Apple's Smartphone Profits Compared to the Competition

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

On July 26, Strategy Analytics (SA) issued a report with the attention grabbing headline "Samsung Becomes World's Most Profitable Handset Vendor in Q2 2013." The report estimated Samsung's (NASDAQOTH: SSNLF) operating profit from mobile phones to be $5.2 billion for Q2, whereas Apple's (NASDAQ: AAPL) operating profit from iPhone sales was estimated to be $4.6 billion. In fact, SA's number for iPhone operating profit was almost certainly wrong, and Apple's iPhone profit was more like $6.2 billion.

Daniel Eran Dilger quickly rose to Apple's defense in Apple Insider, denouncing the report as "simply not accurate." He was so busy excoriating SA for their shoddy analysis that he never offered an alternative to SA's profit figures for the mobile handset business.

Competing keiretsu

In fact, a dispassionate comparison of mobile phone profitability between Apple and its competitors can be revealing. Apple, Microsoft (NASDAQ: MSFT) and Google (NASDAQ: GOOG) each lead keiretsu of numerous companies that contribute to their respective mobile device ecosystems. That leadership derives from the fact that each of the three create and (to a greater or lesser extent) control their mobile operating systems.

Google's principal handset manufacturing partner is Samsung, while Microsoft's principal handset manufacturing partner is Nokia (NYSE: NOK). Any comparison of smartphone profitability needs to include the leaders of their keiretsu as well as their principal manufacturing partners. In the table below, I summarize some top level financial data for all five companies as well as provide data for Mobile Phone revenue and my estimates for mobile phone operating income.

<img alt="" src="http://g.fool.com/editorial/images/61279/mobilephoneincome_large.png" />

As can be seen above, Apple's estimated operating profit from iPhone sales easily surpasses that of any single company, and probably the other competing keiretsu if revenue from apps and iTunes were included. I didn't include these because Apple provides no breakdown of the mobile device income for the iTunes, Software and Services category in its quarterly reports. The Microsoft keiretsu probably has a way to go just to break even.

In the tables below, I provide brief summaries of how I estimated mobile phone revenue and operating income for each of the companies.

<img alt="" src="http://g.fool.com/editorial/images/61279/mobileprofitsexplanation1_large.png" />

<img alt="" src="http://g.fool.com/editorial/images/61279/mobileprofitsexplanation2_large.png" />

Where SA went wrong

Dilger spends a lot of effort trying to pick apart SA's profit estimate for Samsung's mobile phone business, but this may have been misguided. In its Q2 earnings report, Samsung reported an operating profit for its Information Technology and Mobile Communications (IM) division of $5.65 billion. SA is saying that $5.2 billion of that amount came from mobile phones, smartphones, and feature phones.

IDC just reported its mobile phone shipment figures for Q2, and Samsung shipped a total of 113.4 million mobile phones, of which 72.4 million were classified as smartphones. This comes to an operating profit of just $45.90 per phone. As we'll see, this is far less than Apple's operating profit per phone, but it doesn't say that the $5.2 billion operating profit is exaggerated.

Apple's profit number is where SA probably screwed up, but this isn't an easy number to get right and the reader should realize that any number that anyone publishes outside of Apple is nothing more than an estimate. Unlike Samsung, Apple doesn't report operating profit for its operating segments, or for iPhones or any other product category, but only for the company as a whole. Microsoft and Google pose a similar problem.

Dilger actually shows an iPhone operating margin estimate furnished by Canaccord Genuity of 40% as of 2012 Q4, and I went with this estimate derated by the 6 percentage point decrease in operating margin Apple has suffered corporate wide since Q4.

Based on SA's operating profit estimate for Samsung of $5.2 billion, Samsung had an operating profit margin in mobile phones of about 17%. My derated Apple iPhone operating margin is 34%. Why do I think this is plausible? Because Apple's iPhone Average Selling Price (ASP) is about double that of Samsung, even though their smartphones cost about the same to manufacture, as shown in iHS/iSupply teardowns of the iPhone 5 and Galaxy S4.

Apple's iPhone ASP: $581. Apple's operating profit/handset: $197.60. Samsung's mobile phone ASP: $274.

For Google, I just applied the corporate wide operating margin of 22% to the estimated revenue for Android devices. The Android mobile device revenue was derived from Google's 2012 Q3 estimated mobile run rate of $8 billion/year, which includes all revenue from Google Play as well as advertising and search. This run rate includes all mobile devices, not just Android, so dividing by the total number of Android and iOS devices at the time yielded the run-rate per device of $2.23 per quarter.

Microsoft was the most difficult to estimate, both for Windows Phone revenue and operating income, since Microsoft reports neither as separate categories, but lumps these together with Xbox in the Entertainment and Devices Division (EDD). Microsoft dropped enough hints in their earnings reports that I was able to back out a revenue estimate as well as estimates for Windows Phone related operating expenses.

I approximate Microsoft's Windows Phone cost of revenue to be equal to the platform support payments it's making to Nokia. Nokia has indicated that platform support and royalties payments are about equal. Since Nokia accounts for about 70% of Windows Phone sales, this means that Windows Phone license cost of sales is about 70%. This could be higher if other Microsoft partners are also receiving support payments, but so far, only Nokia has acknowledged receiving such payments.

Based on operating costs in EDD, I estimate Windows Phone operating costs to be 27% of revenue, leaving a whole 3% as operating profit.

Nokia turned out to be the easiest case to handle, since their Devices and Services division captures revenue from all phone sales as well as related operating income.

Investor takeaway

Google/Samsung is and will continue to be a fierce competitor for Apple. Of most concern to me is Apple's continuing slide in market share. According to IDC's Q2 data, Apple's market share declined from 16.6% a year ago to just 13.1% for 2013 Q2. Yes, Apple's iPhone shipments grew 20% year over year, but Samsung's shipments grew faster, by almost 43.9%. In Q2, Samsung sold more than twice as many smartphones as Apple.

Investors should be extremely wary of the kind of analysis produced by SA, which seems designed at best, to garner attention. Apple has challenges, to be sure, but not quite as dire as SA's analysis would suggest.

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Mark Hibben owns shares of Apple. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple, Google, and Microsoft. 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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