Android smartphone margins are at risk as Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) standardizes Android's global footprint. While Google's smartphone strategy may be bad news for Android OEMs like Samsung (NASDAQOTH: SSNLF ) , it could provide an opportunity for Microsoft's (NASDAQ: MSFT ) Windows 8 to gain traction in the smartphone market.
A lesson from Dell
In the 1990s, Dell reinvented the PC business by using a direct-sales business model. Direct sales allowed it to offer more variety at a lower cost compared to the competition, which relied on a more expensive retail model to sell PCs. Dell grew quickly, becoming the model of a successful PC manufacturer.
But since all of its competition ran Windows, Dell was unable to significantly differentiate its end product, leaving the company vulnerable to any manufacturer that could create a similar business model with a lower price structure. Dell's low-cost competition came in the form of Chinese manufacturers such as Lenovo and Acer. At the same time, the success of Apple's (NASDAQ: AAPL ) iPod created a "halo effect," which increased consumer interest in Apple's premium-priced MacIntosh line of computers. Dell, squeezed at the high and low end of the market, saw its share, revenues, and profits erode over the course of a decade.
Emerging markets: Squeezing Android margins at the low end
Smartphone manufacturers are aggressively battling for market share in emerging markets, the largest remaining growth market for smartphones. Chinese smartphone manufacturers, greedy for market share, are entering the market with smartphones priced at $99 and below. Many of these bare-bones devices run Firefox's operating system, while other low-end smartphone manufacturers are forced to use dated versions of Android that can run on their underpowered chipsets.
To better meet the needs of the emerging markets, Google recently released KitKat, a version of Android that is efficient enough to run on any smartphone with at least 512MB of RAM. If KitKat is broadly adopted, Android smartphone manufacturers will be, for the first time, running a single Android OS across the full spectrum of Android smartphones.
Despite the advantages of a single operating system solution, Android smartphone manufactures now face a situation similar to Dell's: With a common operating system powering all devices, low cost manufacturers will have increased incentive to engage in price wars to capture market share.
Apple: Squeezing Android margins at the high end
Meanwhile Apple, Android's competition in the premium smartphone segment, is working to create a competitive barrier against Android. Apple's design control -- the company develops its software and hardware -- allows Cupertino to define exactly how the iPhone will be differentiated based on performance, features, and build materials.
Also, by limiting the iPhone product line, Apple has achieved the scale that makes Apple the low-cost manufacturer of premium smartphones. A recent IHS Technology analysis estimates that Samsung's Galaxy 5S actually costs $50 more to make than the iPhone 5s. Android smartphone manufacturers are now in the unenviable position of needing to use inferior build materials (plastic vs. aluminum) to manage costs and earn lower margins if the company's choose to match iPhone prices.
Samsung is feeling the squeeze
The problems facing Android devices can be seen in Samsung, the largest manufacturer of Android smartphones. Since the release of the Galaxy S4, Samsung has been warning investors that price competition was putting pressure on the company's premium smartphone sales. Evidence of Samsung's woes came in the company's latest earnings report. Despite estimates that had Samsung smartphone shipments increasing as much as 20 million units, Samsung reported lower year-over-year revenue and profits for the quarter.
Equally troubling for Android OEMs is Apple's continued pricing power in the premium smartphone category: In the Apple's most recent quarter, the Apple's iPhone increased in sales and revenue, with corresponding increases in company margins.
With the company's recent acquisition of the Nokia smartphone business, Microsoft now controls the features, materials and pricing for the majority of smartphones running Windows 8. If Redmond is able to use its increased manufacturing control to define a profitable niche in the smartphone market, there could be significant incentives for other smartphone manufacturers to consider experimenting with Windows 8.
Dell's decade-long decline provides an example of how a dominant operating system can commoditize computing hardware. Samsung's contracting margins may be an indication that Android smartphone manufacturers are facing the same fate. Investors would be wise to monitor Microsoft's ability to define a market niche for Windows 8.
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