The margins of Asian smartphone makers are likely to contract in the medium term amid heightened competition and product commoditisation, says Fitch Ratings. The slowing pace of hardware development, and more manufacturers achieving a threshold level of build quality and functionality, means that the rapid growth of lower-cost smartphone producers will challenge market-leading incumbents and reduce profitability.
The smartphone industry runs the risk of following the cycle seen in PCs, where device-makers' share of the value chain was squeezed by competition and where operating systems and applicationssoftware have become more important to consumers than hardware from a specific manufacturer. The dominance of Microsoft's operating systems and applications enabled this trend in PCs. In smartphones, this trend may be facilitated by the Android operating system and the open environment for third-party application developers. We think that the smartphone market will consolidate in the long term as hardware becomes commoditised. Notably, the PC industry has witnessed significant consolidation as the market matured, and there are now only a handful of PC makers.
Adding to this is the saturation in developed markets. In August 2014, International Data Corporation (IDC) forecast smartphone shipments in emerging markets, where affordability is lower, to grow at a 16.0% CAGR for 2013-2018, but only 3.6% CAGR in developed markets during the same period. Fitch believes that the rapid commoditisation of smartphones may result in the manufacturers focusing increasingly on hardware as a medium for mobile commerce and a distribution channel for software and applications. Apple aims to expand Apple Pay as a mobile payment system, while Amazon is targeting its Fire Phone to drive e-commerce. China-based Xiaomi, which became the third-largest smartphone vendor in 3Q14, is competing with traditional vendors by selling cheap high-spec phones online. But its strategy over the longer-term is to monetise its user base through applications and other services.
As second- and third-tier manufacturers' hardware improves, the product offering of market leaders such as Apple and Samsung will need to lean more heavily on brand and software. Of the “Big Two”, Apple has advantages in both these areas – with a stronger brand, its own operating system, and a stronger ecosystem to link to other consumer products. However, we expect both to lose market share as lower-cost manufacturers have advantages in emerging markets. Without the ability to differentiate their products through software or cutting-edge hardware designs, most smartphone manufacturers will have to compete on brand and price. Fitch expects that Samsung's credit profile will remain solid, given its technology leadership, integrated structure and wider product range.
Apple too is relatively well positioned owing to its strong brand value and ecosystem. Outside the big two, established brands such as LG Electronics, Sony, HTC and Nokia, will face stiffer competition from low-cost Chinese vendors.
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