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Amazon Is Sucking the Profit Out of iPads — Are iPhones Next?

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Editor's note: This column originally appeared on Business Insider

Consumers around the world rejoice:

Free-market capitalism is working the way it's supposed to.

For the past five years, one company, Apple (AAPL), has been making positively colossal profits on smartphones and tablets, while pretty much every other company in the industry struggles or goes bust.

That's not the way it's supposed to work.

The way it's supposed to work is that tough competition keeps outsize profits in check: Competitors drool at the amount of money the market leader is making, invest heavily to catch up, and then sell the resulting products for lower prices than the leader. And, in so doing, they siphon off some profits and keep the market leader's growth (and consumer prices) in check.

For the last five years, however, Apple has done something that heretofore has been extraordinarily hard to do in the hardware industry: Built a near-monopoly on industry profits in smartphones and tablets.

Apple has done this by:

1) maintaining a huge lead over the rest of the industry in terms of product quality and features, and

2) building a "platform" ecosystem around its devices, thus developing network-effects (and switching costs) that hardware manufacturers rarely enjoy.

At the same time, Apple has gotten so efficient in its manufacturing processes that it has been able to become both the premium-product supplier and the low-cost producer. And this combination has enabled Apple to become the most profitable and valuable company in the world.

But, finally, some other companies are mounting a serious challenge to Apple's dominance. And, in so doing, they're increasing the likelihood that Apple's astounding profit margin will eventually decline.

In smartphones, for example, which account for a staggering ~60% of Apple's total profit, Samsung has finally developed a product that has caught up to Apple's iPhone (the Galaxy S III). Apple's newest iPhone, which will be announced next week, will likely lead to a renewed burst of sales and enthusiasm, but Samsung and Apple are now leapfrogging each other with each release, so consumers finally have a real choice. Some of them will choose Samsung, or another Android phone manufacturer, and this should continue to cut into Apple's profit growth.

In tablets, meanwhile, Apple is suddenly under assault from two companies that have distinctly different business models than Apple and other hardware manufacturers: Amazon (AMZN) and Google (GOOG).

Neither Amazon nor Google ever need to make any money on gadget sales, because they make their money elsewhere: Google in search and Amazon in content and commerce sales. If the two companies can produce products that are competitive with Apple's--not better, just competitive--this should allow them to sell those products at much cheaper prices than Apple. And that's certainly what we've seen in the last few product releases.

Google is now offering a "mini-tablet," the Nexus 7, for $199.

Yesterday, Amazon announced that it will sell a similar tablet, the Kindle Fire HD, for $199.

Amazon also announced that it will sell a larger tablet, one that is close to the low-end iPad (iPad 2) in size and specs, for $299, which is $100 cheaper than the iPad 2. Both of these tablets could put pressure on iPad sales.

For many tablet users, the $199 Kindle or Nexus will be a more attractive option than the $399 iPad. (Think of families with children, for example. Given the risk that a kid will drop, lose, or otherwise break their tablet, the $199 price point is an easier decision than the $399 price point).

Apple is expected to introduce an "iPad Mini" next week, which will compete directly with the Kindle and Nexus, but it seems unlikely that this device will sell well if it is priced at, say, $299 (only $100 cheaper than the full-sized iPad). And if the iPad Mini is priced at less than $299, it's tough to see how Apple will make much profit on it.

The bottom line is that consumers will now have a full range of attractive options in the tablet market, many of which are priced well below Apple's premium tablets. This is a big change from two years ago, when the only tablet competition came in form of tablets that were both worse than the iPad AND more expensive.

This suggests that Apple's profit margins in tablets, which are already considerably lower than its profits in smartphones, will decline further from here.

And how about smartphones?

The iPhone appears to be the most profitable product in the world, generating a mind-blowing ~40% profit margin and dropping a staggering ~$30 billion to Apple's bottom line this year.

Are the iPhone's profits safe?

No, they're not safe. No profits are ever safe. Especially in an industry as competitive as this one.

The rise of Samsung has already led to consumers having a real choice in the premium smartphone market, and the Google-Motorola combination should ultimately lead to more such choices. This alone should allow other companies to capture profit that might otherwise have gone to Apple.

But...

The smartphone market is protected by something that is not a factor in the tablet market: carrier subsidies.

Specifically, in exchange for a consumer agreeing to pay a wireless company $100+ a month for two years, the wireless company pays ~$400 of the ~$600 cost of a premium smartphone.

This subsidy means that the cost of the phone to the consumer is only $200, which is a much easier price-point for most consumers to stomach than $600, especially for a device that they will use for several hours a day for two years.

The $200 price-point in the premium smartphone market is inherently more defensible than the $500 price point in tablets. (When you're going to be shelling out $100+ a month regardless, spending an additional $200 over two years to get the phone you want seems sensible, not extravagant).

So far, in premium smartphones, no one has yet offered a radically lower price option.

But that day may not be far away.

Especially when one considers the total cost of ownership of a smartphone--not just the gadget price.

One of the less-noticed details in Amazon's latest Kindle announcements was the company's decision to offer a cheap wireless data package with some of its Kindles. In doing so, Amazon buys wireless access wholesale from carriers, then packages it up and resells it to consumers.

Given the declining importance of traditional "phone" service in smartphones, it seems reasonable to think that at some point soon someone--Amazon, perhaps--will offer a premium smartphone that, all in, is radically cheaper than current options.

Assuming a $100-a-month contract for two years, a high-end iPhone currently costs U.S. consumers $2,600.

So, imagine a couple of different options that Amazon might offer if it were willing to sacrifice the ~$250 of profit that Apple makes for each phone and/or some services that are declining in importance (namely, traditional voice calls):

  • A free premium smartphone with the normal carrier subsidy and contract (The carrier would pay Amazon $400, and the consumer wouldn't pay anything), or
  • A $100 premium smartphone with a flat $40-a-month unlimited data plan--or less for Amazon Prime members. This phone would be cheaper for consumers up front and radically cheaper over the course of the two years. All-in, the phone would cost ~$1,000 over the two years, versus the $2,600 of today's high-end iPhone. It would not support traditional voice calling, but several new apps and options already allow smartphone and tablet users to use their gadgets as phones without having a traditional carrier contract. So the voice option wouldn't disappear.

Amazon hasn't announced a smartphone yet, but industry reports say it is working on one. And given the company's pricing strategy in tablets--and CEO Jeff Bezos's comments yesterday that the company wants to make money from services, not hardware--a pricing strategy like this would make a lot of sense.

Unlike Google, which has no natural physical distribution channel, Amazon also has the ability to effectively market and distribute its tablets and smartphones. It doesn't need carriers to do this, the way other hardware manufacturers do. This means that Amazon would likely be able to compete more effectively with Apple, especially if it offered a radically cheaper option.

Bottom line, the biggest risk to Apple still appears to be the company's staggeringly huge profit margin, which has gone nowhere but up over the last five years.

The enormous amount of money Apple brings in on each gadget sale has left an opening for competitors like Amazon and Google to take a radically different approach. If Amazon, especially, is successful, this could significantly threaten Apple's profit margin.

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