Good Reasons to Short the Smartphone Industry.

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

As you may know, I am a fixed income investor (see my blog at fixedincomenow), but I am always looking at different industries to see how competitive forces might play a role at defining future profitability levels. Profitability levels play a crucial role on defining future bond's prices. This time I was looking at the high-tech smartphone sector. Big news is always coming from this sector.

Actually, on March 14, Samsung (NASDAQOTH: SSNLF), which is the world's largest smartphone maker, launched the latest iPhone competitor: the Galaxy S IV. The market reacted in an unexpected way: Samsung's shares declined 2.6%, while Apple's (NASDAQ: AAPL) shares rose by the same percentage amount. This is just more evidence that, even if Samsung is leading the race in the smartphone battle (actually its shares have largely outperformed Apple's during the last twelve months), the competitive arena is getting hotter- and this might bring unexpected consequences. Let's take a look at what is going on in the market and what might be the industry's future.

The graph below shows Apple’s decline in share price from the $705 all-time high in September last year.

<img alt="" src="" />

Source: Google.

The smartphone’s new competitive landscape and its consequences.

As competition gets tougher, I would expect lower margins ahead. New developments ring a bell and scream “Sell.” Samsung is leading the battle, but its efforts might bring the sector's profitability level down. Competition is great for consumers but is not great for investors. Let's review the three new developments in the industry that I see bringing the profitability level down going forward.

(1) The Smartphone development cycle is getting shorter.

Samsung has one strategy: it’s aiming to reduce the development cycle. Apple launches a new device every two years with an updated version (called “S”) in between new versions while Samsung has reduced the development cycle to less than a year. Moreover, Samsung is launching newer versions just before Apple launches its own. Samsung's competitive attitude just puts more competitive pressure within the sector. Mr. Michael Maouboussin's phrase is getting more true every day: "The technology market is volatile, constantly selling innovation or managing expectations to meet customer's aspirations." Of course, this last characteristic is terrible for investors; you just can't sit and relax the way you do with well managed Consumer Goods Companies (CGCs) or Utilities. Besides, it seems that this trend is getting even worse as times goes on.

(2) Integrating the supply chain.

Samsung is trying to generate a vertical integration of its supply chain. Integration might bring some cost advantage to the Korean company, but I predict this cost advantage to increase price competition and, hence, hurt the industry. As an example of Samsung's efforts, the company acquired $111 million in shares (about 3% stake) in Sharp Corporation. Sharp provides LCD display panels for Apple and Samsung. This might look like a threat to Apple, as it sources nearly 25% of its LCD panels from Sharp, but in reality it is not a threat at all. In today's world, displays are mainly commodities.

(3) The software battle is getting tougher.

Believe it or not, Samsung is also developing an alternative open-source operating system (OS). The Korean company has partnered with Intel to compete with Google's (NASDAQ: GOOG) Android (the world leader with a market share of 68.8%) and Apple’s iOS. This is probably a response to Google’s acquisition of Motorola Mobility, which can turn into a competitor any time soon. Even if the move might make some sense for Samsung in the short term, it’s a nonsense move in the long term. Developing software takes a huge amount of resources, and bringing another OS into the arena looks as useless (for shareholders) as Google's investment in Motorola Mobility.

<img alt="" src="" />

Source: IDC.

Even if Samsung's strategy seems to be working well, as its market share grew 11.3% between 2011 and 2012, it is putting the industry's profitability level in danger. The three reasons I listed above are enough to make me a pessimist in the sector. I think great times are coming for consumers, but the consequences for smartphone makers are not going to be as great. After all, innovation brings change which is great for the world, but is usually bad for investor's pockets. Maybe you should buy a new phone and short its maker!

Federico Zaldua 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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