I don't care how much you like your iPhone, or whether you think that Google's (GOOG) Android is in its death throes - Apple (AAPL) is coming under some very serious fire from the Android camp, with the charge led by Korea's seemingly unstoppable Samsung (OTC:SSNLF). The market share and sales data are in, and just a few short months after publishing my piece, "Apple's Samsung Problem Can't Be Solved", it seems that my conclusion, which was met with harsh criticism, was spot on:
Margins will likely continue to compress, ASPs are likely to come down, and market share will almost certainly continue to erode.
Keep in mind that Samsung is just the tip of the iceberg; its profits, too, will evaporate as competition from HTC, ZTE, Huawei, Lenovo (OTCPK:LNVGY), and Google's Motorola Mobility continue to muscle in to take their fair share of the market. The "flip phone" business was a lousy one from a margin and profitability standpoint, and I see no reason for the smartphone business to be any better in the long haul. Why?
How Do You Differentiate Phones?
These are cell phones - any major company can design and build one. As long as you've got a modem, an apps processor, a screen, some DRAM, and a decent software team to build upon the freely available Android operating system, then you're good to go. Google's "Android" provides a very rich ecosystem, and that's the real value here. While the hardware vendors are busy trying to play in the cutthroat phone sales race, Google is quietly raking in billions by welcoming people into its ecosystem and getting money from search.
And the thing is, not any company can just magically create a viable ecosystem. Microsoft's (MSFT) moat and massive profitability is built upon the uniqueness of its ecosystem (something that it foolishly tried to throw away with Windows RT), and this is why Google has been and will continue to be wildly successful. Apple, too, has an ecosystem, but that ecosystem is tied to the sales of Apple devices. Whether you buy an Android phone made by Lenovo or Samsung, Google doesn't care - it's enabling yet another user to get on the web and use Google search and other services.
The High End Phone Market Isn't Where The Money Is
It may not be clear now, but the high end smartphone market will come to a screeching halt in terms of growth rather soon. There will always be demand for higher end, higher performing devices, but the volume is made up at the bottom, especially as phones have always gotten to that "good enough" point very quickly in every one of their "revolutionary" makeovers. Of course, the device vendors don't really make too much money off of these devices either - it's the ecosystem vendors, component vendors, and so forth that benefit from this massive scale.
Want to make money off of hardware sales into phones? Buy Qualcomm (QCOM) - they're the leaders in modems and apps processors for phones and print money with every smartphone sold. Want to benefit from an ecosystem? Buy Google.
But the point is, Apple has been able to rake in massive profits as it has ridden the "cool" factor of these devices, but when you can buy a $100 Android unsubsidized phone that takes pictures, plays videos, handles games decently well, and makes phone calls with the best of them, what reason will most consumers have to pony up for the next iPhone or next Samsung Galaxy? They won't. It'll be just like flip phones all over again.
Conclusion: Invest In The Arms Dealers
At the end of the day, it seems that investing in the device makers such as Apple and Samsung carries a lot of risk. Further, owning component vendors that are highly levered to an individual player is also risky. The key is to own the ecosystems and to own the arms dealers. Google and Qualcomm are the obvious leaders, Taiwan Semiconductor (TSM) builds the majority of the apps processors in this space (and pays a good dividend, too), but don't forget up-and-coming players in this space such as Microsoft, a company that at the end of the day is selling an ecosystem rather than hardware (I don't expect "Surface" to be a long-term thing). This makes Apple and even Samsung super risky plays that require a good deal of product cycle timing and market-share anticipation tied to consumer whims rather than product merit.
Additional disclosure: No position in AAPL, no plans to initiate one.