Google’s New Phone Is a Sign of Things to Come

Google's (NASDAQ: GOOGL  ) purchase of Motorola Mobility has been interesting, to say the least. On one hand, the division continues to lose rather significant amounts of money -- $342 million in the most recent quarter. But on the other hand, it allows Google to continue to drive adoption of its Android ecosystem.

It's not clear if Google will eventually want to run Motorola Mobility in order to turn a meaningful profit. But in any case, Google's latest Moto G smartphone -- a $179 off-contract device -- highlights an important trend in the handset market.

The future of smartphones is cheap
Looking at the newly minted Moto G smartphone, it's clear that there's quite a lot of value to be had here for $179. It packs a Qualcomm (NASDAQ: QCOM  ) Snapdragon 400, which sports quad ARM (NASDAQ: ARMH  ) Cortex A7 cores, 1 GB of RAM, and a 4.5-inch, 1280x720 display. These aren't incredibly high-end specifications, but this type of performance is certainly more than adequate, and the feature set rather robust for the money.

Going forward, thanks to the magic of Moore's Law, the lowest-end smartphones will continue to become more powerful. While higher-end phones will certainly pack more punch and sport higher build quality and more features, the law of diminishing returns is likely to kick in sooner rather than later.

While both Samsung (NASDAQOTH: SSNLF  ) and Apple (NASDAQ: AAPL  ) currently run printing presses with their smartphone businesses, it seems likely that selling handsets isn't going to be a great business in the long term, as the industry sees a broad mix shift down to lower-margin devices.

Google's phone already proves it
There's very little chance that Google is out to make a profit off of its Moto G. But the beauty of Google's participation in this market is that doesn't really need to. Google's bread and butter is drawing users into its ecosystem and generating revenue from Google-owned sites as well as its partner sites.

When people use stock Android phones, they're likely to use Google Chrome -- which helps drive Google Search -- as well as Google Maps, Gmail, and all of Google's other services. So while Google isn't making money on the hardware, it is building a much wider and deeper moat than a mere handset vendor could ever have -- a profitable ecosystem.

What does this mean for the hardware makers?
It's no secret that the market doesn't have particularly high hopes for the continued viability of the robust profitability at either Apple or Samsung, the two companies that control the vast majority of the profits in the smartphone space. Apple, for instance, trades at about 13 times earnings, and Samsung trades for about 7 times earnings -- the valuations are even less aggressive on an ex-cash basis.

It is unlikely that Samsung and Apple will see meaningful multiple expansion as fears that growth, or even sustainability, of the current profitability base is unlikely over the long term.

That being said, Apple has a few distinct advantages over Samsung. First, its brand is much stronger and its customer base is much more loyal. Next, Apple's tight control of its software ecosystem and its rich ecosystem is a real competitive advantage. On the flip side, Samsung has a great cost structure, thanks to owning just about the entire smartphone supply chain, and that allows it to flood just about every segment of the smartphone market profitably.

It will be interesting to see how the landscape evolves over time. Will the profitability in this space be allowed to spread to many more players, with each getting a much smaller slice of the pie? Or, will it stay largely a duopoly with players like Google/Motorola and Microsoft/Nokia -- both ecosystem owners -- carving their own niches?

Foolish bottom line
Google has proven that great devices can be sold for extremely low prices, as long as the company can support it with the right business model. Further, the advances in semiconductor and display technology will enable increasingly fully featured, low-priced phones.

The market is increasingly likely to become even more competitive, which could erode profitability for the two heavyweights. That's why this Fool prefers to invest in the components suppliers, which often command respectable margins and can drive sales based on technical merit rather than consumer whims and tastes, rather than the device vendors themselves.

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  • Report this Comment On November 15, 2013, at 8:24 AM, fpl1954 wrote:

    Actually, there are three markets for smart phones.

    One is the large market of people who will pay anything for an IPhone or Galaxy because the phones are fashionable and they are insecure. This is proven by the number of people paying huge prices for IPhones and Galaxies, and the profits of the sellers.

    There is a small, but still significant market of people who are more self-confident, thus won't pay the price of IPhones and Galaxies. This is proven by the number of people who can afford but DON'T own IPhones and Galaxies.

    The largest market of all is insecure people who lust for fashionable phones, but simply can't afford them.

    Google is targeting the second two groups. Smart people who realize IPhones and Galaxies are more fashion than performance will buy a phone that delivers good value. They aren't opposed to smart phones, just wasting money following the mindless herd. Those lusting for IPhones will buy the Google phones just to own a smart phone, and endless yearn to "upgrade".

    Google knows they will sell LOTS of phones keeping prices low, and Apple knows they will make LOTS of money selling to insecure people.

    Both have good business plans, just different.

  • Report this Comment On November 15, 2013, at 9:11 AM, GaryDMN wrote:

    The Android market has evolved into the commodity smartphone market. Profit margins are low and going lower for device manufactures as they fight for the low end commodity sales. Most manufactures need to make a profit, but Google/Moto's profits come almost exclusively from advertising, so they can subsidize loses on unprofitable devices, giving them an unfair advantage over Samsung, HTC and the other leading commodity phone vendors.

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