Smartphone Pricing War

The smartphone market is today becoming increasingly polarized between high-end devices from Samsung and Apple, and low-end smartphones being rolled out by Chinese OEMs such as Huawei and ZTE. As Apple’s dominance declines, new players emerge and middle ground players struggle to find their niche the industry is undergoing a next wave. So what’s going on in the pricing war in the smartphone arena and what’s the future outlook?

If we look at history, the average selling price (ASPs) of smartphones in 2011 has been kept up mainly because of Apple and Samsung. Smartphone industry ASPs actually rose in 2011 by 4% to $330, Apple being the major factor with an ASP of over $600. Looking at profitability trends with Apple included indicates that over the past 5 years overall industry profits for the handset segment have risen at a CAGR of nearly 21% ($13.7 billion in 2006 to $34.9 billion in 2011, Source: Credit Suisse), much faster than the 13% revenue CAGR in industry revenue. However, we can call it the “Apple effect” as the data without Apple’s profitability shows that industry profits have declined with a CAGR of -1% while the revenue rose by 8%. This clearly means that despite the increasing smartphone sales and adoption, declining prices due to competition are putting a pressure on the OEM margins. This argument establishes that the smartphone ASPs are declining.

Given that there is certainly a price war going on in the smartphone arena, it will be interesting to look at some data that give us insight into the near future. Looking at the data for the smartphone sales volume and sales revenues, it is quite clear that the smartphone ASP could decline up to almost $200 by 2016.

The bill of material analysis of latest smartphones proves that the smartphones are sold at very high margins which could be hard to sustain.

Bill of Material Analysis (BOM):

A bill of material analysis from iSuppli Research of the iPhone 5 reveals that the average mark up over bill of material cost of Apple is up by 270% ($207 BOM+Manufacturing cost against the no contract pricing of $649 for a 16GB model). In our opinion, the bill of material is surely going to fall with declining hardware component prices. Such high margins will be difficult to sustain in the light of shortened smartphone release cycles and intensifying competition, hence decreasing prices further.

We can prove this hypothesis by taking the example of Google’s Nexus 4. Google has fuelled the smartphone pricing war by launching its flagship model, the Nexus 4, at a price of $299. If in the most optimistic scenario, if we assume that the BoM cost of Nexus 4 is around $200-$210, Google is barely making any profit on it. This suggests that such high margins on devices won’t be sustainable as vendors will be pressured to absorb the cost of innovation while keeping up with price war. Hence, to remain profitable and competitive, the vendors will have to reduce their operational costs which could eventually force industry consolidation.

This also ties in with the projections highlighted in the projected ASP of roughly $200 in 2016. Based on the aforementioned arguments and taking into account factors of reduced margin and reduced manufacturing costs, we concur with the industry analysts’ view of ASPs hitting the $150 mark in the next four to five years. We have the following reasoning for falling ASPs:

  1. Falling hardware component pricing: Component pricing such as the memory, camera, etc. required to build a smartphone have been falling continuously and are expected to fall further driving the prices down. Even as the DRAM continues to be an increasingly important component in the smartphones, the DRAM percentage share of smartphone BoM cost continue to fall indicating the declining prices of DRAM. iSuppli Research data shows that this percentage has fallen from 14% in Q1’11to almost 6% in Q1’12.
  2. Increasing entry level smartphone demand: The average smartphone price will also fall due to the introduction of cheaper entry level smartphones (sub $150 range) especially in the emerging markets. The study by Credit Suisse highlights that the sub $150 segment smartphones is expected to constitute up to 30% of the total smartphones sold in 2015 as compared to 8% in 2011.
  3. Rising competition: The competition in the smartphone arena is increasingly intense. Companies like Google and Amazon could be the milestones in taking this war to a different level. According to industry sources, Amazon plans to introduce a “disruptive” pricing plan. It has already contracted with Foxconn, the Taiwan-based company, for manufacturing. Also, we believe that Amazon’s phone could very well make an entry mid 2013 with a price range of $150-200, very much on the lines of Nexus 4. The Kindle 3G offered unlimited 3G access, which could be used to download Kindle content over 3G connections, without any incremental fee to the end user. Amazon’s strategy is to sell the hardware at almost break-even prices by lowering the margins on the devices and make profit on the content that users are buying from Amazon to use it on Kindle. Such a strategy can be very well replicated with its smartphone.
  4. Apple’s entry in the low priced segment: With the declining share prices, Apple could be developing a new strategy to provide cheaper iPhones and capitalize on the existing iPhone brand. iPhones cannot make it to the hands of emerging markets customers as the high prices make it unaffordable for lower economic segment. Rumor has it that in the wake of its declining market share, Apple certainly needs a cheaper phone to augment the clientele. The question arises if Apple would be able to deliver a cheaper smartphone that could compete with the already existing cheaper Android phones? The answer lies in history where, iPhone is struggling hard to keep against competition. Apple plans to target the emerging markets with the launch of the low-end iPhone and it could well be successful in building its base. However, we would have to wait and watch if the much talked about strategy could help Apple rise again. It certainly needs to impress customers with the much awaited launch of the iOS7.
  5. Google’s role: Google has a pivotal role in the pricing war by taking a low profit margin on its devices. It is actually pushing the war from devices to platform by doing so. This could mean that the users get subsidized devices in exchange of paying for content. Google aims at driving the stickiness of Android among the customers. Once they have their documents, music, movies, apps, pictures, etc. associated with one platform, it will be extremely hard for them to migrate to other platforms. Google’s financial interest lies not only in getting customers on-board the Android platform, but locking them in. The more customers use the Google Play stores, the more money Google makes. Instead of turning a profit from the software and hardware, Google is trying to strengthen its position in the pricing war by capturing advertisement and other revenue sources. We could fairly assume that Google will lead the pricing war, at least in 2013.

In the coming years, the market is expected to mature and will be divided into two zones: Feature War Zone and Price War Zone. The feature war zone will be dominated by innovative companies who will add new features and high-performance components to every new product cycle. The innovators will include players such as Google, Samsung and Apple. The price war zone will be dominated by players who will emulate the innovators and bring the innovative smartphones to the mass market at a cheaper price. Vendors such as Sony, Nokia, HTC and LG will compete in the price war zone competing mainly on the price point. These players will struggle with the price erosion and find it hard to sustain their margins. They could either try to compete with the Innovators in the feature war zone or continue to take hit on their margins from the fierce competition by Chinese handset makers such as Huwaei and ZTE. The consumer is to benefit in any case as the smartphone makers will have to align their pricing strategy with market demand if they want to sustain.

Given the above arguments, we expect prices of the smartphones to erode further before flattening out. The pricing war will continue to shift from devices to content and platform as OEMs come up with innovative strategies and partnerships to lock customers. Also, customers can expect to see the introduction of more entry-level smartphones with high-end features. As they say, consumers are king, and will continue to drive the smartphone players towards new pricing strategies.