Mallinson: How Apple profits overwhelmingly in smartphones

Keith Mallinson

Apple continues to go from strength to strength with stellar profitability because it competes so effectively on several different fronts. Its smartphone industry profit share grew to 94 percent during the September quarter, up from 85 percent one year ago. This is in part due to the fact that Samsung, the only other smartphone maker which has shown decent profitability in recent years, has significantly declined of late. It is also because of Apple's enormous ongoing strengths in trading and competing with other smartphone ecosystem players, including its customers.

The iPhone maker's overwhelming share of all smartphone operating profits is despite Apple still having a much lower market share than Samsung. According to Canaccord Genuity research, Samsung, the largest Android licensee by far, took a distant 11 percent share of total operating income. Adding those percentages exceeds 100 because most other phone makers reported negative operating income.  Apple earned its enormous share of profits despite producing just 14.5 percent (48 million) of the smartphones sold in the quarter. Samsung shipped an estimated 81 million units in the same quarter, accounting for 24.5 percent of the total.

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Profits margins are ratios derived from costs and prices; total profits and profit shares are dependent on unit sales volumes as well. Apple has the highest prices and among the very lowest costs which provides it with the highest profit margins. While Samsung has significantly higher sales volumes, Apple's volumes are nevertheless substantial and have been achieved while preserving its relatively high prices. It is this combination of factors which enables Apple's share of total smartphone profits to be 8.5 times larger than Samsung's. According to the cited research, the average selling price of iPhones in the last quarter was $670, which drove 37 percent operating margins, while Samsung's ASP was only $180. Other sources estimate more than $40 billion in annual iPhone profits last year. Apple has built its $200 billion cash pile -- most significantly from large and sustained profits in iPhones. This is enormous in comparison to any other companies' net cash position, and particularly in comparison to the net debt of most of its carrier customers and many of its suppliers.

Apple's market power, from which it derives its relatively high profit margins and total profits, is wielded in several ways. Buyers seek to minimize what they pay and sellers like to maximize their prices and revenues. Michael Porter's famous Five Forces of Competitive Position model provides a simple means for assessing a company's bargaining strength in the battle for profit margins versus suppliers, customers, existing direct rivals, substitutes and new market entrants.

Apple has enormous purchasing scale and is tough on its hardware component suppliers and contract manufacturers in its procurement practices -- minimizing costs and thus squeezing suppliers' profit margins to the benefit of Apple's. It is also a hard and smart negotiator and in patent licensing. Apple has minimized what it has paid out in licensing fees to Nokia, Samsung and others through litigation and negotiated worldwide settlements. It is still in patent-licensing dispute with Ericsson.

It is vertically-integrated with its own custom-designed applications processor chips and operating system software. This pays off in the bottom line with relatively-low subcontract manufacturing costs from a foundry, in comparison to product prices from merchant chip suppliers, because Apple has sufficient volumes to make up for the relatively high fixed costs in developing its own applications processor chips. These volumes also justify the cost of it developing iOS, with the proprietary benefits including differentiation that provides.

Apple commands premium pricing through various innovations, branded cachet and contractual arrangements. It is perceived to be the coolest: customers tend to switch to Apple rather than away from it. Rival carriers have been so very pleased to have or to break exclusive arrangements, or even to be one among several offering iPhone, that they have made large and long-term financial commitments. For example, AT&T's exclusivity with iPhone in the U.S. started in 2007 and ended when Verizon Wireless started supplying iPhones in February 2011.  Sprint entered subsequently with a $15.5 billion minimum purchase agreement to Apple. Sales had to be significantly subsidized to ensure there was sufficient end-user demand to meet this pledge. It is still possible to buy a new iPhone for virtually nothing when signing a two-year service contract in the UK and in other nations. For example, Vodafone UK is offering the new iPhone 6s 16GB for a payment of only £9 ($15). Directly from Apple without subsidy the price is £539. Vodafone pays Apple most of the latter figure up front while Vodafone finances the £530 difference as it recovers the costs from monthly fees over a two-year term for a service contract.

Apple has complementary branded activities including Apps from its App Store from which also derives significant contributions to profits. It has provided capabilities which are unique to Apple products (e.g. FaceTime videotelephony). That draws-in people who do not want to be isolated from their social groups' communications. BlackBerry used to command a unique position with its BlackBerry Messenger (BBN), but it was unable to sustain that exclusively to BlackBerry devices when these lost their popularity to iPhones and Android smartphones.

Innovations have made iPhones and smartphones in general very effective and significant substitutes for all kinds of other products including Walkmans, MP3 players, CDs, DVDs, radios, TVs, paper-based organizers, PCs, books, magazines, newspapers, dictaphones, navigation devices, fitness trackers and a whole lot more. Revenues and profits have been displaced accordingly.

The smartphone industry is being flooded with new market entrants, including many from China in recent years, who are using highly-standardized software (e.g. Android) and hardware components. However, with these commonalities there is little scope for meaningful differentiation. Consequently, these players compete among themselves with parity; they price at around their marginal costs and consequently generate weak profits or losses. They have made little or no headway in undercutting Apple, which is in a totally different competitive position. Apple continues to be able to hold substantial market share while pricing at much higher levels than all comers, including the above and other major incumbents such as Samsung.

Keith Mallinson is a leading industry expert, analyst and consultant. Solving business problems in wireless and mobile communications, he founded consulting firm WiseHarbor in 2007. Find WiseHarbor on Twitter @WiseHarbor.