The Battle To Go Small Means Big Profits

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

If you were in the market for a tablet just a year or so ago, you basically had one real choice. You could buy an iPad, or you could buy something no one wanted. Apple's (NASDAQ: AAPL) introduction of the iPad was initially met with much disdain for the name in particular, and many called it "just a bigger iPod touch." Now that a few years have passed, the tablet market is moving the other way. The battle is not only for the 9" to 10" form factor, but also for the smaller tablets that are close to 7." To be fair, these are almost two separate markets, and understanding who wins and loses is key to knowing which stocks to buy. Now that sales of the iPad Mini are in full swing, and the holidays are almost here, which is the best tablet to buy is likely a popular question. The question of what company benefits the most is almost a different discussion. 

The Contenders

Looking at the small tablet market, there are really four major manufacturers, but three eco-systems in play. Everyone pretty much is aware of the iPad Mini, and Amazon's (NASDAQ: AMZN) Kindle Fire 7." The two other 7" tablets are the Google (NASDAQ: GOOG) Nexus 7 and the Samsung Galaxy Tab 7." The difference here is while Apple makes the iPad Mini, Amazon makes the Kindle Fire, and Samsung makes the Galaxy Tab, Asus was awarded the contract to produce the Nexus 7. That being said, Google's Android runs the Kindle, Nexus, and the Galaxy Tab, but Amazon uses a modified version for its tablet. I know that there are people who will make a big deal about the pixel density of each tablet, or the processing speed, but in truth, specifications aren't what sells tablets. There have been other tablets like the BlackBerry Playbook and the Motorola Xoom that had arguably better specs than the iPad, but they didn't sell because the eco-system wasn't there. 

Price Matters, But Customers Like a Shiny Apple

A worry about the iPad Mini when it was introduced was that Apple might price the device too low and have to cut out key features, or too high and it wouldn't be an attractive option. This was a worry expressed by Rick Munarriz on Fool.com when he said, "how do you price these?" He suggested that the Kindle Fire 7" at $199 had a better camera, better graphics, and more storage than before. He also mentioned Google's Nexus 7" at $199 as attractive with a better screen and the backing of Google. To say that he got a lot of feedback is an understatement. There are 28 comments on his article, but many followed the same logic. The theory is, Apple is looking at the iPad Mini replacing the iPad 2 at some point. The smaller form factor of the Mini makes the lower resolution screen look better because the pixels are squeezed into a smaller area. The Mini starting at a 34% discount to the $499 gives customers the Apple experience for a lot less. Another comment was the Apple eco-system is far superior. Finally, one person really hit the nail on the head by saying, "the iPad Mini will get used because Apple will show us how." 

Apple Gets It, Amazon Sells It, Samsung Is Getting Smarter: 

Each competitor has very different reasons for selling a 7" tablet. Apple's primary objective is to make money on the sale of each device. If customers buy an iPad Mini and use it to purchase items from iTunes, that's extra icing on the cake, but the main point is to make money at the point of sale. In addition, Apple has been masterful at advertising that focuses mainly on how its products work. The fact that Apple shows customers how to use their products is clearly working based on the number of iPads that have been sold.

The company's head start, and closed system for apps, has also attracted by far the most tablet ready apps with over 275,000 at last count. For those worried that the iPad Mini will hurt Apple's profit margins, worry not my friends. According to a USA Today article, the iPad Mini carries a 40% profit margin, while the iPad 4's profit margin is 40.88%. Believe it or not, the iPad 3 was probably updated not because of Apple's desire to introduce a new iPad, but because this same article found the iPad 3's profit margin was 37%. When you plan on selling millions of these devices, a 3.88% increase in your profit margin makes a big difference.  

Amazon's tablet is a different animal all together. Amazon's profit margin reportedly is just 13% on the Kindle Fire 7" according to the same USA Today article. However, the company hopes to make up for this small margin by increasing its sales through the web site. Strangely enough, Amazon's best growth has come in its general merchandise segment and not from digital content. In fact, in the last few quarters, general merchandise sales have increased by more than 35% versus a low double digit increase in digital sales. In the end, Amazon's Kindle Fire is a content consumption machine, with a whole lot of Amazon's merchandise catalog thrown in. 

Samsung should be Google's best friend at this point. The company is leading the charge in smartphones and tablets that use the Android operating system and they are getting better at what they do. Samsung makes the lion's share of the profit on the hardware sales, but Google benefits from the increased usage of the Android OS. In truth, one of the game changing additions to the small tablet industry is something that's not technically a tablet, and that is the Samsung Galaxy Note 2. This 5.5" screen monster smartphone has many of the attributes of a tablet in a form factor just less than a 7" tablet. The fact that this device has developed an almost cult like following, shows that Samsung is onto something here. 

Conclusion

In the end, I firmly believe that Apple and Samsung are the two big winners. The fact is, the profit margin on the sale of the device is much greater than trying to make up for this lost profit in the sale of other merchandise or services later. In addition, since small tablets are cheaper, their lifecycle is likely to be shorter. Just because someone spends $199 on an Amazon Kindle today, doesn't mean they won't consider spending $300 next year, or the year after that, on a new tablet. Google benefits from the increased use of its other services, but this is incremental and not a substantial profit center for the company. It's no coincidence that Apple and Samsung spend heavily on advertising and are battling it out in the courts. After all, this small battle means big profits for the winners. 


MHenage owns shares of Apple. The Motley Fool owns shares of Apple, Amazon.com, and Google. Motley Fool newsletter services recommend Apple, Amazon.com, 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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