Why The Smartphone Makers Are No Bargain

by: jaberwock

Within the next two years, a "perfect storm" of market forces will come together to drive down the price of smartphones and the profit margins of all manufacturers. Three market forces will come together to drive this decline, the saturation of the market in developed countries, an increase in the replacement cycle and an increase in competition.

Market saturation in the USA

The number of smartphone subscribers in the USA has nearly doubled in the last two years, to 125 million. Over half of the adult population now uses a smartphone.

We are now entering what is commonly termed the Late Majority stage of adoption. People in the Late Majority are likely to be older, and less affluent than the general population. This group is less likely to want, or be able, to pay $50 to $100 a month for a piece of communication technology that they have so far lived without. Lower prices and lower profit margins are typical of this phase of the product cycle.

The total life cycle cost of building and operating a cell phone network consists mostly of amortization of the infrastructure costs. Once the system is built, the cost of adding a new customer is relatively low, and the profit margin on the new customer is very high. As smartphone ownership reaches saturation levels, the carriers will have to attract customers from the "Late Majority" to generate growth. They will do this by offering low use service plans at lower cost, and without the $500+ subsidies that are currently offered on high end smartphones. This will open the gates for a flood of low cost phones.

Compare the current state of the U.S. market with that of the U.K., where smartphone ownership has already reached 63%. The graph below shows the total cost of ownership cost of a typical high end and low end phone with a two year service plan, in the two countries:

In the USA, low usage smartphone service plans are hard to find. If grandma wants a smartphone, she has to buy a plan with much more data usage than she needs, and at a price she can't afford. In the U.K., grandma can afford a smartphone.

The cost of an Apple (NASDAQ:AAPL) iPhone 5 in the USA is only about 20% more than the cost of the lower priced phones, whereas in the U.K., the iPhone5 is 4 to 5 times more expensive than the lower cost phones. The state of the market for carrier services in the USA has allowed Apple to maintain its high profit margins and market share. Eventually, competition will erode those margins.

Reduced replacement rates

Technical advances, which have driven the replacement cycle of phones among the more enthusiastic users are now reaching the top of the S-curve. Newly introduced phones offer only marginal improvements over the older versions, or offer gimmicks which are more likely to annoy rather than improve the user experience. Phone life-cycles will inevitably extend, and a two year replacement cycle will become three years or more.

Increased competition

At a time when the market is becoming saturated, we have an influx of new products from a range of manufacturers. A market that was once owned by one or two dominant players is becoming increasingly competitive. This increased competition will inevitably drive down prices and profit margins.

In the face of increased competition and declining profit margins, none of the smartphone manufacturers can be regarded as solid long term investments. The pace of change in the industry is such that no company can remain at the top for very long.

The two Korean manufacturers, Samsung (OTC:SSNLF) and LG (LG) are huge, diversified conglomerates who could drive down prices to the point where other manufacturers are losing money. They have done this in the flat screen TV business. If they chose, they could do it again in the smartphone business. Their major Japanese rival, Sony (NYSE:SNE), has higher manufacturing costs and will find it hard to compete in a price war.

Nokia (NYSE:NOK) has tied itself to Microsoft (NASDAQ:MSFT) and the Windows operating system, where its major competitor is HTC (OTC:HTCCY). Windows does not seem to be gaining any traction, and will very likely lose the race for third place in the battle of the operating systems. This leaves Nokia in a very precarious position, with negative cash flow and no real prospect for profitable growth.

Apple is a company that has always prospered from innovation, and has always maintained high profit margins because customers have been willing to pay a higher price for its leading edge products. However, in the smartphone world, Apple's products are beginning to look ordinary. The iPhone 5S will have to be something more than a marginal upgrade of the iPhone5 for Apple to maintain its appeal. By all the usual measures of price, earnings, growth and cash flow, Apple shares look like a bargain right now. In fact, the market is simply pricing in the risk of increased competition and lower margins, and until we see a revolutionary new product in the pipeline from Apple, the share price is likely to stay at its existing depressed levels.

BlackBerry (NASDAQ:BBRY), once the market leader, has stumbled badly but seems poised to make a comeback. The Z10 phone, with its new operating system has received very good reviews. The QWERTY version of the phone is expected to hit the markets soon, and lower priced versions are expected later this year. With the higher level of security appealing to enterprise users, and a business model which derives a good portion of its profits from services, BlackBerry has the best chance of carving out a small niche market for itself. Many of the sell side analysts still have BlackBerry target-priced for failure, and at about 30% of the float, the amount of short interest seems to indicate that the company is about to go out of business. However, there are good articles like this one right here on Seeking Alpha that indicate otherwise.

All smartphone makers are risky investments in today's market. If you like to gamble and shoot for a high return, BlackBerry is the one that makes the most sense based on its current valuation and short term prospects.

Disclosure: I am long BBRY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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