What Google’s Nexus 7 Means For the Tablet Market

Four months.

That’s how long it took for Google (Nasdaq: GOOG  ) and hardware partner Asus to develop the brand new Nexus 7 from scratch. Asus put together an engineering team with a 24-hour development cycle, stationing some workers in Silicon Valley to be in close proximity to the search giant.

"Like torture"
It was a tough gig, to be sure, with Asus Chairman Jonney Shih even saying that his company’s engineers likened it to "torture" due, in part, to Google’s very specific demands on quality and price. Big G was dead set on selling a high-quality device for just $200.

Even more interesting is that Android head Andy Rubin confirmed to All Things D that the device is sold at cost, and the company is eating all the marketing and distribution costs associated with selling the device. "When it gets sold through the Play store, there’s no margin," he said. "It just basically gets [sold] through."

Who needs profit margins?
No margin. That’s right. Let’s dig into those two words, because there’s a very important difference in this arrangement compared to other devices that sell around cost, most notably, Amazon.com’s (Nasdaq: AMZN  ) $199 Kindle Fire, which the Nexus 7 is aimed squarely at.

With the Kindle Fire, Amazon tapped third-party contract manufacturer Quanta to help design and manufacture the device, in a move to get it to market before the holidays last year. By definition, contract manufacturers primarily deliver just the manufacturing service, leaving the rest of the marketing and distribution process to the company that tapped them to build the device. For example, you don’t see Foxconn out there marketing Apple’s (Nasdaq: AAPL  ) iPad, and you won’t see Pegatron pitching Microsoft’s Surface later this year.

After they get their cut for their services, the rest is in the hands of the other company that usually sets the pricing and other key strategic variables. If that company is able to price it, and earn a 58% gross margin, like Apple does with its entry-level third-generation iPad, so be it. If that company’s prerogative is to give it away at cost, like Amazon’s Kindle Fire, so be it. That’s the role of a contract manufacturer.

In contrast, a hardware OEM typically is in the game to make a gross profit on the sale of the device itself, pitching in with marketing and distribution. While they similarly craft the device, they also look to boost margins, and have a broader role in the value chain. They have much more of a say in final pricing and other important factors.

Here’s the significant part: Asus is a hardware OEM, not a contract manufacturer. At least not until this week.

Profit margins are so overrated
If the Nexus 7 is being sold at cost, with no profit margin, who makes money? Of course, we’re not privy to the financial details behind the partnership between Google and Asus, but it seems likely that Google is simply paying Asus for manufacturing services, while it calls the shots on aggressive pricing to bolster sales and market share. Those manufacturing costs are just included in the overall bill of materials.

Asus isn’t making any money off the sales price, but is, instead, getting paid in the same way as contract manufacturers. Google gets its cut indirectly through additional mobile advertising revenue and economic moat expansion, and is now focusing heavily on content sales through its Google Play unified storefront.

Even within Google’s own Nexus brand, there’s now a discrepancy. At its full retail price of $650, you can bet that Samsung is making some money directly on the Galaxy Nexus, the current Android flagship smartphone.

No OEMs allowed
This has important implications for the low-end tablet market, including for Asus itself. The Kindle Fire and Nexus 7 are likely to be the show stealers in the $199 price segment, and both devices are selling at cost. That's likely what will shape consumer’s perceptions of what a 7-inch tablet is worth. After all, that’s precisely the message that two of the biggest players, Amazon and Google, are sending.

If that’s the case, then there’s not much room for hardware OEMs to squeeze in with their own offerings if they have any hope of making an actual profit on the device. This specifically prevents Asus from entering with a 7-inch tablet of its own. Its current Transformer family of Android tablets occupies higher price points and larger display sizes, but now, it effectively can’t move down-market if it wants to, because it will just be competing with itself against a device that sells at cost.

This dilemma will apply to all of Google’s hardware partners, including all of the Samsungs, Acers, and Toshibas of the world. If consumers have a mental price ceiling of $199 for a 7-inch Android tablet, OEMs won’t have much leeway to differentiate or innovate with hardware, and the only path to profitability is cost cutting, which only leads to lower-quality devices that won’t sell as well as a higher-quality no-margin device at the same price point.

That consumer perception will also put an interesting twist, with Apple’s rumored push with an iPad mini targeting the 7-inch crowd. The difference is that Apple is more capable of differentiating with hardware and software integration earning premium pricing, while Android OEMs face commoditization.

If I go down, I’m taking all of you with me
Meanwhile, competing directly with the iPad in the higher-end segment at the same price points continues to be a losing proposition time and time again. With the Nexus 7 and Kindle Fire at $199, and Apple’s iPad 2 at $499, the only real space left is right around $300, unless Apple decides to stake a claim there with an iPad mini.

Sorry, Asus, but I think you just shot yourself in the foot, along with every other hardware OEM that had hopes of profitably tapping the 7-inch tablet market.

Apple seems ready to dominate more of the tablet market with an iPad mini, which could be a big opportunity for the company. If you’re wondering if you should buy or sell Apple today, then grab a copy of this brand new report. After you’re done there, you might want to check out 3 stocks that will help you retire rich, including one company mentioned right here in this article. This report is totally free.

Fool contributor Evan Niuowns shares of Apple and Amazon.com, but he holds no other position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Amazon.com and Microsoft. The Fool owns shares of Google. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Amazon.com, Google, Microsoft, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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