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Turning Loss Leaders Into Profits in Smartphones and Tablets

The big battle is between the different models for doing so


An interesting article titled “Apple, Google and Amazon are so profitable because they know what to lose money on” showed up on Quartz a few days ago. Looking at the companies vying for success at selling smartphones or tablets, the authors point out that none of the current main players makes big money on both hardware and content.

Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and Samsung each subsidizes either content or hardware, while struggling companies like Nokia (NYSE:NOK) and Microsoft (NASDAQ:MSFT) have resisted the loss-leader model and are at risk of being pummeled by commodity manufacturers.

First, a quibble. Lumping Amazon in with Apple and Google as being “so profitable” makes for a good title, but it’s misleading given Amazon’s performance. The company posted a net loss of $274 million in its most recent quarter, with its best showing this year being the $201 million profit in Q1, while both Apple and Google measure their quarterly profit in billions of dollars — even when posting “disappointing” results. End of nitpicking.

The gist of the article is that the companies most likely to come out on top in this industry are pursuing variations on the business model made famous by Proctor & Gamble’s (NYSE:PG) Gillette division: a willingness to essentially give something away (a razor) in the hope that customers will spend money on an accompanying product that has much higher profit margins (razor blades). In this high-tech version:

  • Apple treats content as a loss leader to make big bucks on iPads, iPhones and iPods.
  • Google subsidizes hardware (smartphones and tablets) to make money selling advertising. It earns more on search-based ad revenue on the Android platform, so it releases cheap Android hardware to create a tie-in.
  • Amazon sells tablets and e-readers as loss leaders because of their close integration to its online stores where it makes money on books, music, movies and other products.

The result, say the authors, is a market with a huge barrier to entry for other smartphone or tablet makers. They either have to somehow create a content ecosystem rich enough to compete with the big three, or be willing to sacrifice margins to compete on price.

According to this theory, Nokia (premium-price smartphones with no supporting ecosystem) is pretty much doomed. HTC is in trouble. Samsung gets a bye because it has already established itself as an industry leader and is essentially taking a free ride on the loss-leader content by hitching itself to Google’s Android.

Microsoft could also find itself in a tough spot. Its Surface tablets are priced (or in the case of the soon-to-be-released Surface Pro, likely to be priced) at a premium, so it’s not competing on price. Yet it has a very limited app ecosystem.

The Windows software the Surface Pro will run is expensive compared to apps. For example, Adobe’s (NASDAQ:ADBE) Photoshop CS6 Windows version retails for $699, while the less comprehensive, but still powerful version of Photoshop for Apple’s iPad goes for under 10 bucks. In addition, Microsoft isn’t competing against just other platforms (Apple/Google/Amazon) for customers, it also has a slew of hardware manufacturers preparing to undercut it on tablet pricing.

On the content side, Apple is a company whose “razor” is reaching the scale where it would represent a very profitable line of business for other companies. The Quartz article referenced 2010 financials to say Apple is giving its content away. That’s no longer the case.

The App Store, where developers flog the hundreds of thousands of inexpensive (and often free) apps that help make Apple’s iOS devices so desirable (and allow it to command a premium), is predicted by IHS iSuppli to hit $4.9 billion this year in revenue. With Apple taking a 30% cut from developers, that’s $1.47 billion. Even subtracting operational expenses, it’s hardly chump change, and it’s rapidly increasing — expected to be up nearly 70% compared to last year and poised for continued growth.

Hardware subsidizers don’t see this effect. The manufacturing cost on a break-even product can drop quickly, turning a loss-leader into a profitable product, but not for long. For example, as its new tablet went into production, Google was estimated to be losing $15 in manufacturing costs on every 8GB Nexus 7 tablet it sold. Google admitted there was no margin on the device, so call it break-even at best.

However, shortly after release, analysts were pegging the component cost of the $249 device at under $152, suggesting that after manufacturing expenses, Google was already turning a small profit on sales.

The problem is hardware life cycles are short. Only three months after release, Google had to bump up the specs of the Nexus 7 to compete with Amazon’s new Kindles, once again lowering its profit margin.

Apple and Google are two companies that have mastered the balancing act. They’re a yin and yang of the tablet/mobile world: One uses content to boost a core premium hardware business, the other leverages cheap hardware to support ad revenue. Both are in a strong position for continued success. And in Apple’s case, its “razor” is itself becoming a contributor to the bottom line — not a bad position to be in.

Samsung’s lofty position looks safe as long as it keeps up its reputation of selling high-end gear. Microsoft is in dangerous territory unless it can either scare up a ton of Windows 8 app developers or is prepared to lower its tablet prices.

Pretty much everyone else better learn to be content with fighting over scraps for a while.

As of this writing, Brad Moon didn’t hold a position in any securities mentioned here.

Article printed from InvestorPlace Media,

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