In the market for a high-end Android phone? Well, you're in luck – the phones are cheaper than they've ever been, and the discounts might just amount to the first shots in an overdue price war. That's bad news for Motorola (NYSE: MOT) and other Android manufacturers ... but chances are that Google (Nasdaq: GOOG) isn't quite so heartbroken.
Why Android is a profit machine …
Thus far, Android has been a godsend for its three biggest phone manufacturers: Motorola, Samsung, and HTC. Not only is the mobile operating system keeping these companies from being laid to waste in the smartphone market by the juggernaut known as Apple's (Nasdaq: AAPL) iPhone, but it's also doing wonders for the profit margins and average selling prices produced by their phone businesses. Last quarter, thanks to sales of the Droid X, Droid 2, and other Android models, Motorola reported a cell-phone ASP of $223, up nearly 80% from the $124 reported a year earlier. Even more importantly, booming Android sales allowed Motorola's phone division to go from a $183 million non-GAAP operating loss in the year-ago period to a $3 million operating profit.
High-end Android phones are often sold by the Motorolas and Samsungs of the world to carriers for more than $500 (before the carriers sell them to consumers at highly subsidized prices). And with teardowns of these phones usually showing that they cost less than $200 to manufacture, we can assume that they're earning a pretty penny for the manufacturers, even after you factor in other expenses such as marketing and R&D.
... and why it won't last
But can investors expect these enormous profit margins to last? Normally, for a hardware manufacturer to keep its gross margins at the levels that Android manufacturers are apparently seeing for high-end devices, its products need to be highly differentiated. That simply doesn't seem to be the case for phones such as the Droid X, HTC's EVO, and Samsung's Galaxy S. When it comes to core features such as a phone's display size, processing power, memory, and camera(s), there's very little to give any individual Android vendor a real edge. Sure, manufacturers have developed custom user interfaces for their Android phones, but from all indications, very few users see them as a big selling point.
Backing up the notion that high-end Android phones are steering very close to commodity status is the way in which the market share of leading manufacturers is constantly in flux. A year ago, HTC was easily the biggest Android vendor in the United States. But following the runaway success of the original Droid with Verizon (NYSE: VZ), Motorola stole HTC's crown. Now, after a big summer push in which versions of the Galaxy S were rolled out by all four major American carriers, Gartner is reporting that Samsung has displaced Motorola as the U.S. market leader.
Also adding to the notion that Android manufacturers can't differentiate themselves is the way in which the most popular/hyped Android phone has been changing almost every month. First, the Droid was seen by gadget enthusiasts as the must-have Android phone. Then it was HTC's Droid Incredible. Then it was the EVO. Then the Droid X arrived. Then Samsung stole headlines with its Galaxy S barrage. And now HTC's Desire HD and Samsung's forthcoming Nexus S are generating the most buzz. Is your head spinning? Good; it should be.
Signs of trouble
If the struggles of the PC industry are any guide, a lack of major differentiation will inevitably produce serious price competition and dwindling margins. We might have recently gotten a sign of things to come for Android, with Amazon.com, Best Buy, and other retailers offering phones such as the Droid X and Samsung Captivate for free with a contract, rather than the $199 that they typically go for.
Sure, it's the holiday season, and retailers often provide discounts on popular items to get consumers to visit their stores and websites. But when the discounts are this steep, and this widespread, chances are that price cuts from suppliers have something to do with them. After all, Radio Shack is trying to reel in customers by offering a discount on the 16GB iPhone 4, but (no doubt thanks to Apple's historically tough stance on pricing) it's still charging $149 for the device.
And speaking of the iPhone, if it turns out that those never-ending rumors about AT&T (NYSE: T) losing exclusivity in early 2011 prove true, then that can't help but worsen any Android price war that breaks out. If high-end Android vendors have to contend with direct competition from Apple for the dollars of Verizon subscribers (and perhaps also Sprint and T-Mobile subscribers), then their natural response is going to be to try to undercut Apple in terms of price.
Motorola's loss is Google's gain
If the salad days of Android manufacturers are about to end, you can count on it being bad news for Motorola's shares. Profits from Android phone sales are the only thing keeping the Mobile Devices division from again being a giant cash sinkhole. But for Google? Cheaper Android phones have to be music to its ears. Less costly hardware should translate into a higher smartphone market share for Android, and that translates into more mobile advertising revenue for Big G.
Qualcomm (Nasdaq: QCOM), meanwhile, is a company that stands to both gain and lose from a price war. On one hand, the royalties that Qualcomm gets for individual Android phone sales will go down as prices decline. But on the other hand, sales of the costly Snapdragon processors that power many Android devices will get a boost, and the company's total royalties might still increase on account of Android phones' taking more share from Research In Motion's (Nasdaq: RIMM) BlackBerrys and inexpensive "feature phones."
The economics of Planet Android are bound to see some gut-wrenching changes over the next couple of years. With limited product differentiation, it's probably just a matter of time before the Android phone business looks a lot like the PC industry, with a big chunk of the profits going to the operating-system provider and chip companies, and hardware manufacturers forced to live in a world of thin margins and frequent price wars.
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