The reality for the smartphone industry is that unless you happen to be Apple (AAPL) or Samsung Electronics (SSNLF), you’re probably either making very little on your products or losing money on them. Fat Apple margins on iPhones and Samsung’s hugely profitable Galaxy phones have been big contributors to the bottom line of these two tech giants. But what happens when those profits bottom out?
That may seem unlikely in the face of record iPhone 6 sales, but Samsung released pre-earnings guidance earlier this month suggesting its quarterly profits could fall by 60% compared to last year. A big part of that problem is declining profit margins on smartphones and reduced shipments of flagship models. As a result Samsung’s stock is down about 20% on the year.
This may not be a blip. In fact, Samsung seems to be scrambling to shore up other lines of business as a fallback. Quartz is reporting the company will invest $15 billion in a new semiconductor factory aimed at upping its share of the market for mobile device components.
Investors in Apple should keep close watch on these developments. When its biggest competitor and the only other company making money on these devices faces slowing sales, falling margins and a potential 60% profit drop, the question has to be asked: Is Samsung the canary in the smartphone coal mine that signals danger?
The argument could be made that Samsung’s misfortunes are its own making. Indeed, it chose to run with the Google (GOOG) Android crowd. Now the Motorolas, Sonys (SNE) and HTCs of the world have largely caught up to the Galaxy smartphone, while Chinese competitors are relentlessly driving prices downward.
Apple has no direct competitor for the iPhone 6 since it doesn’t license iOS, its operating system. Unless a consumer is willing to accept an alternate operating system and app ecosystem with Android, BlackBerry (BBRY) or Microsoft’s (MSFT) Windows Phone, Apple fans will keep on buying iPhones.
However, that fact doesn’t necessarily mean Apple margins are safe.
iPhone 6 Release Strategy Blurs Apple Margins
While iPhone 6 sales have jumped (by 16% over last year according to Apple’s Q4 numbers), much of that volume is pent-up demand from iPhone fans who have waited years for a bigger display — which Apple finally delivered with the iPhone 6 and iPhone 6 Plus.
And the impressive 20% increase in iPhone revenue is at least partly attributable to a numbers game Apple played with iPhone 6 pricing.
As in previous years, the base model iPhone 6 is 16 GB at $649 (without a contract). However, 16 GB has long been considered just barely adequate. With the larger iPhone 6 display, it’s an even less attractive option (higher density displays and faster CPUs mean more capable apps with higher resolution graphics — which means more storage space required).
With the iPhone 6, Apple eliminated the previous 32 GB upgrade option and instead offers 64 GB of storage for $749 as the mid range. This looks like a big leap in storage, at half the price it used to cost, making the upgrade a sorely tempting offer for iPhone 6 buyers.
By nudging consumers into buying the 64 GB mid-range iPhone 6 instead of settling for the base 16 GB model, Apple is able to boost iPhone revenues and profits — even though the iPhone 6 costs Apple more to make than the iPhone 5s did.
More people are choosing to pay the extra $100 and when they do, iPhone revenue doesn’t just go up, but Apple margins do too. The 48 GB of additional memory to get to 64 GB likely costs Apple well under $20, making the upgrade very profitable and helping to keep iPhone 6 margins in line with what investors expect.
With the iPhone 6 Plus, things are even rosier for Apple. Analysis from Teardown.com suggests the bigger iPhone costs Apple just $15.50 more to build, making its $749 base price more profitable than the smaller iPhone 6 at $649.
What all this means is that without increasing the entry level price of the base iPhone 6 — and subsequently risking consumer backlash over higher prices — we’re seeing overall iPhone sales, revenue and margins that remain impressive. This is despite the fact that AAPL’s profit margin on just the base model alone is actually less than it was on last year’s iPhone 5s.
Historically, Apple Margins Have Been Falling
In reality, Apple margins on iPhones have been slipping for years now. Quartz has graphed the slide, starting at 60% in 2009, falling to 49% with the iPhone 5, roughly 46% with the iPhone 5s and now 41.5% with the base model iPhone 6.
Circling back again to Samsung and whether Apple has anything to worry about, Apple is not immune to the market forces hitting Samsung. For now, any signs that the iPhone is losing its status as the company’s profit engine are being quite effectively obscured by four factors:
- Pent-up demand for larger iPhones
- Artificially higher Apple margins through the popularity of 64 GB storage upgrade
- The steeper price being charged for the iPhone 6 Plus
- The first Chinese iPhone launch with all three major carriers simultaneously
Apple may never see a quarter where slowing iPhone sales threaten to lower its profits by 60% the way Samsung has, but the days where the iPhone dominates AAPL’s bottom line are bound to end eventually.
Apple is going to hit a point where 16 GB is too little to run an iPhone, forcing it to make 32 GB the base model — giving buyers some breathing room without requiring a storage upgrade. At that point, the backlog of bigger iPhone upgrade holdouts will have subsided.
And the Android competition will have continued to relentlessly improve, offering faster hardware and better build quality than ever before at lower prices. Faced with a $649 base model iPhone and a very compelling Android flagship from a Chinese competitor — or Samsung — that may cost half that price or less, Apple risks losing price-sensitive customers.
There’s a good chance the smartphone market of the future looks more like today’s PC market. Apple sells high quality, high demand products like the MacBook Air and iMac, charging a premium over Windows PC counterparts. It’s a profitable business line, but even Apple can’t get away with charging iPhone-level margins. As dominant as it looks now, even the iPhone seems unlikely to maintain those 40% Apple margins in an era where smartphones become commodities like PCs.
It’s just happening to Samsung first.
As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.
