Apple: Soon To Face Severe Margin Compression

Apple (AAPL) and Samsung (SSNLF.PK) are about to enter the abyss of price and margin contraction of smartphones and tablets.

The Nexus 4 is, perhaps, the beginning volley of the price war that ultimately ends high profit margins for Apple and Samsung smartphones forever. The Nexus 4 is a capable competitor to the iPhone 5. Offered by Google (GOOG) at a an unlocked price of $299, this product is only the beginning of a serious migraine for Apple and Samsung. There are already capable tablets from Amazon (AMZN) and Google available for little more than the cost of manufacture.

Previous price wars in the consumer electronics business have been brutal. This one promises to be brutal++.

There is always price attrition in high technology consumer products once the feature set and functions become universal and uniform in usability among the various device suppliers.

Shocking price attrition on electronic products has never been averted in the past. Four function calculators cost $249 40 years ago, five years later they were $5.

PCs cost $5000 in the 1980s. Today they are literally thousands of times more capable and sell for $500.

The same thing has happened to flat screen televisions and VCRs, and DVDs, video games and every other consumer electronic device that I can think of.

Voice only cell phones (called cellular radios, back then) started out at $4500 in the 1980s. I know, I bought five of them. Voice only phones are now infinitely better and are free. Well, sort of free. They still cost the service provider some small amount, but they are truly free to the consumer.

It is now the time that smart phones will enter the Black Hole of price cutting phase in their life cycle.

As though the accepted brutality of technology price declines isn't bad enough, the smartphone (and tablet) price wars will be even worse. Led by companies like Google and Amazon (AMZN), whose very business models are dependent on control of the mobile devices, and absolutely don't need earnings from the devices themselves, this price war could be over by next summer.

Google can't leave their business fortunes in the hands of Apple and Samsung because they can cut off the Google "click" revenue by using another default search engine, to the detriment of Google. Even AT&T (T) or Verizon (VZ) could "sell out" to Microsoft (MSFT) Bing or Yahoo (YHOO).

The affect of this price decline will be most evident on Apple, since Apple is a near pure play on smart phones and tablets. What happens to Apple earnings in an all-out smart phone and tablet price war?

The Apple iPhone costs about $200 to manufacture. It has an unlocked price to the consumer of over $600, for a 66% gross margin. The Apple corporate gross margin for the most recent quarter was 40%, so the iPad and some iPods must have lower gross margin than the iPhone.

Below is a table with the actual Apple earnings for the third quarter with three gross margin columns, 40%, 20%, and 10% to analyze the affect of the margin squeeze on Apple.

This is how the impending price war decimates Apple.

The final price attrition to near zero gross margin has to happen to smart phones. It has never not happened to a semiconductor intensive consumer electronic device.

My speculation is that Intel (INTC) has figured out that Google will win ("win" is a relative term here) the final price war and will supply the vast majority of smart phones in the future. Through the Intel/Google cooperative agreement, Intel could be cooking up the ultimate smartphone-on-a-chip for the ultimate winner, Google. The Intel/Motorola agreement seems redundant in view of the Google purchase of Motorola Mobility, but it does indicate that Motorola, Google and Intel are in deep cooperation.