Why only Apple makes money in phones

A recent article from highly regarded mobile market analyst Ben Bajarin recently predicted than Samsung would be out of the smartphone business within 5 years, joining a long list of famous brands that have exited or virtually disappeared from the phone market (Nokia, Blackberry, Ericsson, most of the Japanese OEMs... ).

This sounds crazy: why would the Korean giant consider retreating from a huge, growing market it is leading in market share and which is the biggest revenue contributor to the company (as well as an end market for its components business) ? The answer: because despite its mighty scale it couldn't stay profitable enough in the long term.

The phone market is ridiculously massive...

The mobile phone business, on track to be soon a smartphone-only market, is an absolutely huge market, both in units and revenues. It dwarves all other Consumer Electronics categories: twice as many smartphones will be sold this year as all PCs, TVs and Digital Cameras combined, generating revenues of more than $200 billion, just for the hardware sales.

...but the industry as a whole struggles to make any profits

 For all its scale and the number of players (some says over 1000 brands coexist, most of them in emerging markets), making money on phones is tough: outside of Samsung and Apple, barely anyone makes money on phones. This is true for public companies and widely assumed for privately-owned OEMs like Huawei or Xiaomi.

Going deeper, according to the Wall Street Journal a single player with only about 15% global market share manages to grab a whopping 90% of the industry's profits : Apple. 

• Platform commoditization: with Symbian gone and both  Blackberry and Windows marginalized, only iOS and Android remain as viable options for a phone operating systems. Most brands are therefore inclined to use Android (either official one with Google services or the open source version AOSP which is popular in China where Google services are not available).
• Race to the bottom: the Android ecosystem is now able to produce good enough sub $100 phones through reference designs while Samsung sells phones on average for $180. Meanwhile Apple not only maintains but managed to slightly increase its Average Selling Price to $670 (which is higher than the ASP of all PC makers...except Apple). It is obviously far easier to make money when your ASP is 3x the market average.

“Handsets are commoditized now. They’ve gone from being technological devices to fast-moving consumer products. It’s like Coke and Pepsi now. That’s the war these companies are fighting. It’s not a sexy business anymore.”

 Kirt McMaster, Cyanogen CEO

iPhone: higher ASP but also scale

With the iPhone Apple has dramatically extended the definition of the premium segment. In automotive, more than a dozen brands, mostly German or Japanese, compete in the premium car segment which represent about 13% of car sales in the West and only 5% in emerging markets. What is truly amazing with the iPhone is that Apple alone owns 10% of the global phone market, or about 13% of the smartphone market with a premium-priced product ! Not only that but Apple market share reaches 19% in China (where the larger screens of the 6 Plus models are very popular) though it is significantly lower in other emerging markets such as India.

So Apple has managed to stretch the premium segment, driving a higher a ASP than competition but driving volumes and therefore economies of scale comparable to mass market players: great moneymaker for Apple, perfect storm for the competition...

How the iPhone pulled it off...

 Aspirational brand, sleek industrial design, custom components for higher performance, user friendly interface, (closed) software ecosystem promising (and usually delivering) "it just works" experience: all these ingredients were previously used by Apple in the Mac, but much less success. How come the iPhone can be so dominant while the Mac has always been an underdog to PCs running Windows ?

The weakness in the Mac ecosystem is that Apple always struggle to get the software companies to develop (and update !) Mac versions of their programs, simply because software companies followed the money and PCs had a much larger market share. Microsoft and the Office suite is an infamous example of this.

Starting with the iPod, Apple developed a whole ecosystem ranging from content (signing very favourable deals with music labels or book editors) to hardware adjacencies with the made for iPod (MFi) certified accessories. But the introduction of the Appstore in 2008 created overnight a whole new opportunity for software developers to sell apps directly to end users instead of working with Symbian, RIM or phone carriers for distribution deals. Even today mobile developers tend to develop first for iOS over Android because of the global reach and the size of the install base (which incidentally is more affluent hence usually more profitable for developers). 

...explains why the other brands struggle

In true Google fashion, offering Android for free has essentially wiped out competition in the operating systems. However, if it makes it easier/cheaper/faster to build a smartphone, it also makes it much harder for brands to differentiate, in the premium segment but also in the low end (Android One program failed because of this but Google is attempting a reboot). 

In the Wintel PC ecosystem, Intel and Microsoft milk the profit while the PC makers are engaged in never ending race to the bottom involving cost cutting and consolidation. PC OEMs fight for scale with razor thin margins, or try alternative routes (IBM, Sony and Samsung retreated from the PC, Dell went private and HP just split). In the non-iOS phone market, there is more competition in processors but Android domination largely prevent differentiation by a single OEM: how can you innovate without asking Google for software support ?

Without a differentiated product, better distribution or huge advertising budgets are required to push a brand. However online channels have levelled the playing field and massive marketing budgets only Samsung can afford bring diminishing returns without a compelling story to tell. How a $600 Galaxy is better than a $500 Xperia, a $400 HTC or a $200 Motorola when they run the same software on a similar screen and processor ?

Ultimately on Android you are doomed to compete primarily on price and sacrifice margins.

What will happen next ?

60% of Apple's revenue and a bit more of its profit come from the iPhone and therefore its market cap is dependent on continuing to charge premium prices to more phone buyers. That means customer retention in developed markets which are increasingly saturated and driving demand to become as strong in emerging markets. They seem to execute extremely well in these two areas, helped by superior products whose innovations are hard to replicate and increasingly developed internally. Apple will continue to capture most of the attention and the industry's profits as long as innovation in smartphones can justify a significant price premium.

Samsung has tried developing a 3rd ecosystem with Tizen but failed like Microsoft with Windows Mobile. Samsung and Huawei try to go more vertical developing their own chipsets a la Apple but as we have seen value is now in the platform, not in hardware only. New players like Xiaomi try to copy the Apple model (cool aspirational brand offering great value for money and a broad ecosystem) but they are already copied (eg OnePlus, LeTV) or undercut by even lower cost new entrants (eg Micromax, Wiko).

Samsung may well still be selling smartphones in 5 years, but this will be with low margins if these phones run Android. The Android smartphone industry overall stands little chance to avoid the same fate as the PC industry. That is, unless a new disruption hits the mobile market, any idea what this disruption could be like ?