And Now The Chinese Knockoffs Are Coming To Clobber Apple...

The reason Apple’s stock has been crushed in the past year is that the company’s massive profit margin is collapsing.

In the fourth quarter of 2011, Apple’s operating margin peaked at an astounding 39%. This year in the first quarter, the margin had fallen all the way to 30%.

Despite the hopes of some Apple faithful, this margin decline may be only the beginning.

The reason Apple’s profit margin is collapsing is that the market for high-end smartphones–Apple’s most profitable and important product–has matured.

The growth in the global smartphone industry now is coming from emerging markets like China, India, and Brazil. In these markets, the $600 price tag for a high end smartphone like the iPhone is a non-starter for most buyers, especially because these countries have few carrier subsidies to help reduce the upfront cash outlay for consumers. The companies that are winning huge market share in these markets are those that can sell full-featured smartphones for only $100-$200, versus the current $400-$600 price points for high-end smartphones.

Apple has made clear that it does not want to chase low-price smartphone sales simply to maintain its market share. Apple’s latest ad campaign, for example, says that the company’s goal is not to make “the most” products but to make “the best.” This is exactly the market position Apple has always occupied–the “premium” segment–and it is one that Apple’s fans are proud of.

(Point out to any diehard Apple fan that Apple is losing market share, and he or she will say that that’s just fine: If the hoi polloi really want their Kia and Chevy smartphones, the Apple fan will say, they can have them: The Apple buyers will continue to pay up for and enjoy their BMWs.)

There is little doubt that there will always be a “premium” segment in consumer electronics. And Apple is positioned well to continue to dominate it.

But just because Apple has a strong position in this market segment doesn’t mean that the company will be able to maintain its profit margin, let alone increase it.

Why not?

Because in consumer electronics markets, as opposed to car markets, prices inexorably drop. 

When a consumer electronics company introduces a new gadget that is truly revolutionary and exciting, the company may be able to generate very large profit margins for a while. But, eventually, as the gadget becomes commoditized, and each new generation offers less improvement over the prior generation and cheap knockoffs offer most of the same functionality, this high profit margin usually gets competed away.

That’s what’s happening right now in the global smartphone market.

As Peter Burrows of Bloomberg notes, the average price of a smartphone worldwide has dropped from $450 at the beginning of last year to $375 now, according to IDC. And a new generation of smartphone manufacturers, who don’t have fat per-unit profit margins to protect, are selling smartphones for much less than that.

Chinese manufacturers Huawei and Lenovo are gaining huge market share in China, Burrows reports. And they’re selling smartphones profitably for as little as $100. 

In the United States, where carrier subsidies are well-entrenched, the $400-$600 price points where Apple, Samsung, and other high-end manufacturers sell their phones, are likely sustainable, at least for a while. The gadget price to the consumer in this market is $0-$200, so there’s little or nothing to be gained by opting for a cheaper phone.

But the premium segment of the U.S. market isn’t growing much anymore. And with ever-smaller advantages to owning the latest, greatest version of a gadget (are iPhone 5 owners really going to rush to shell out for the 5S?), upgrade cycles are lengthening.

At some point, moreover, even in the U.S., a carrier or manufacturer (Amazon? A Chinese company?) will likely offer a full-featured smartphone that is not just cheap to buy but also has a cheap monthly data plan. And although this phone won’t likely appeal to the aesthetes who will pay anything for “the best,” it will appeal to a lot of buyers who would otherwise have shelled out for an iPhone. As a result, it will help drive smartphone prices down across the board.

(At $200 for the phone and, say, $150 a month in voice and data charges, a smartphone upgraded every 2 years costs $3,800. That’s a lot of money. And it creates a lot of profit for both the smartphone manufacturer and the carrier. And one company’s profit is another company’s opportunity.)

Apple’s only defence against this inexorable price erosion is to keep rolling out magical new products that people want so desperately that they’re willing to pay a big premium to get them.

As Apple has shown in recent years, however, this is extraordinarily hard to do.

Apple’s profit margin on the iPad and iPad Mini is much lower than it is on the iPhone. (Without the carrier subsidy, the company can’t sell these products at anywhere near the same markup than it can sell the iPhone). As a result, Apple’s overall profit margin is dropping even though these products are mega-hits.

In fact, as Business Insider’s Jay Yarow pointed out earlier this year, Apple’s profit margin on its iPhone was likely a historical anomaly–a once-in-a-lifetime opportunity that is now running its course. And as smartphone become more and more commoditized, Apple’s profit margin could fall a lot more than it already has.

As this chart from Wikinvest shows, over the last four quarters, Apple’s operating profit margin has fallen from 39% to 32%. When one limits one’s historical perspective to this chart, the situation doesn’t look too alarming: Apple’s profit margin has just fallen back to where it was at the end of 2010.

Apple Operating MarginApple’s operating margin for the past 10 quarters.

A longer-term view, however, is more worrisome.

Thanks to the iPhone, Apple’s profit margin is still vastly higher than it has been historically. It is also vastly higher than the profit margin of any other device manufacturer (possibly in history).

Here’s a chart showing Apple’s profit margin going back to 2004. See how low it was back then? See how low it was even in 2009, when the iPhone was already gaining significant traction?

Apple operating margin 2004 to 2012Apple’s operating margin from 2004 to the first quarter of 2013.

Apple’s operating profit margin in 2009 was 22%, a full 10 points below where it is right now. Apple’s profit margin back in 2004, moreover, when it was still primarily an iPod and Mac company, was a pathetic 5%.

And now look how high Apple’s current profit margin is compared to the margins of some other hardware manufacturers, including Dell, Nokia, Sony, and BlackBerry.

The highest profit margin at any of these companies is Sony’s 11%. The margins at Dell, Nokia, and BlackBerry are under 3%.

Apple's operating margin in contextApple’s operating margin (right) compared to Microsoft (left), Sony (SNE), Dell, BlackBerry, and other companies.

Yes, all of these companies are troubled. But only a few years ago, like Apple, they had profit margins and product lines that were the envy of the industry. And they illustrate what can happen in consumer electronics manufacturing when a company ceases to maintain a clear product edge.

Will Apple’s profit margin collapse to the level of BlackBerry, Sony, Nokia, or Dell?

As a shareholder, I certainly hope not.

But to avoid that fate, Apple is going to have to do what it has largely failed to do since the launch of the original iPad: Roll out new product categories that are so dazzling, revolutionary, and popular that, for a few years, at least, they have vast and wildly profitable markets to themselves.

That is the only thing that will allow Apple to maintain its profit margin at the current level while competing in an industry as competitive as this one.

In the meantime, the margins for Apple’s current products are likely to continue to compress. 

SEE ALSO: The Bull Case For Apple

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