How will Google's attempt to devalue hardware hurt Apple?

With Google’s recent release of the updated Nexus 7 tablet at $229, a lot of comparisons have been made between it and other low priced tablets on the market. It sure seems like Google wants to put pressure on vendors to offer solid specs with affordable price tags for consumers. After all, this helps sell more devices, and that increases the potential market for Google services, which is where the search giant makes its profit. This isn't dissimilar to how the race-to-the-bottom in App Store pricing has commoditized software, which benefits Apple's hardware-centric revenue model. But it does prompt the question, will it force down prices, or catalyze a price war, such that nobody really makes any money on hardware? And if so, what will become of Apple's business model?

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I’ll be the first to admit I can’t predict the future, but for right now, I’m mildly concerned that Google is making it hard for other to earn a buck. That said, I don’t see this destroying Apple. Instead, it could push the Cupertino computing giant towards gross margins on products that Wall Street thinks are more sustainable.

It is well understood that iPhone margins are closer to 60% while iPad margins are more in the 30% range. On a $499 full-sized tablet that works out to $150 of gross profit, and I think it’s quite reasonable to assume that a $329 iPad mini has gross margin dollars of $100 or less. Compare this to a $229 Nexus 7, which probably has gross profit dollars of zero. Or compare this to the Amazon Kindle Fire HD, priced at $199, which probably also has gross profit of about zero.

Jeff Bezos has been incredibly clear about his company’s goal to make money when people use the tablet instead of when they buy the tablet. Google’s strategy is pretty much the same. (Again, Apple has stated the same strategy when it comes to iTunes - to operate it at just above break-even.)

If Google and Amazon are selling tablets at close to break even, doesn’t this practically guarantee that Samsung’s Galaxy Tab 3 7.0 ($199 for 8 GB) isn’t very profitable either? The difference here is that Samsung needs to make money from selling hardware ... just like Apple.

Assuming I’m right in saying that all of the major Android tablet vendors are not making money on their 7-inch tablets, then Apple is the only tablet vendor that makes any significant profit. Even then, Apple’s gross profit contribution from iPad sales is down from the days prior to the existence of the iPad mini. I think we all realize Apple makes a decent profit on its low priced $329 tablet, but it pales in comparison to the full sized iPad.

Can Apple maintain it’s price differential on tablets? I think they can. It’s looking like the iPad is about $100 more than a similar-sized Nexus tablet ($229 vs. $329 and $399 vs. $499). The world is full of examples where people pay more based on perceived value, and user experience. I think Apple has created more compelling user experience for the average customer, and much more so for Mac customers. Please understand I’m not saying the iPad is better. I’m saying it’s a cleaner, easier experience for most consumers. The iPad also has a much better tablet-optimized app selection compared to the Google Play store, although Google’s store caught up with smartphone form factors, so it seems reasonable to assume they’ll catch up eventually on tablet form factor apps too.

Either way, I think Google has created a situation where Apple’s tablet margins are lower than they might otherwise be. But at the same time, I think these lower prices are causing enormous growth in the market. And that’s good for Apple, especially if they can achieve solid penetration into markets like education, healthcare, or other verticals where a tablet form factor helps automate processes, reduce error, eliminate paper, speed up business, etc.

So that’s tablets. But what about smartphones? Truth be told, that’s where I’m more worried. What’s stopping Google from causing the same damage to Apple’s smartphone margins? They already have the Nexus 4 at $349 (for 16 GB), which is much, much cheaper than an off-contract iPhone 5.

This hasn’t affected Apple’s pricing much yet, but I think that’s mainly because of carrier subsidies in developed markets (where the iPhone is so successful). The simple truth is that Apple’s carrier partners make awesome money attaching voice and data plans to smartphones. As long as customers are clamoring for the iPhone, and the current pricing lends itself for decent carrier profits, Apple can probably maintain its pricing.

But what if Google were to offer something like the Nexus 4 through carriers? I’m not saying they will. But if they did, it would put pressure on Samsung and Apple to drop prices. I suspect some Apple premium would still hold, but it wouldn’t fetch Apple 60% gross margins. Maybe margins on the iPhone would drop to 30%.

Long term, there is nothing wrong with earning 30% on a decent chunk of the smartphone market. In fact, at lower prices, Apple could probably compete much more effectively in more countries. Maybe those are two of the factors that have Apple, according to rumors, considering a less-expensive "iPhone 5c".

I think Apple has to be planning for continued pressure on smartphones, and it makes perfect sense for them to launch a lower cost iPhone in the near term. The smartphone segment is really the only major product line Apple has where pricing options are a function of device generation rather than feature spectrum. I think we all know that has to change.

The big question - what happens to Apple’s profitability? Does it shrink? Stay the same? Can it actually grow based on higher potential sales volume around the world?

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