Apple to focus on software growth as Samsung warns of shrinking hardware profits

As Samsung warns investors of the risk of shrinking hardware profits in the future, analysts note that Apple's future potential lies with exponential software growth, something the company has a distant lead in creating and an apparent exclusive in understanding.

A variety of Apple analysts and observers have been struggling to identify the "next innovation" that will propel Apple outward and enable new growth, suggesting everything from wearable computers to HDTVs.

However, Global Equities Research analyst Trip Chowdhry noted in speaking to AppleInsider that Apple's recently outlined changes in reporting its performance highlight the company's unique software solution to an issue facing every other smartphone maker: the increasing problem of turning a hardware profit in what was once an industry where money appeared to grow on trees.

Not only are the majority of smartphone makers currently struggling to turn a minimal profit or actually losing money, but of the two issuing standout profits, Apple and Samsung, the latter has warned investors that its rapid ascent in smartphone hardware profitability may be a short term fluke.

Samsung warns of an end to its growth

According to a report but the Telegraph UK, Samsung warned investors in its latest earnings statement that "the furious growth spurt seen in the global smartphone market last year is expected to be pacified by intensifying price competition, compounded by a slew of new products."

The "crisis of design" that Samsung solved by copying Apple is now morphing into a "crisis of competition." On the software side, Samsung doesn't own its own primary mobile platform as Apple does. Instead Samsung is split between Google's Android, Microsoft's Windows Phone, and its own Bada, a platform it has failed to build into a software ecosystem rivaling Apple's App Store. But Samsung is also facing problems on the hardware side.

Samsung sold more smartphones than Apple in the winter quarter, but the majority of Samsung's sales were low end devices. Less than a third (an estimated 22 million of the 63 million total) of Samsung's smartphone sales were its high end Galaxy S III or Galaxy Note II models. In contrast, all of Apple's 47.8 million iPhones sold were "higher end," fully functional models capable of running the latest version of Apple's operating system.

As a result of Samsung's lower end product mix, the company earned (correction: the article previously overstated Samsung's earnings by citing operating profit, not net profits) $6.5 billion in net income on $52.45 billion in revenues for the quarter, compared to Apple's $13.1 billion in net income on $54.5 billion in revenues. That's means Samsung made less than 50 percent of the profits Apple earned while selling 32 percent more handsets.

Looking ahead, Samsung warned that "In the first quarter, demand for smartphones in developed countries is expected to decelerate, while their emerging counterparts will see their markets escalate with the introduction of more affordable smartphones and a bigger appetite for tablet PCs throughout the year." This indicates that Samsung expects its product mix to drive even further towards the low end, just as it has pushed its PC line downhill with new offerings including its $250 web-only Chromebook.

The report cited Dominic Sunnebo, an analyst with Kantar Worldpanel ComTech, as noting that "In Great Britain," where Samsung enjoys a lead in smartphone shipments, "there is a significant shift to the contract market which exacerbates this [difficulty of finding new subscribers] further as consumers find themselves tied into 24 month contracts. This is an area that carriers and retailers alike are trying to address, with deals providing a discount to consumers wanting to upgrade early, but it remains a difficult line to tread between maintaining driving consumer satisfaction and maintaining margins."

Apple is not warning of a collapse in profits

In contrast, Apple's executives haven't signaled any similarly impending collapse in its smartphone profitability, mirroring the company's decade long success in building premium Mac desktops and notebooks even as the rest of the PC industry has floundered while churning out cheap netbooks and low end desktops.

Instead, Apple's chief financial officer Peter Oppenheimer outlined a variety of changes to how the company will report its results going forward to emphasize where its money is coming from, as most analysts do not seem to understand the company.

"We are reorganizing the presentation of our results to provide greater transparency," Oppenheimer stated, first in establishing "a new operating segment of Greater China" to highlight the "very significant contribution of that region to our overall business" and secondly Apple will be "allocating certain manufacturing cost and variances, including cost related to product tooling and manufacturing process equipment to our operating segments instead of including these expenditures in corporate expenses as we've done in the past."

However, Chowdhry noted that the third change that Oppenheimer outlined is even more significant because it highlights to analysts the importance of something that has the potential to be Apple's fastest growing profit segment: software.

Apple knows software

Chowdhry described many analysts covering Apple as "stuck in the day before yesterday because they are only looking at hardware," and said the findings of those hardware-oriented analysts "have been totally useless because they only look at the supply chain," or how many will units be produced.

Chowdhry's criticism of analysts who only look at how many devices Apple is producing, or what components the company is sourcing, or the orders that are shifting between suppliers, comes after Apple's chief executive Tim Cook lambasted misleading reports published by a series of prominent news organizations that claimed Apple had slashed iPhone component orders in half.

Cook noted, "I would suggest it's good to question the accuracy of any kind of rumor about build plans, and also stress that even if a particular data point were factual, it would be impossible to accurately interpret the data point as to what it meant for our overall business, because the supply chain is very complex and we obviously have multiple sources for things, yields might vary, supplier performance can vary, the beginning inventory positions can vary, I mean, there's just an ordinate long list of things that would make any single data point not a great proxy for what's going on."

Rather than searching for clues in hardware orders, Chowdhry directed attention to Oppenheimer's comments on how Apple would report its software revenues going forward.

"We have realigned a presentation of product information in our summary data schedule to provide greater visibility to revenue by product category," Oppenheimer stated. "Under this new format, revenue from iPhone, iPad, Mac and iPod sales is presented exclusive of related service and accessory revenue."

Essentially, rather than grouping Mac, iPhone and iPad hardware with software, service and accessory revenue, Apple will now break out hardware and software sales separately. This means two things, Chowdhry said. Firstly, that Apple would continue phasing out shrink wrapped software sales from its retail stores, relegating software sales to the Mac and iOS App Stores. That will not only free up retail shelf space, but will consolidate software sales online, using Apple's iCloud infrastructure for easy access. Apple is expanding its data centers and iCloud infrastructure to accommodate this shift.

More importantly, by outlining software sales separately, Apple will emphasize its clear advantage in attaching software profits to its hardware sales. The company already makes more money for every Mac, iPhone and iPad sold than its PC, smartphone and tablet competitors. Now analysts will see a clear detail of that extra software segment revenue that other PC, smartphone and tablet vendors aren't earning at all.

Apple earns software revenues both as a retailer of third party titles in iTunes, as well as in selling its own first party titles, including iMove, Garage Band, Pages, Numbers and Keynote, all of which are among the most popular titles for the world's most profitable mobile software platform.

Selling software is not a new exercise for Apple. In 1979, John Couch, the soon-to-be head of Apple's Lisa project, was in charge of all software at Apple Computer. He commissioned the poster "Software Sells Systems" to emphasize the importance of software.

After a disastrous period in the 1980s and 1990s during which Apple ceded the software market to third parties, the importance of first party and third party software was nearly forgotten. Apple's iWork, iLife and Pro Apps, along with the development of other titles such as Safari, helped reestablish Mac OS X as a platform, while Apple's App Store curated what quickly became the world's largest mobile software library.

The Android, Windows Phone software crisis

Over the last five years, Apple's iOS defeated the well established positions of Nokia's Symbian, RIM's BlackBerry, Microsoft's Windows Mobile and Palm in large part due to having exceptional software, and a platform that was easy to develop for and profitable to for developers.

Google copied many of the usability aspects of the iPhone for Android, but has been wholly unable to launch a profitable, healthy software ecosystem, in large part because Google is focused upon web apps and advertising monetization. Google has only ported a variety of its web service apps to mobile platforms. It hasn't created new desktop style productivity apps for Android; certainly nothing on the order of Apple's iLife or iWork suites. Nor have third parties enthusiastically adopted Android as a place to create unique, original titles.

Windows Phone entered the market so late that it was forced to compete against Apple's mature iOS platform with a library of hundreds of thousands of titles. Faced with such a daunting challenge, Microsoft emphasized its integrated first party software, even going so far to suggest that having apps was a complication to getting things done.

Only Apple and Android really have a critical mass of users, but Apple's cohesive market for mobile and tablet apps, tied to a single, successful and very visible App Store, means that only Apple is earning significant software revenues from mobile users.

Apple's software opportunity

With an installed base of around 400 million users, Apple is now selling 4-8 apps per month to users who "don't even think about buying 99 cent titles" Chowdhry said. That results in software revenues around $300 million per month, and future sales will grow exponentially, just as iTunes media sales have enjoyed compounded growth as its users shop the App Store via recommendations.

The "new Apple," Chowdhry notes, "is not about new hardware. it's about software attach rates." Analysts tracking Apple's revenues will need to consider download volumes, the frequency of sales, and in app purchases. "Existing Apple analysts, if they don't come from a software background, will be missing a key ingredient," Chowdhry said.

Apple's software revenues appear set to enjoy compounded growth of 30 percent over each of the next five years Chowdhry stated. In the US, iPhone users already spend $80 on average over the life of their phone, a significant addition to the hardware profit Apple earns on the original sale.

While Amazon has promised its investors the potential of earning software profits on its largely unprofitable Kindle hardware, Apple is already earning strong profits on both hardware and software, and it set to rapidly expand its software earnings even as hardware-oriented competitors like Samsung face more challenges in turning a device profit.

Chowdhry compared Apple's future with that of IBM, which sold mainframes to a finite audience of customers, but then continued to make increasing profits on the sale of software, services and customization.