samsung may, through their spat, be squandering an opportunity to create mutual advantages of scale through co-production. At least their split works in favor of antitrust principles.)
Samsung is a longtime maker of LCD screens. When Apple first transitioned its desktop computers from CRTs to LCDs in the earliest years of the 21st Century, it locked up LCD production in part by making a loan to Samsung. Although the Korea Times reported Apple would lose access to Samsung LCDs, Samsung denied that report was true; Samsung supplies not only Samsung at the high end, but also Apple - even in its latest products. Samsung also produces LCDs for HTC's mobile hardware. Lots of folks buy Samsung LCDs, including folks building televisions (or buying Samsung-branded flat-screen televisions). What this means is that Samsung is able to spread its fixed LCD costs not only across its own handsets that include LDCs, and across entirely different business lines, but across the handsets of many of its direct competitors. Nice, eh? And at a markup, to boot. If Samsung can't sell you a handset, it will profit selling components to whomever succeeded - cutting its own products' overhead in the process.
Apple may be the world's largest Flash RAM buyer, but Samsung is the world's largest Flash RAM manufacturer. By supplying so many firms that include Flash RAM in their complete products, Samsung spreads expensive fixed costs of fabrication across not only many units, but across different markets (desktop computers, thumb drives, cell phones) and at a variety of price points (from OEM supply to Apple to completed storage products ready for retailers), making the Flash Samsung consumes for itself some of the lowest-priced parts (net of sales to third parties) on the planet. In the commodity market, this pricing advantage is an outstanding advantage: Samsung can profit from products priced too low for higher-cost competitors to stay in business. By pricing products at the point competitors are barely able to tread water, Samsung swims in gravy (relatively speaking). By itself, Samsung reportedly captures 16% of operating profits to be had in the mobile hardware market - more than is made on all other non-iOS hardware sold worldwide.
A Look At Another Non-Apple Competitor
To illustrate the problem of component pricing and the advantages of vertical integration in the mobile segment, let's look at the only other hardware vendor to make a profit recently in the mobile sector: HTC Corp. (HTCKF.OB). To signal quality to buyers, HTC announces its product includes Corning's (GLW) Gorilla Glass 2 and features speakers by Dr. Dre's Beats Audio. The source of the HD display or the Flash RAM storage is not disclosed, but HTC makes neither in-house. The company must buy them - in competition with every other OEM consumer. HTC hopes to reduce dependency on Samsung for parts (which has to work against margins: paying a competitor a profit for parts), which may be why HTC doesn't disclose the current source of its displays. There are several places to source displays, but sources that can reliably ship the high-pixel-density parts demanded in the highest-end smartphones will bargain for high margins as will any premium part provider. HTC's relatively modest purchasing volumes (compared to Apple, or the volumes consumed by Samsung) may be insufficient to motivate much movement in bargaining for terms.
Although the highest-volume source of Android phones in 2010, consistent pressure from Samsung sapped HTC's share and profit. HTC's move into the market for Microsoft's Windows 8 smartphones will be a move into a market in which differentiation will not come mostly from software: all Windows 8 vendors will present what Microsoft permits. Competition will inevitably focus on hardware, as in the market for PCs shipping with Microsoft operating systems - and with the same results: hardware manufacturers will become low-margin commodity vendors. HTC may not become a mostly-Microsoft vendor, but its other operating systems are also equally available to competitors, and for the same prices. HTC is in a position akin to that of historic Dell before it refocused on higher-margin enterprise services: lacking a competitive moat, it is a commodity vendor subject to the pressures facing all vendors of commodities. Its ability to fund innovation will be curtailed by its limited reinvestable profits, which are already under pressure. As its products become impossible to distinguish from competitors, the only tool for competition will be price. As margins fail, increased unit sales will be required to maintain profitability. Financial success is difficult for a commodity vendor. HTC manages it better than most, but would you pay money to participate in those results?
The margins advantage of owning the technology that makes the products work cannot be overstated in a market otherwise dominated by commodity competition. Samsung has the manufacturing infrastructure to own lower-level production than competitors, and by acting as an OEM supplier it spreads its fixed costs across even its competitors' products. Duplicating Samsung's strategy isn't an overnight effort: it involves both capital and expertise - and expertise from diverse fields affecting the numerous components in which Samsung as amassed valuable expertise. Competitors without such advantages will find that competing with Apple and Samsung is an exercise in surviving by scrambling for scraps.
Click to read Part III on Apple and the outlook for its ongoing profit in the mobile marketplace.
Disclosure: I am long AAPL.