Apple's Mobile Profitability: The Illusion Of Advantage

Jul.28.14 | About: Apple Inc. (AAPL)

Summary

Recently, analyses have been published showing that Apple takes the lion's share of mobile phone profits.

Such analyses suffer from conceptual flaws that fail to take into account the structural differences between the Android and iOS ecosystems.

A more balanced analysis shows that Android and iOS are about evenly matched in revenue and gross profit.

Apple's greater mobile device operating profit derives from spending less on R&D and Sales and Marketing, and doesn't confer a competitive advantage.

As Apple's (NASDAQ:AAPL) mobile device market share has waned, another metric has found favor among Apple fans and fan/bloggers: Apple's fraction of all mobile device profits. For instance, Philip Elmer-DeWitt has pointed to the work of Horace Dediu (Asymco) and Canaccord showing that Apple receives the lion's share (~65%) of mobile phone profits. Although the analyses are numerically correct, they create an impression of superior profitability and competitiveness that does not in fact exist.

Conceptual Flaws

How can I say that? As I've thought over the above analyses I've realized that they suffer from a number of conceptual flaws that tend to skew the results in Apple's favor. These flaws are:

1) Ecosystem Comparison: As Stephen Elop once said, the mobile device war is a "war of ecosystems". Any comparisons of profitability between iOS and Android has to be done on an ecosystem-wide basis. This isn't easy, of course. Both Apple and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) lead large keiretsu of allied companies in the form of suppliers, contract manufacturers, third party hardware makers and software developers.

The profit analyses have focused exclusively on mobile phone manufacturers such as Samsung (OTC:SSNLF) or BlackBerry (NASDAQ:BBRY). But Apple's primary competition in mobile devices comes from Android, and I don't see how to do a comparison between iOS and Android profitability while leaving Google out of the picture.

2) Operating vs. Gross Profit: The analyses have focused on operating profit, leaving the impression that Android ecosystem is relatively poor. As we'll see in the tables below, the Android ecosystem enjoys about the same gross profit as Apple's iOS. The difference is that the Android ecosystem spends more of that profit on things such as Marketing and R&D than Apple.

3) Time Frame: The analyses tend to come out after calendar Q4 results are in and focus attention on those results, which are seasonally strongest for Apple.

In the analysis below I try to address each of the above issues:

1) Ecosystem Comparison: Ideally, one would like to include all the companies in the respective keiretsu, and maybe some day I'll be able to do that. In the meantime, I've decided to focus on reasonable proxies for the respective ecosystems. For iOS, it's just Apple's mobile device business, including sales, gross profit, and operating profit for iPod Touch, iPad, iPhone, and the mobile portion of iTunes, Software and Services.

I thought about including major contract manufacturers such as Hon Hai Precision Industries (Foxconn), but Hon Hai's operating margin for 2013 was a razor thin 6.4%. I suspect the margins for other contract manufacturers are equally small, so excluding their profit from the iOS profit analysis does not introduce a large error. Apple is the key profit center for the iOS ecosystem.

The same cannot be said for the Android ecosystem. Here, the structural differences between the two ecosystems needs to be accounted for. The revenue, cost, and profit split between Google and its manufacturing partners should not be ignored. Google performs the key function of mobile OS development, while also receiving revenue from Google Play and mobile advertising. Manufacturing partners make and sell devices, and may also provide mobile device services such as app stores.

To simplify the analysis, I decided to use Samsung as a proxy for the community of Android device manufacturers. In 2013 Samsung had 68.7% of the unit shipments of the other 4 of the top 5 smartphone makers (exclusive of Apple and white box Android sales, according to Gartner). In tablets, Samsung had 58.2% of the unit shipments of the other 4 of the top 5 tablet makers (exclusive of Apple and white box Android sales, also according to Gartner). Including the other members of the top 5 might increase profit for the Android ecosystem or even decrease it if there were significant losses. I believe that Samsung by itself is an appropriate proxy for the Android device makers.

2) Operating vs. Gross Profit: in the tables below I show estimates of gross profit and operating profit associated with the mobile device businesses of Apple, Google, and Samsung. I also provide a breakdown of mobile associated operating costs for the three companies.

3) Time Frame: in order to reduce the effect of seasonal variations in the mobile devices businesses for the three companies, the tables below present results for calendar 2013.

Mobile Profit Comparison

In the table below, I summarize the mobile device revenue, gross margin and operating profit for Apple, Google and Samsung:

Apple's mobile device revenue includes sales of iPod Touch, iPad and iPhone for calendar 2013, as well as 75% of iTunes, Software and Services, my estimate of the fraction of iTunes revenue attributable to iOS device users. The gross margin is an average for all iOS devices. Operating margin is based on the historical norm for Apple in 2013, as published in Apple's quarterly earnings reports.

Google's mobile device revenue includes revenue from Google Play and the fraction of advertising revenue attributable to all mobile devices in 2013. These mobile devices include both Android and iOS. It may seem unfair to include iOS advertising revenue, but in fact, one of Google's advantages is that it can derive revenue from any mobile device platform. The iOS ecosystem is in effect subsidizing Android development.

Google's gross and operating margins are based on historical norms for 2013, as published in their 2013 10K.

Samsung's mobile device revenue is based on feature phones as well as Android smart phones and tablets. Samsung doesn't provide a separate breakout of smart phone revenue, so analysts typically run with their overall mobile device numbers. I doubt it introduces much error in profit estimation, since most of Samsung's profits probably derive from smartphones. In effect, feature phone profits, if any, are subsidizing Android development.

Samsung's gross and operating margins are based on their historical norms for 2013, as published in their 2013 annual report.

As the reader can see from the table, total mobile device revenue and gross profit are about the same for Apple and Google/Samsung. Google/Samsung's mobile device business is approximately as wealthy as Apple's. The key difference is operating profit, and here it's worthwhile to break down the mobile-related operating costs of the respective companies, as shown in the tables below:

Operating costs related to mobile are estimated based on 2013 historical percent of revenue for SG&A and R&D, applied to the mobile device revenues of the previous table. As the reader can see, operating costs are much higher for Google and Samsung. Spending as a percent of revenue is particularly high for R&D for Google and Samsung.

Competitive Advantage

There has been a tendency, on the basis of analyses by Dediu and others, to regard Android as the poor man's mobile ecosystem, which Apple was "crushing" through its superior profitability. In fact, in terms of raw profit, the two ecosystems are about evenly matched. Apple runs with much lower operating costs and chooses to hoard the resulting cash. The impression that this cash hoarding confers competitiveness is also an illusion. Apple's much smaller spending on R&D in particular does not enhance its competitiveness.

I would argue that the Android ecosystem is spending its profits appropriately for growth. Higher spending for marketing existing products as well as developing new products enhances Android's competitiveness with respect to iOS. How successful this has been for Android will be the subject of a future article.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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