Distilling market noise into market sense
The VisionMobile blog is a space where VisionMobile analysts and industry insiders exchange views on the fast-changing mobile market and the trends that define the future direction of telecoms.
The Apple and Samsung Profit Recipe
[Apple and Samsung are sucking the oxygen out of the room. What's the recipe of their profits and why are all the other OEMs struggling? In this reiteration of April 2012's Mobile Insider, VisionMobile analyst Stijn Schuermans gives insight into sustainability and profits in the handset market.]
The mobile handset market is in turmoil. Since Apple launched the iPhone in 2007, OEMs have been rushing to jump on the smartphone bandwagon. Five years later, few have managed to do so profitably. Even if more companies are gaining a significant market share, only two seem to be making a profit out of it: Apple – the creator of the market in the first place – and Samsung, a fast follower. Attractive profit margins are elusive for most of their competitors. Some are toppling from their former glory (Nokia, RIM), while some newcomers seem to be gaining speed (ZTE, Huawei). But will they manage to become profitable? This article is based on an issue of Mobile Insider, a monthly publication by VisionMobile. that examines under-the-radar and forward-looking trends in mobile. Each issue focuses on a specific topic distilling the insights in an easy-to-digest 5-page format. Mobile Insider is part of Telco Economics, a range of strategy research and workshops that deliver a 360° view on the new economics of the mobile industry and changing role of telcos in the era of digital ecosystems.
The state of the handset market
Mobile handsets are expected to be a quarter of a trillion dollar market in 2012, with 1.75 billion units sold. Four out of ten units are expected to be smartphones, which considering their higher average selling price, will account for the vast majority (more than 85%) of the handset industry revenues.
In our recent 100M Club infographic, we provided an extensive overview of how many units each of the main platforms and vendors in the handset market ship. The biggest players don’t necessarily make the most profits, however. The table below shows the profit margins for different vendors in the first three quarters of this year, as estimated by Arete and Asymco.
The most successful companies in the handset market anno 2012 are without a doubt Apple and Samsung.
Apple, despite having only a handful of smartphone models, captures a substantial part of the market, and experiences strong growth (58% YoY increase in units and 56% YoY increase in revenue in Q3 2012). It also has an exceptional profit margin compared to its competitors.
Samsung’s handset division accounts for more than half of its revenues and for 69% of its operating profit in Q3 2012 . Operating profit margin of the division improved to 18,8% from 13,5% a year ago. In Q1 2012, Samsung ended Nokia’s 14-year reign as largest handset maker by volume.
Smartphones play by different rules than feature phones
When Apple launched the iPhone in 2007, the basis of competition in mobile phones changed radically. Instead of performance of the device (hardware features like battery life or colour depth, software features like address book), the success of a smartphone now depended on the ecosystem it tapped into (i.e. apps, driving much wider use cases for the device).
The success of app ecosystems is driven by network effects that create lock-in, turning them into “winner-takes-all” markets. Two dominant ecosystems emerged: iOS and Android. Any handset manufacturer that missed the Android train was left behind. Notably, Nokia failed to compete using Symbian, the dominant pre-smartphone platform, which was built for OEMs, not developers, and could not keep up in the new apps-driven ecosystem world. One other company – RIM – did have a valuable ecosystem, built on a messaging network and email synchronization. However, its value went up in smoke when the foundations upon which it was built were commoditized by OTT internet services like Gmail and WhatsApp.
Mobile phone production is now a commodity
Back in the day, the proprietary devices we now call feature phones followed a traditional industrial model: supply-side economies of scale were key to keeping costs down and margins up. This led to a gradual concentration of the market, resulting in a small number of dominant players, headed by Nokia. In 2008, soon after the appearance of the modern smartphone, Google launched Android, a free to use platform to build smartphones, with the explicit intention to lower barriers to entry for handset makers, and therefore commoditize the making of smartphones. Android succeeded in its goal: time-to-market decreased, development costs went down and smartphones converged into a virtually homogeneous form factor.
As barriers to entry went down, many companies small and large could now make Android smartphones. This is immediately apparent in the market concentration, which plunged after 2008 as devices became more and more uniform, as shown in the chart below. Many companies are now getting a chance in the smartphone market: the amount of OEMs with more than 2% global market share went from 6 to 10 in two years time. However, in this commodity market, market share doesn’t guarantee profitability!
Apple is the innovator
According to Harvard strategy professor Michael Porter, to gain a competitive advantage companies must create a unique value chain configuration. There is more than one recipe to achieve that. Apple has chosen to innovate across the chain: the Cupertino company owns its own platform (iOS), enhanced with content (e.g. apps, music, video) and services (e.g. iTunes, iCloud) and an outstanding product experience; it has a strong, tribal brand, while on the other hand its strong control over the supply chain makes it behave as a vertically integrated company, pushing costs down and appropriating profits across the supply chain. On the distribution side, Apple is the only major OEM to partially own the retail channel, i.e. Apple stores.
Among followers, only Samsung has got a unique advantage
As competition is based on ecosystems, beyond Apple only Android-carrying OEMs are still in the game. They are in a “race to the best device”, a race which cannot be won. Coming back to Porter, the only possible basis for profitability is a unique competitive advantage, i.e. a tailored value chain that is inaccessible for competitors and delivers value for consumers. The only handset maker apart from Apple who has built such a unique value chain today is Samsung. The electronics giant not only assembles handsets, but also makes a lot of the most expensive components, notably screens and chipsets. This allows the company to capture profits across the value chain, where its competitors can only capture the value of assembly. Samsung also has an excellent time-to-market and distribution network in emerging markets, as Javed Anwer explained in the Times of India recently.
Where Samsung doesn’t own a value-adding element (e.g. the platform or the retail network), the company hedges its bets. That’s why Samsung has multiple platforms and excellent operator relationships. Samsung can then reinvest those gains in R&D (e.g. bada, handset components), marketing (the Galaxy brand) or acquisitions that strengthen the competitive advantage it already has, creating a virtuous cycle.
Others left behind
Samsung’s competitors either don’t have the cash to invest in a virtuous cycle (due to streaks of losses), or they have no unique value chain configuration to invest their cash in, making the spending ineffective. Nokia used to have a feature phone cash cow and strong financial backing by Microsoft, but it has divested several key value-adding elements, notable the platform, now produced by Microsoft. ZTE and Huawei are backed by a profitable network infrastructure business. For now, this money is proving ineffective at producing a highly profitable business. Money can buy high volumes and fast growth, but without a tailored value chain this growth is likely unsustainable. HTC perhaps came closest at a competitive advantage based on the HTC Sense UI and fast time to market, but this advantage is proving to be unsustainable. In the third quarter of 2012, HTC’s net profit tumbled 79% YoY, making Q3 its least profitable quarter in six years.
A duopoly emerges, or does it?
The result of Apple and Samsung’s success in creating a tailored value chain, and the failure of others to do so, is that the two companies between them capture over 98% of all available profits in the handset market (smartphones and feature phones combined). In 2011, they were the top two smartphone manufacturers in volume, with a combined market share of 39% of units shipped. In the first half of this year, their combined share had risen already well above 50%.
This, however, should not be mistaken for a “done deal” consolidation of the market. The smartphone market as we know it is less than five years old. While per-capita smartphone penetration in mature markets is approaching or has already surpassed the 50% point, there is still a lot of room for expansion in emerging markets, and therefore for new differentiated value propositions.
We can see at least two opportunities left at the table. In mature markets, a company like Amazon could enter the smartphone market with a unique business model of subsidizing (self-branded) hardware to drive a content and retailing ecosystem. This is akin to operators subsidizing hardware to drive voice and data subscriptions, only here Amazon managed to have its own branded devices, which operators never managed to make a success. We discussed this “kindelization” opportunity extensively in volume 1 and volume 2 (year 1) of Mobile Insider.
Secondly, the mobile user experience is not always tuned to emerging markets, which will be the main growth markets in the coming years. This creates opportunities for value chain differentiation, for example by tuning phones for payments (of digital goods, in shops or between people) without requiring credit cards.
Next week, we’ll discuss one promising attempt to create a new profitable handset business. Chinese OEM entrant Xiaomi is putting itself in the spotlights with impressive first year sales and innovation across hardware, services, brand and business model. Stay tuned.
The launch of the iPhone fundamentally changed the basis of competition, eliminating players without a vibrant app ecosystem (i.e. iOS or Android). Android then commoditized the production of smartphones, reducing the importance of economies of scale that had made Nokia a leader in the past and sending market concentration in a plunge.
To sustain profitability in the commodity smartphone market, OEMs need to create a tailored value chain. Apple has done so by innovating at each point of the value chain. Among all other OEMs, only Samsung has created a unique value chain configuration by integrating across hardware production and capturing profit at multiple links of the value chain. It’s no wonder that together Apple and Samsung capture more than 98% of the profits in the handset market.