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With Research In Motion (RIMM) swinging to its first quarterly loss in years and Nokia (NOK) warning that its deal with Microsoft (NASDAQ:MSFT) still hasn't enabled it to sell handsets at a profit, the risks are serious for manufacturers trying to eke out a living in the smartphone market by selling hardware dependent on low-share platforms. Despite serious competitive advantages enjoyed by each firm, each is losing money in competition with manufacturers of devices running Google's (GOOG) Android or Apple's (AAPL) iOS operating systems.

Research In Motion

Research In Motion owns its own operating system and thus enjoys freedom from per-unit licensing overhead, making it attractive to those who believe that its next-generation platform (BlackBerry v.10, based on tech from the QNX acquisition) will offer an attractive differentiated product. The potential per-unit advantage enjoyed by Research In Motion is compounded by recurring service revenues from enterprise customers and customers' cellular carriers. Research In Motion need not even make a profit on handsets to remain in the black. Moreover, its application store - App World - is the number two smartphone application market on the planet. The company has no need to hold large market share to enjoy profit from a loyal subscriber base, and has previously gained subscribers (occasionally at rates that set company records) even as it lost share in the rapidly-growing smartphone market. However, Research In Motion has halted its reporting of subscriber numbers despite the metric's previously high-profile position as a corporate metric. Why? After missing subscriber forecasts for a few quarters, the company's inability to correctly forecast its performance and its failure to meet targets made the metric more dangerous than useful to management.

After a change in management at Research In Motion, new leadership has publicly recognized that traditional differentiators like enterprise support and push email are simply no longer significant differentiators. Effort to sell into the booming tablet market spanked the firm, which suffered costly inventory write-downs and had to cut tablet prices to move inventory. Last month's portrait of Research In Motion as a long-term investment suggests that the company has potential to compete, but discloses some serious barriers that must be overcome to succeed. Thus far, the new management has not shown how these challenges will be met. A plan to sell to enterprise isn't a product strategy, it's a marketing strategy, and if there's one thing we've learned from Apple it's that the product itself can impact performance.

Nokia

Nokia, once the world's largest smartphone vendor by volume, lost the smartphone volume crown when it was passed by both Apple and Samsung (OTC:SSNLF) during 2011. Share loss driven by uninteresting products led to mounting quarterly losses, which drove the firm into bed with Microsoft. As a result, Nokia is the largest vendor of Microsoft smartphones, which sounds good until one realizes Microsoft's operating system has less share than Bada. Ever heard of Bada? Bada, a Samsung platform based on Linux, enjoys nearly 3% of the global smartphone market despite not being offered for sale in the United States. In the nearly 2% of the global market that Microsoft's operating system enjoys, Nokia is the leading hardware vendor. To place Nokia in this position, Microsoft isn't collecting a net per-unit licensing fee at present because it is paying Nokia a subsidy to enable it to remain in business to sell hardware preloaded with Microsoft products. Selling 2 million Lumia handsets in 1Q2012, even with Microsoft's subsidies, hasn't placed Nokia on the road to profit.

The danger in shorting Nokia is that it is not being allowed to follow the path of failure that preceded its Microsoft deal. Microsoft's massive quarterly payments could theoretically maintain even a brain-dead patient with apparent breath. However, the astute historian will review the history of Microsoft's business "partners" and conclude that Microsoft will not subsidize Nokia at a level that will enable it to thrive financially, only enough to keep it in a position to churn out Microsoft products. If Nokia should threaten a profit, Microsoft will no longer see the need to subsidize it. Microsoft will reduce Nokia to another Dell (DELL), suffering under the load of per-unit licensing fees so that Microsoft rather than the hardware vendor captures the profit in products being sold. Firmly in the grip of the great tick of Redmond, Nokia's prospect of thriving as an independent company is dim. Indeed, its solution to its current losses is already more to the advantage of Microsoft than to itself: instead of working to deliver a product that impresses users to pay a premium, Nokia has committed to selling phones even cheaper than the $99 Lumia (or is it $0?). Presumably the cheaper models will help Nokia sell to low-margin prepaid users, foreign markets in which subsidies are unlikely, and other market segments which don't seem a first stop on the hunt for profit. How much success can be found following the path of other low-margin commodity vendors with no moat against encroachment by competitors?

Ecosystems

Selling into an established ecosystem has benefits to a manufacturer with good supply-chain control. Samsung sells hardware supporting several platforms, including both Android and its own Bada platform (which has eclipsed Microsoft's Windows Phone platform in share and will have support from Intel going forward). From 1Q2010 to 1Q2011, Samsung enjoyed 300% share growth in the expanding smartphone market. Samsung rode the wave of Android's global growth to become the world's largest smartphone vendor in 3Q2011, a title it retained until Apple launched its next phone the following quarter. Since Samsung sells more products at more unsubsidized price points, however, it has an advantage over Apple in competing on sheer volume, particularly in markets whose characteristics do not support significant hardware subsidies. Samsung should be expected to resume its climb toward the volume crown. Apple, meanwhile, should be expected to continue to garner more profit thare than any other firm, supported by high margins maintained with the support of a number of largely low-margin OEM suppliers and assemblers.

As a differentiated vendor owning both the platform's operating system and its application delivery system, Apple has much more control over the customer experience than commodity hardware vendors. Its control is akin to that of Research In Motion, which recently decided to kill application side-loading in order to combat security and piracy risks. However, Research In Motion lacks market power and is guided by fear: it backpedaled under media pressure and won't halt the side-loading after all. Although Google is rumored to offer a tablet later, only Apple seems to enjoy soup-to-nuts control over its mobile product ecosystem.

Overview of the Environment

Both Google's Android platform and Microsoft's phone platform are features of ecosystems in which multiple manufacturers compete to sell hardware using a common third-party operating system. If the operating system is successful in distinguishing itself as the central feature of the platform - which is likely given the importance of applications to smartphones and the dependence of applications on the operating system - then the multiple hardware manufacturers are in competition to sell handsets that are adequate substitutes for each other in running the platform's operating system. Competition in such a commodity market tends to drive down not only price, but margins.

There are two routes to success in such an environment. A successful vendor finds a way to distinguish its product so that it is not perceived as having a ready substitute, or finds a way to produce it at such a price that it can profit at levels that competitors cannot match. At present, both Nokia and Research in Motion are still grappling with the fact that their products are not adequately differentiated (as illustrated by their lack of pricing power), and they have yet to produce their products at a cost that enables profits at the prices they are able to command. At present, Research In Motion and Nokia are both failing. Neither BlackBerry service revenues nor Microsoft subsidies has been sufficient to staunch recent red ink. While it's possible either company might turn its performance around, the endeavor will be difficult and require discipline neither company has recently displayed.

Vive La Différence

To capitalize on the ineffectiveness of these commodity vendors without exposure to the risk that every player in the market might benefit from a marketplace updraft that might improve the fortunes of every company simultaneously, investors might consider a long/short. Because the success of the Android platform in market share suggests its top vendors may be in a more attractive place than the commodity vendors servicing a smaller commodity platform, a successful Android manufacturer might be attractive for the long leg of a long/short trade based on differences in capability to compete in a cutthroat commodity market. To invest in the fortunes of a successful commodity vendor like Samsung, unfortunately, requires investment in proxy tickers that are not purely focused on the target company. Matching a Nokia short against a successful commodity vendor requires identifying one in which investment is readily available.

To invest in the relative fortunes of a differentiated product vendor over a failing commodity vendor is easier, as Apple exists as a readily-identifiable example of a successful differentiated vendor whose fortunes turn largely on its smartphone platform. This author previously described a long/short investment involving Apple as the long leg and Research In Motion as the short leg, to invest in the relative performance of two vendors competing to produce differentiated products. However, one can instead pair a failing commodity vendor as an alternate short leg. Nokia has been failing for some time, and its partnership with Microsoft to champion an operating system commanding less share than Bada does not seem to be a recipe for success even with the existing subsidies from Microsoft. As the company currently depends on Microsoft, its risk has been magnified by the power ceded to Redmond to control its behavior for the benefit of Microsoft.

Nokia appears to be a good candidate for the short leg of a long/short position in a play based on the competitive disadvantage of commodity hardware vendors. In order to avoid confounders arising from competition between platforms, one might prefer to select a long leg investment in a firm that is succeeding in its commodity competition in the same market. Unfortunately, this author is unaware of a firm making a profit from hardware supporting the Microsoft's mobile phone operating system. Since targeting the leading commodity vendor Samsung is made challenging by its lack of U.S. listing, one seems driven to pick an opposing ticker that has more going for it than just better management than Nokia. One seems compelled to select a vendor targeting a different operating system and even perhaps a completely different strategy, such as differentiated mobile products rather than commodity products.

Apple fits this bill, though people interested in owning Apple likely already have positions. Adding a few shares in an amount balanced against a short position in Nokia may be a way to avoid risk associated with industry-wide trends while capitalizing on Nokia's ongoing challenges as it tries to transition to a product line-up that delivers Microsoft's operating system at every price point. This trade might not be attractive if one has high expectations for Microsoft's platform, but consider: any profits from the platform will accrue to Microsoft due to its per-unit licensing model, not to a hardware vendor subject to losing its subsidy when the smell of green begins to affect the bosses in Redmond. Meanwhile, Apple need not dominate in share, only continue to dominate in profit. Apple's growth in China suggests that it's on the way to growing profit regardless of the low-margin share captured by competitors.

And that's why it's an attractive long leg of a long/short play targeting the poor outlook of unsuccessful commodity mobile hardware vendors.

Disclosure: I am long AAPL. The author has been short RIMM as part of a long/short position established while the article Apple: The Long and the Short of It was pending publication. The short leg of this position is subject to being closed without notice if the holders of puts written against the RIMM short should exercise their options.

Source: Investing In Smartphone Failures