Apple: Winning The Profit Battle, Losing The Smartphone War

| About: Apple Inc. (AAPL)
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Summary

Apple had an extraordinary quarter due to the new iPhone 6 and 6 Plus.

However, the overall dynamics of the smartphone market are now deeply unfavorable to Apple.

If these dynamics are allowed to persist - and they most likely will persist - Apple will be exposed to the same thing that happened to the Mac.

Android devices are now as useful as iPhones even at very low price points.

And Android already overwhelmingly dominates the market. Habits are forming which favor Android.

Apple (NASDAQ:AAPL) relies massively on the iPhone to produce its revenue and earnings. The iPhone represented a massive 68.6% of its revenues in the just-reported quarter, and a much larger share of its income (certainly over 3/4ths). And this doesn't include the other major iOS device, the iPad, whose sales are already declining (at a -22% year-on-year clip no less). Without the massive iPhone success, Apple's stock would necessarily be worth a whole lot less.

When it comes to the iPhone, Apple has decidedly taken the higher road. It is gunning for the high-end of the market and little else (though it keeps on selling past versions at a discount). For now, due to its brand image, ecosystem and good software/hardware integration, Apple has been successful with this strategy, gobbling up the overwhelming majority (86%, in fact) of profits available to smartphone makers. Apple became even more successful with this strategy with its iPhone 6/6 Plus, once it matched the larger displays that had already been available on Android handsets for a while.

Anecdotally, not only did the iPhone 6/6 Plus lead to the usual upgrade cycle from former iOS customers, but it also managed to steal back many Android customers as well. This led to pain over at Samsung (OTC:SSNLF), hit from above by Apple and from below by the emerging Chinese handset makers led by Xiaomi. It's likely that these Android customers Apple managed to dislodge would have been Apple customers already, had those larger displays been available before.

The success of the iPhone 6/6 Plus was so massive that it allowed Apple to rekindle its overall growth. For the latest quarter, Apple posted gigantic +30% revenue growth and 47.8% EPS growth. This EPS growth was helped both by the larger volume and higher ASP/margins of the iPhone 6 Plus to boot.

While the market broadly expected Apple to surpass the consensus EPS going into the earnings report, Apple did even better than those whisper expectations. Its earnings whisper number stood at $2.74 per share, 5.8% above the $2.59 EPS consensus for the quarter and Apple reported an incredible $3.06 EPS. Naturally, the stock reacted positively and is showing a gain of more than 8% to $118.15 as I write this.

This strategy, however, carries risks

In gunning for only for the high-end of the market, Apple left the rest of the market totally unchecked. This, in turn, led to a massive increase in Android market share worldwide, which stood at around 84.4% in Q3 2014. Android device makers filled every nook and cranny which Apple decided not to touch, and are now fielding devices that are even encroaching into the dumb/feature phone market below $100.

Apple will have regained a small part of that market share in Q4 2014, but the gain was probably one-off stemming from it finally having made larger displays available. There was certainly a lot of pent-up demand for larger displays from Apple, and this showed especially well in the Chinese market, where Apple posted a 70% year-on-year increase in revenues.

However, the incredible growth in Chinese revenues was also helped by the release schedule in China. Whereas the iPhone 6/6 Plus was available for sale from October 17, the iPhone 5s was only available for pre-orders from December 25, 2013 and store sales only began on January 17, 2014. The comparison base was thus skewed toward showing much larger growth.

The low-end is changing

For a while, this large Android market share was illusive. It was padded by low-end, emerging-market-bound devices that barely functioned above the levels of a feature phone. You couldn't really use them effectively as satisfying smartphones catering to your every online need.

This, however, is changing. Nowadays, even low- to mid-level Android handsets are entirely usable. Be them based on Qualcomm's (NASDAQ:QCOM) advanced Snapdragon 800/801/805/810 chips or more lowly offerings both from Qualcomm and other SoC suppliers including prominently Mediatek.

So, what was once a near-feature-phone $100 handset is now a fully functional $100 smartphone. And Android itself, from around version 4 to the latest Lollipop (5.0), has become tremendously usable. Android customers are being exposed to handsets that are a joy to use, both from a hardware and software perspective. And they're being exposed to this even at very low costs.

The high-end is changing too

This reality is then compounded by the presence of flagship-spec'd phones from the likes of Xiaomi, OnePlus and others. These things start at $250 or so, undercutting Apple's offerings by half or more even though they offer little to no disadvantage in actual use. One would usually exclude the camera, but even there one can start to have doubts when someone like me with little photography experience can get these kind of results in his 4th or 5th picture out of a OnePlus One without any effort:


Again, keep in mind that this is without any background in either photography or any great usage of smartphones to take pictures. And these were taken from my 4th or 5th photo attempts using that particular smartphone. I am aware that the iPhone takes very good pictures with little effort (after all, my daughter has had an iPhone 5s for more than one year), but these photos took no greater effort from me than they would take from her - they were basically point, focus, shoot.

The app marketplace has changed as well, and there's a habit forming

The app picture, once a defining Apple advantage, is also for the most part entirely gone. If you desire some kind of app, you have it on Android and it works well. Buying and installing apps or upgrading them has become as seamless as it is on iOS. Using them is the same. Plus Google (NASDAQ:GOOG) (NASDAQ:GOOGL) Play is filled to the brim with free apps to boot, all based on the freemium model of in-app purchases to an even greater extent than that available on iTunes. This hasn't gone unnoticed by the apperatti.

Apple retains its higher-end brand image for sure. But the reality is that people are being overwhelmingly exposed to a competing ecosystem that's a lot cheaper and as viable, agreeable and easy to use as iOS. That's better than what Windows had on the Mac, and yet Windows ended up dominating by the sheer numbers which ultimately led to a software advantage.

The same thing could eventually happen with Android/iOS. Presently iOS customers spend more even though there are fewer such customers. They're wealthier and can still compensate for their lack of numbers. But the erosion is ongoing and seems very likely to continue.

Worse still, as those 84% get exposed to the Android ecosystem in a usable form, they will develop habits. Then, if and when they try to switch to iOS, many will find it strange and awkward. This will happen in much the same way as when in late 2014 I was exposed to a MacBook Air for a few weeks (as I was in hospital), and the thing was incredibly hard to use for someone coming from Microsoft (NASDAQ:MSFT) Windows. Worse still, several other Windows users had used that same machine and they all came to the same conclusion. This included even children (so without as much in the way of long-formed habits)…

The software advantage might be seeing its first steps

As I said, Android's sheer domination by numbers can, at some point, produce an effect similar to what happened with Windows/Mac. At some point, Android might get a software advantage against iOS. For many businesses, more than the purchasing power of any single customer, what matters is the sheer number of customers you can reach. Think Facebook (NASDAQ:FB), Twitter (NYSE:TWTR), mass-market advertising in general, mass-merchandise markets, etc. For those businesses, you want to reach as many people as possible, even if they aren't the wealthiest.

These businesses will already see Android, even in its present form, as a more attractive market than iOS. The Android market is already 7 times larger, a difference that's larger than the gulf between iOS and Windows Phone. It is thus no surprise that slowly, many of these businesses will start focusing more on Android than on iOS. A first sign of this could be seen a couple of days ago with how Facebook is testing a special version of its app catering for emerging markets. I am talking about Facebook lite. It uses much less RAM and much less data. And it works only on Android.

Then, there are things like Tasker. Tasker only exists in Android - there is no direct equivalent in iOS even though the app achieves unique functionalities for the smartphones using it. Tasker relies on Android's openness to be able to function, but it still shows that over time as more and more of these situations crop up, you'll end up having a market where users might decide not to consider iOS due to the sheer lack of specific functionality. Already, some are becoming aware of this.

This is obviously a very long process. But with a market share 7 times as large, it's also a process that's very likely to take place and nearly unstoppable. Unless, that is, Apple somehow decides to use its massive profitability to again try and balance the market some more.

All this to say

There's nary a doubt that the last quarter went terrifically well for Apple. Apple had the benefit of years of pent-up demand for larger displays, both from its own customer base and from part of the customer base it had lost to Android over the last few years due to the unavailability of said larger displays.

So, in launching the iPhone 6 and iPhone 6 Plus Apple got to sate this massive pent-up demand in just a few months. This effect certainly temporarily counteracted the improving Android scene as well as the way in which low-end Android devices are becoming so satisfying to use.

But the question beckons. What now for Apple? The larger display will have run its course and Apple's price premium is not going to be loosened. On the other hand, Android will reach both lower and lower and higher and higher into the spectrum of customers it serves. And those customers will build the habit I described. And trust me, there is nothing you can achieve with an Apple device right now that you can't do likewise with your Android, and as easily.

Tinkering

Android might still have a reputation for tinkering; I have certainly tinkered with my own device, changing settings left and right to set it to my tastes. But I didn't need to. And on the other hand, I was forced to tinker with my daughter's iPhone 5s as well to restore her battery life. Because, it turns out, when you go on for an entire year installing stuff into an Apple phone it gets the same symptoms as doing the same in an Android device. All those apps end up tying into the system and eating resources and draining the battery through updates, notifications, location checks, synchronizing and stuff.

So, as much as I could have left my device alone because it was new and would offer good battery life no matter what I did with it for a while, I couldn't let my daughter's as hers was not lasting a full day anymore (while mine easily went for 2-3 with moderate usage). What this means is that there's no intrinsic Apple advantage here, either. Here or seemingly anywhere else (except against most Android cameras, though - part of which is down to software but also seems likely to change over time).

Conclusion

With Apple's value leaning heavily on the iPhone, it's important to notice how the iPhone's greatest threat is getting ever more real and Android is getting ever better while already holding 84% of the worldwide market.

In a way, the PC/Mac experience has already been replicated. Android grew large enough, and its devices are becoming alluring enough, even at the low end, that we can no longer dismiss one (Android) or the other (the low-end devices).

The low-end Android devices are no longer only stop-gap measures by cash-constrained consumers. They're fully usable. In time, if this massive market share difference persists, it's likely that the final leg of the PC/Mac experience will make an appearance - that would be when developers start targeting Android first and iOS second.

All it would probably take, at this point, would be for the Android software market to be twice as large on a money basis even though its share in terms of devices is up to 7 times larger already. It can happen. If it does, Apple is neither going to hold on to its margins, its profits or its present revenue levels (post-iPhone 6).

So, for now Apple is clearly winning the profit battle, but arguably it's also losing the smartphone war.

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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