Smartphone Commoditization: Losers and Winners

In the ever-evolving smartphone wars, Google (NASDAQ: GOOGL  ) and subsidiary Motorola have fired a shot across the bow of equipment makers, lowering the unsubsidized price of its flagship Moto X to $350, and its Moto G phone to $199.

So, how much can Google really make off the sale of these products? According to The Wall Street Journal, "Research firm TechInsights estimates that the components inside a Moto G with 16 gigabytes of memory cost $123," and along with other costs, the Moto G will generate a profit margin around 5%.

Contrast of margins
The flagship models of leading competitors sell for hundreds of dollars more than the Moto G and Moto X. As the Galaxy S4 and iPhone 5s only have an estimated $91 and $107, respectively, in extra hardware costs, they would need far superior functionality to justify these prices.

In fact, Samsung  (NASDAQOTH: SSNLF  )  carries 28% margins on its flagship S4, and Apple (NASDAQ: AAPL  ) can boast an estimated 30%-35% profit margin on its iPhone 5s and 5c models.

Rationale for low margins
Motorola is currently losing Google nearly $1 billion per year, yet for some reason, the company has decided to slash prices and sell its smartphones at extremely low margins. Why?

Google purchased Motorola for its patent portfolio, both to defend itself against patent litigation and use it as a "nuclear deterrent," as the mere threat of a counter-suit might actually prevent a lawsuit from being filed. 

Here are reasons Google doesn't need to make an immediate profit off Motorola: 

  • The patent portfolio was a major reason for its acquisition. 
  • It helps Google control the fragmentation of its open-source Android system. 
  • Google derives an incredibly rich amount of data from Android users supported by multiple OEMs. 

Google uses this data to support Google Maps and its search engine moat, which remains the biggest profit driver, and to help serve more relevant ads. This is why Google benefits from the commoditization of cell phones and getting Android into as many hands as possible, regardless of immediate profits. 

Who does this affect?
Attempting to turn the smartphone into a commodity has a more profound impact on Samsung than it does Apple or Microsoft. While Microsoft runs its own competing Windows Phone OS, Apple seems to have no intention of earning market share at the expense of margins and profits, and completely controls its closed operating system.

The vast majority of Samsung's devices run the Android operating system, and thus face immediate comparisons to the Motorola phone. On Google's side, Samsung is an important partner in promoting the Android experience to the world, and therefore doesn't want to see Google fail.

For Samsung, Android was a gift representing a huge piece of the smartphone puzzle. Of course, if users start to perceive the Android experience as a cheap commodity, demand to buy phones from Samsung could diminish. 

Samsung's move
To counter potential commoditization, Samsung is developing Taizen, its own operating system. However, it would be a risky move by the company to actually employ it. On one hand, there are clear benefits in being able to differentiate itself in the marketplace, but on the other hand, the new OS might fall flat on its face. A common complaint from users is that the software Samsung added to the Galaxy line is "crapware," so it makes sense for investors to have doubts. 

Takeaway
A price war seems to be on the horizon. While all high-end smartphone makers will feel its affects, investors should take note that Samsung has the most to lose in the short run if Google continues to commoditize the business. The more people who use Android-powered devices, the more searches are directed to Google, and the more apps and media sold on Google Play, making the data Google collects that much more valuable. As long as Google is willing to subsidize low prices (and Motorola as a whole), the greater negative impact it will have on other Android makers, especially Samsung, which currently sells its products at higher margins.

Profiting from the smartphone revolution
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