This article on mobile manufacturers continues from Part I: Killer Competition (on how easily money is lost in mobile) and Part II: Samsung Sells More Stuff (which illustrates how money is, in practice, actually made in the mobile market).
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.
As discussed in Part II of this article, Apple (AAPL) and Samsung (SSNLF.PK) make the mobile market's profit. Samsung does it by manufacturing not only its own low-level parts, but everyone else's as well: it sheds to competitors much of the fixed costs of its prodigious production. Apple doesn't sell as many units, but it concentrates its sales in a smaller range of products. To understand how Apple succeeds in its high-margin business, it's helpful to recall that Apple wasn't originally a mobile maker. Apple had its own financial flop in the Newton and learned to do things right only relatively recently.
A Brief History of Apple's Mobile
Apple's current line of mobile products had its genesis in the iPod, which at $399 launched as the most expensive portable music player on the planet. It had a capacity of 5 gigabytes (approximately 1,000 songs using then-dominant encoding practices), and because it used Firewire hardware as its only interface (power and recharging), the product initially had little addressable market beyond that of Apple's existing Mac customers. Due to platform issues - the first iPod software expected to synch music with Apple's iTunes software, which was then capable of running only on Macs - most of the world's music listeners were required to buy third-party Musicmatch software to load music collections onto Apple's music players. Before finally selling an iTunes music library manager for customers running an operating system from Microsoft (MSFT), Apple licensed and prepackaged Musicmatch (at the cost of lowered margins) to sell products to its non-Mac customers. At one time, the Mac and non-Mac versions of the iPod were packaged separately and had different management software and on-device hard drive formatting.
How times have changed. Apple's mobile devices are now not only available to non-Mac customers, but to buyers in scores of countries. Physical products have been augmented with a massive store to sell content, which as described by Horace Dediu at Asymco has become a $12 billion business with double-digit growth. This doesn't mean Apple has ceded hardware to others in favor of content: Apple sells more mobile music players than any other vendor on the planet, half of which are iPod Touch devices nearly identical to Apple's smartphone (except for the ability to call). The new version of Apple's phone just experienced successive best-ever launches in the United States (>5m sold the first weekend) and China (>2m sold the first weekend). Apple's tablet has experienced enormous growth; earlier this year, Apple was considered the world's largest PC vendor by unit volume largely on the strength of its iPad business. Measured by ads served to web users over the month following launch, Apple's new iPad Mini outsold by 50% the strong launch month enjoyed by Amazon (AMZN) the prior year with its cheaper, lower-margin Kindle tablet.
Apple makes more mobile money than anyone else, taking a profit that dwarfs its sales share. Although Apple does the same in PCs (taking outsized profit with modest share), it's succeeding even better at this in mobile.
Apple As A Competitor
At the same time, Apple upgraded the internals of its existing tablet to keep ahead of new rival devices' hardware performance:
In terms of pure gaming we simply can't recommend Surface RT when the same games run with higher-resolution and more consistent frame-rates on third-gen iPad. And, unluckily for Microsoft, its tablet launches against an even more powerful fourth-gen Apple product.
Richard Ledbetter, "Microsoft Surface RT Review", Eurogamer.net.
How does Apple do it? It owns more of each of its products. For example, Apple designs its own CPU. By hiring third parties only to fabricate it, Apple acts as the architect to third parties' carpenters and drywall crews: Apple keeps the high-margin money involved in paying for the design. Acquisitions (like PA Semi and Intrinsity) brought Apple not only valuable CPU IP, but talented engineers capable of pushing the limits of available technology. Because Apple has such huge volumes, it is free to engage in unusual, high-dollar design techniques other vendors could not safely invest for concern of making back their sunk costs. Processor cores aren't the only technology Apple has in-house. It made a relatively big (for Apple) investment when it bought a top memory controller firm (Anobit), which allows it to include memory controllers in its system-on-a-chip hardware and to save money and parts building a complete phone. Anobit's publications included a white paper on making reliable storage from cheap-grade components ordinarily unacceptable in the enterprise space (with Anobit's site now down, the paper has disappeared). Reliable operation with cheaper parts is the stuff of which competitive advantages (and perhaps freedom from Samsung) are made.
Those competitive advantages may not be obvious or appear as box-label marketing points, but they affect subtler but crucial things like under-the-hood battery life enhancement and component costs. Enhanced margins are why Apple makes outsized profits from modest market share. As a high-end buyer - and sometimes as a huge buyer - Apple's pricing power protects it from competitors: when Apple launched the original iPod, nobody else could buy the 1.8" drives contained within them because it'd cornered the world supply. When Apple first transitioned its entire desktop line to LCD screens, competitors were stuck with leftover units Apple had rejected.
To push Apple's competitive advantages in its high-volume businesses, Apple is making significant investment in property, plant and equipment ("PP&E"). Apple's PP&E spend recently eclipsed Intel's. This is rather different than the picture painted by critics who like to say Apple doesn't invest in innovation. Apple's innovation is often in its supply chain, which creates both production capacity and competitive advantages associated with production efficiencies. Some criticize Apple for "falling behind" in R&D measured by percent of sales, but Apple's enormous sales may make spending a high percentage of sales a spendthrift exercise rather than a badge of honor. Bloated "research" departments producing little innovation may not be as good an investment as some are keen to portray. Apple may not pour as high a fraction of its revenue into R&D as some firms - especially firms in totally different industries - but it certainly develops products that produce a profit.
That said, Apple's Research and Development ("R&D") expense is up 40% for 2012 to several billion a year. Apple's new campus proposal includes an entire dedicated R&D building. Apple's innovations aren't about things like manufacture of silicon wafers - plenty of others are advancing that art, including Intel (INTC), Samsung, Taiwan Semiconductor Manufacturing Co. (TSM), and Texas Instruments (TXN). Apple has made clear from before the iPhone launch that it wants to innovate where it will make a difference, and to concentrate its effort there. Some of its hardware innovations involve notebook computer enclosures, antenna design, batteries and battery recharging systems, and other things that Apple uses to differentiate its gadgets in the marketplace. (Apple also seeks differentiation through software innovation, but this is a hardware article.) Apple's innovation matters to its competitive position; if Apple is to maintain its position as a differentiated manufacturer, it will need to continue to retain and attract people capable of dreaming up new solutions to problems - especially problems customers hadn't realized they needed solved.
Apple shares have taken some lumps recently. Is the Apple rotten? Some declines seem related to widely-reported non-events. Most recently, launch-day line-length observations led to fears that Apple faced weak demand in China (and explanations for the shorter lines). In fact, sales reached 2 million iPhone 5 units in China alone the first weekend that product was available there. That one-weekend figure is more than 10% of Apple's entire FY2012 sales of iPhones to China. Since Apple also sells the iPhone 4S in China, sales of which are not included in that figure, Apple's overall unit sales are even higher; demand in China is extremely strong. (The fact that Apple hasn't reduced its price to China's largest cellular carrier affects the number of places its products are sold, but Apple's pricing policy appears too successful to criticize lightly.) Counting the units Apple appears poised to sell can paint a much more dramatic picture of Apple's sales volumes than pictures of Apple's stores following a new reservation system and dramatically increased points of sale. The "calmer, less chaotic launch" should be good news to those hoping to prevent sales-suspending fracases. And as for those reports Apple's pricing on its Samsung-fabricated CPU designs were going to be jacked up 20% suddenly by Samsung? Samsung said the story was rubbish: processor prices set under the contract "aren't changed easily."
Headlines that emphasize market share gains by Android manufacturers may be the most substantive of the reports adversely affecting Apple shares. But do sales-share figures affect Apple's business? Does the inevitable ascent of Android's sales share toll the death of Apple? Or is John Gruber right about what "winning" in mobile really means? The fact is that sales share and profit share haven't been even remotely similar for years. Performance on the bottom line - where it counts - isn't about market share: Nokia proves that "success" in selling lots of cell phones can amount to a financial train wreck. Bottom-line performance is driven by a formula too simple to misunderstand: Profit = (Profit/Unit) x (Units Sold). Apple is growing year-over-year unit sales and has industry-leading profit margins. And according to some of the most recent reports, the newest hardware refresh has increased Apple's share against Android - grabbing 53% of the U.S. smartphone market, and increasing share in China from the negligible to nearly a fifth of all smartphones. With profit driven by both margins and share, Apple's growth should mean outstanding returns.
It's against this backdrop of fierce competition led by the successful duo of Apple and Samsung that Research In Motion (RIMM), Nokia (NOK), Google (GOOG) (through its Motorola Mobility) and Microsoft (through its Surface) seek space in the mobile segment. It'll be rough going. The following chart includes Google and Microsoft, not because they are platform vendors but because they both are developing mobile hardware businesses. As software companies, you'd think these two would have outstanding margins with comparison to a gadget-seller like Apple, but ...
... Google and Microsoft have recently lost money entering the hardware market to compete head-to-head with the likes of Samsung and Apple, which hasn't improved their margins. (The author wishes that Samsung and HTC could be added to the graph, but YCharts lacks data on these shares that don't trade on major exchanges in the U.S.)
The Secret Is ... In The Sauce?
Apple's success hasn't been because its products were cheap. The original iPhone was famously (though inaccurately) derided by Microsoft's CEO as "by far the most expensive phone in the marketplace." Currently, the unsubsidized price of Apple's phones reaches $850.
If price isn't the secret, what is? Quality. Apple's reputation for products that work simply and predictably led half of surveyed consumers to report willingness to pay a premium for an Apple-branded television - sight unseen. Contrary to the mistaken view of onlookers whose view of Apple is stuck in the mid-'90s, Apple is building success not by pushing caviar on fast-food diners, but by making a better sandwich. People liked Apple's music player that just worked, they liked Apple's phone that just worked, and they're eager for other things that just work. The music player wasn't sold by virtue of a Jedi mind trick or a lack of competition; the music player market existed before Apple arrived, and when Apple showed up it was promptly threatened with efforts to drive all commercially-sold music onto file formats that would not play on Apple's devices. Apple fought tooth and nail for its music business, and won largely on a combination of its products' ease of use and their expansion across all contested price points. Competitors will doubtless compete to deliver mobile hardware that cost less than Apple's, but whether they make the user experience as enjoyable is quite another thing entirely.
The author pauses here to think about an insurer which is delaying notebook computers' issuance to employees in order to have them re-imaged with an older operating system, because someone in authority at the insurer decided Microsoft's newest operating system was "too hard to use." The anecdotal report hasn't got a supporting link, but it reflects the risks associated with user-interface innovation, and the difficulty of making change that is good change. Apple's competitors will either try to offer the same thing Apple does - in which their products will lack differentiation - or they will take risks to offer something that isn't the same. In a market as competitive as the mobile market, that may not seem a particularly enticing prospect.
Price to the retail customer may not be a major advantage for Apple. Apple has, however, leveraged its supply-chain expertise to cover the entire price range with profitable products. At least, in markets that include mobile service contracts and carrier-subsidized handsets. For the rest of the market - where Apple has been challenged by the dominance of prepaid phone plans that prevent carrier subsidies - Apple is working on even lower-priced products. Apple isn't fighting to make the most on each device it sells. Apple is strategically pricing products lower so as to generate enterprise profit. Apple has a solid mobile market strategy. Against the steep slope of that effective strategy, competitors must compete to take profit from a company with a powerful brand and a reputation for satisfying customers, and which has a track record of making products customers enjoy using.
Based on the profit share graphs, it's clear that's a tough place for a competitor to be.
Competitors Fighting For Scraps ...
The nightmarish vision of a largely-money-losing industry segment painted in Part I of this article has a direct effect on market participants and their willingness to risk capital (or more capital) in such a cutthroat marketplace. The mobile battlefield is littered with failed or fled firms. Texas Instruments, though named a Windows RT platform partner by Microsoft (which targeted TI's hardware with its single-binary Windows RT release), abandoned the mobile market before shipping a single Windows RT device. TI's own hardware partner Toshiba had quit, apparently over the entry of Microsoft into the tablet market. TI was unable to find a replacement, and it wasn't willing to risk going it alone. Shortly after Apple announced its A6 processor, TI announced it was shuttering its processor program targeting tablets and smartphones. Amazon is reportedly looking to acquire TI's mobile chip business; it uses TI chips in its Kindle Fire products (just as Barnes & Noble (BKS) uses them in the Nook.) It's an entirely different question what will be left to buy after Apple's quickly-reported and apparently successful effort to poach TI's mobile chip engineers in the wake of the announcement TI was leaving the business. Or maybe Apple's poaching has been going on all year.
Fear of Microsoft's competition in the tablet segment has apparently alarmed another hardware partner: Azus. Azus announced that it would not have a Windows tablet on offer in 2012, but would release one after it had a chance to see Microsoft's Surface launch. Anyone care to bet how much Azus is willing to invest to develop a really innovative tablet under these circumstances? And how excited is Azus to go up against a combined Microsoft and Barnes & Noble in the tablet space? Particularly when the combo is willing to lose millions to keep Nook competing? (One might also ask about Microsoft's move in entering the tablet market as a manufacturer in competition with itself as the co-owner of the Nook venture, but some already regard the Nook venture as doomed.) Is the Microsoft-powered hardware effort guided by a coherent strategy, or is it spray-and-pray marksmanship driven primarily by the confidence it won't run out of ammunition?
Google's move into hardware may eventually allow it to develop a superior Android platform, but it raises interesting questions about its relationship with competing hardware vendors who must wonder about the wisdom of shipping software that will subsidize a competitor's hardware. In the dog-eat-dog world of mobile hardware competition, independent OEM hardware vendors will sell whatever platform will make the most money, and ditch anything that doesn't make sense to sell. Thus HTC, which ran into import troubles following patent-related difficulties with Apple, sells not only the Android OS that precipitated its patent problems, but now also various colorful models shipping with Windows Phone 8. The reported per-unit licensing fees HTC pays Apple to avoid trouble with Android shipments are reportedly much lower than those demanded by Microsoft to license Windows, making Android devices a lower-margin and more profitable product even after Android's royalty overhead. Although this surely affects the relative commitment of manufacturers to Microsoft-powered hardware, it doesn't leave Microsoft out of the Android fun, though: HTC and Samsung already have licensing deals under which they pay Microsoft for each Android phone sold. But that's a licensing business, not a mobile hardware business, and drifts from the article's topic about mobile hardware competition.
With patent risk and cut-throat competition, small competitors cannot safely risk capital to develop innovative hardware, particularly as bigger competitors will just copy anything that sells. The smartphone handset market will end up looking like the market for PCs: a sea of undifferentiated hardware vendors, spotted with a few luxury craft. Although it's possible to build a business moat without differentiated retail products, long-term profits require a durable competitive advantage. And Apple has demonstrated in the mature PC market - a cutthroat business if ever there was one - that it knows how to
survive thrive in exactly that kind of market. Mere assemblers have no obvious competitive advantage. The few willing to invest in truly distinctive hardware will be selling at nearly-unmarketable prices to specialty markets with peculiar needs, unless they are capable of selling in enormous volume or willing to sell at a loss.
The present belongs to Apple and Samsung, where advantages driven by vertical integration enable superior margins. The companies' enormous and growing volumes mean huge and growing profits, even as they make competition more difficult for incoming competitors. Comparing U.S. share of the cell phone hardware market and the smartphone platform market, one concludes that Apple's customers are about a third of U.S. cellular subscribers and that Samsung's smartphones account for about a quarter of U.S. smartphone users. Samsung and Apple dwarf Research In Motion, which in turn dwarfs Nokia.
The substantial market advantages of Apple and Samsung in the mobile device market are illustrated by their stranglehold on smartphone profits. These advantages derive from a mutually-reinforcing combination of superior margins and superior volumes of high-end hardware. Loss-leaders, and low-volume hardware made by vendors without the capital to invest in genuinely differentiating characteristics, seem doomed to the dustbin that ate so many mobile manufacturers.
In the short term, the mobile hardware profit will continue to flow to Apple and Samsung. The long term offers an interesting puzzle: can Microsoft continue to subsidize also-ran smartphone vendors until they demonstrate heretofore-absent competitive advantages (and profit), and one day make an XBox of its cellular business? Or is Microsoft funding another Zune or Kin? And - if Microsoft is to succeed in smartphones - what hardware vendor (if any) will reap the benefit (if any)? Dell (DELL) offers an illustration of how Microsoft can succeed without bringing hardware vendors along for the ride:
Microsoft may have a better opportunity to compete in a market segment where the competition is less mature than in the longstanding dog-eat-dog smartphone market. The tablet market is only a few years old, and products like the Nook and Fire illustrate that platform network effect isn't essential to success in the scramble to sell units. By acting as a tablet manufacturer, Microsoft places itself in a position to leverage its buying power, platform control, and enterprise relationships to differentiate and market its hardware. Looking at the mobile market, however, one must ask: at what volumes will Microsoft's tablet business break even? With many more units, Research In Motion continues to lose money. Must Microsoft rely on commodity parts to keep down fixed costs in the face of small volumes? If so, what will differentiate its hardware?
Google's efforts with Motorola are similar, but Google makes not only Nexus tablets but a line of smartphones. Like Microsoft, it has a cash-producing non-hardware business to fund the effort to find mobile hardware profit. In the long term, it's still an exciting battle. And as previously discussed in the article on Google's in the mobile market, Google can enjoy success as a platform vendor regardless what it achieves in hardware sales.
However, the tale of the tape is clear. It's all too easy to lose money in mobile hardware. Only Apple and Samsung currently have what it takes to produce profit. With Apple and Samsung both growing, the effort to overcome their advantages in hardware is becoming harder by the quarter. If only Apple and Samsung weren't at each other's throats, they might strangle the rest of the market with hardware production efficiencies and economies of scale with which none could compete. On the other hand, they may each manage equivalent performance separately. In the short term, there's little reason to expect otherwise.
Disclosure: I am long AAPL.