Smartphone Profits Erode As Price Competition Heats Up

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Price competition for smartphones is heating up. This trend echoes what has been happening in the tablet market, where devices and content seem to have followed a razor and razor blades pricing strategy.

The best ways for investors to combat the trend of profit-eroding price competition is to demand low prices among investments in this market.

Amazon to Launch Smartphone

Amazon (NASDAQ: AMZN) plans to launch a new smartphone in 2013. According to various industry observers, the company will introduce a “disruptive” pricing plan. Amazon has contracted with Foxconn, the Taiwan-based company, for manufacturing. Last year, the company launched Kindle Fire HD, which competed against Apple’s (NASDAQ: AAPL) iPad, Google’s (NASDAQ: GOOG) Nexus, and other tablets.

Kevin Smithen, an analyst at Macquarie Capital, said that the company’s entry in the market for smartphones would have an impact on the industry’s pricing for data services. He expects that company will offer the new phone in mid-2013 at average selling prices of $100 to $200. In a 2013 telecom industry outlook, Smithen said, “We expect that Amazon’s smartphones may include a disruptive pricing plan. The Kindle 3G offers unlimited 3G access, which can be used to download Kindle content over 3G connections, without an incremental data fee to the end user.”

The company’s strategy is to sell hardware at almost break-even prices and earn profit on the content users buy from the company for use on the Kindle. If Amazon follows this strategy with a phone, it'll be horrible news for companies that try to turn a profit by selling smartphones.

Google’s Android operating system and its host devices were already a disruptive technology in the smartphone space. Instead of turning a profit from the software and hardware, Google was trying to parlay its participation in this technology into advertisement and other revenue sources. Amazon would be another disruptive threat to smartphone makers.

Apple to Make a Cheaper iPhone

Apple is responding to heightened price competition and is set to introduce a cheaper smartphone before year end in a bid to attract budget conscious customers, particularly in emerging markets. A reduced-cost iPhone is expected to cost anywhere between $99 and $149 and will help Apple compete more favorably with Google’s Android smartphones, which boast about 75 percent market share. The designs are still private, so many sources cannot be identified, but The Wall Street Journal has reported how confidential sources have leaked this strategy. According to sources, “The device would use cheaper parts and may be smaller than current models.”

Apple has made consultations with more than one leading U.S. wireless carrier and there is a likelihood that the new low-cost smartphone will work on multiple wireless networks. The company’s Chief Executive Officer Tim Cook is very optimistic about targeted markets like China, where at least 2 million iPhone 5's were sold a month after the debut. Apple devices have increased their popularity in developing countries, though they remain out of service or out of budget for many residents. The cheaper iPhone could be just what they need to embrace Apple’s products. Earlier versions of the iPhone continue to be sold at affordable prices, and a cheaper iPhone may see revenues surge since iPhone sales make up at least 50 percent of Apple’s revenue.

Valuation Considerations

Since a price war is brewing, we must check to see if any smartphone players trade at attractive valuations:

<table> <tbody> <tr> <td> <p><strong><span>Ticker</span></strong></p> </td> <td> <p><strong><span>Company</span></strong></p> </td> <td> <p><strong><span>P/E</span></strong></p> </td> <td> <p><strong><span>P/S</span></strong></p> </td> <td> <p><strong><span>P/B</span></strong></p> </td> <td> <p><strong><span>P/</span><span>FCF</span></strong></p> </td> </tr> <tr> <td> <p><span>NOK</span></p> </td> <td> <p><span>Nokia</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>0.41</span></p> </td> <td> <p><span>1.63</span></p> </td> <td> <p><span>NA</span></p> </td> </tr> <tr> <td> <p><span>RIMM</span></p> </td> <td> <p><span>Research In Motion</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>0.5</span></p> </td> <td> <p><span>0.66</span></p> </td> <td> <p><span>7.57</span></p> </td> </tr> <tr> <td> <p><span>AMZN</span></p> </td> <td> <p><span>Amazon</span></p> </td> <td> <p><span>3790.57</span></p> </td> <td> <p><span>2.1</span></p> </td> <td> <p><span>15.92</span></p> </td> <td> <p><span>113.49</span></p> </td> </tr> <tr> <td> <p><span>MSFT</span></p> </td> <td> <p><span>Microsoft</span></p> </td> <td> <p><span>14.3</span></p> </td> <td> <p><span>3.08</span></p> </td> <td> <p><span>3.24</span></p> </td> <td> <p><span>9.93</span></p> </td> </tr> <tr> <td> <p><span>AAPL</span></p> </td> <td> <p><span>Apple</span></p> </td> <td> <p><span>11.85</span></p> </td> <td> <p><span>3.15</span></p> </td> <td> <p><span>4.16</span></p> </td> <td> <p><span>11.88</span></p> </td> </tr> <tr> <td> <p><span>GOOG</span></p> </td> <td> <p><span>Google</span></p> </td> <td> <p><span>23.23</span></p> </td> <td> <p><span>5.12</span></p> </td> <td> <p><span>3.58</span></p> </td> <td> <p><span>19.23</span></p> </td> </tr> </tbody> </table>

Nokia and Research In Motion trade at low sales multiples, but are very speculative since neither has made a net profit for the trailing twelve months.

Amazon has been chronically expensive based on earnings. It trades at a high price-to-sales ratio too, since its core business is internet retail. Investors should avoid Amazon until its valuation drops to lower levels. At the very least, its price-to-sales ratio should drop closer to other retailers.

Between Microsoft, Apple, and Google, Apple is clearly the best investment. It is trading at a price-to-earnings ratio that is lower than its peers and the 14.20 average of the Standard & Poor’s 500 index. It also trades at a solid price-to-free cash flow multiple and boast’s the world’s most valuable brand. Investors should expect that its price-to-sales multiple will fall as it lowers prices, but they should expect that it will remain higher than industry and market averages based on consumer perceptions of value. Essentially, Apple customers are willing to pay more for a virtually identical product if it carries the Apple logo.


The smartphone market is going to get really ugly as more companies compete on price. Fortunately, this industry strife is already priced into Apple shares, which trade at low valuations today.

BillEdson11 has no position in any stocks mentioned. The Motley Fool recommends, Apple, and Google. The Motley Fool owns shares of, Apple, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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