A Different Playbook

Apple’s stock has fallen significantly in recent weeks, reflecting concern over whether the company can sustain the high product demand and high operating margins it experienced in recent years. For one of its main product lines, the iPhone, the company is eyeing growth in Asia, where the penetration rate for smartphones is lower, but growing quickly.

Recent hyper-growth in China demonstrates the opportunity set. The Chinese smartphone market almost tripled in size in 2012, reaching 215 million units. Some estimates project this market could grow another 45% in 2013 to 312 million units. Still, smartphone penetration remains lower than the rest of the world.

But Asia’s handset market is developing quite differently than in Europe or the U.S., creating an entirely different playing field for Apple and other handset makers. Major brands are being challenged by the rise of cheap, but very capable generic smartphones. If major brands cannot innovate above and beyond the new offerings of these emerging cheap smartphones, they will not be able to command the high prices, and corresponding high profit margins, that have underpinned their success.

Our handset industry analyst recently spent two months in Asia assessing the region’s smartphone market, conducting more than 100 meetings with mobile carriers, chip and component makers, handset manufacturers and other ecosystem players. One of many key takeaways was how quickly smartphone average selling prices were collapsing, driven by the introduction and acceleration of cheaper, low-end market phones.

Several low-cost chip and processor companies have caught up with higher-end competitors in terms of technology, creating a system-on-a-chip, which has brought down the cost to manufacture a smartphone for all handset suppliers. This is enabling many new market entrants to gain a foothold in the smartphone market without the need for much technological experience or capital. Today, for just $100 out of pocket, Chinese consumers can buy a very capable, large-screen 3G Android smartphone that looks, acts and feels like any $300 smartphone sold by today’s established brands.

The rise of inexpensive, yet capable smartphones is not just a challenge for Apple. Other handset makers like Samsung, LG, HTC and Sony have high-end smartphones, but also have created a profitable niche selling “mid-end” smartphones. As the price gap widens between any of these name brand phones and the low-end phones that seemingly get cheaper by the month, it is questionable how much of a premium consumers will be willing to pay for a brand when everything inside the phone is virtually the same.

For Apple and other major brands playing in the high end of the market, we believe the only way they can sustain price premiums is through innovation. But innovation may not be as easy as it was in the past. Network speed was one of the last frontiers to set smartphones apart, but that advantage will be reduced once all phones are compatible with 4G networks. We are also at the theoretical limit where better screen quality on a device as small as a smartphone is no longer detectable to the human eye.

Handset makers using Google’s Android operating system face another challenge. They all rely on the same underlying software and hardware specifications, making it harder for any player to distinguish itself.

Other competitive advantages of larger smartphone players are also being erased. Distribution networks used to matter in emerging markets, but that is no longer the case now that markets are more mature. Scale is also no longer an advantage for large players because the smaller players can outsource production of the phones they design to contract manufacturers. These contract manufacturers produce phones for multiple handset makers, and provide the same advantages of scale achieved by a larger player in the market.

Apple has advantages, however. It is one of few players that controls its own hardware, software and services, which gives the company the building blocks for product differentiation. This has been a key factor in the company’s long history of product innovation beyond its competitors. We aren’t counting out the ability of major brands such as Apple to innovate further and retain a price premium in emerging markets. Apple is spending a whopping $13 billion this year alone in research and development and non-retail related capital expenditures, and it is hard to imagine that kind of effort will only bear incremental improvements. But if Apple or any of its major competitors cannot come up with something wildly new, it will be hard for them to justify their price premium.

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Investing involves market risk. Investment return and value will fluctuate, and it is possible to lose money by investing.

The views expressed are those of Janus research analysts as of January 2013. They do not necessarily reflect the views of Janus portfolio managers or other persons in Janus’ organization. These views are subject to change at any time based on market and other conditions, and Janus disclaims any responsibility to update such views. No forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of any Janus fund.

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