In June I wrote a post about the dilemma Android smartphone manufacturers face. I said:

What the incumbents that went into bed with Google did not realize is that Google does not care about their profits. They only care about getting as many Android phones into as many consumer hands as possible. While the manufacturers earn their money by selling phones, Google earns it from the use of the very same phones. And as suddenly all manufacturers are selling phones with the same software on it – the only remaining differentiator is price. And so with more and more manufacturers joining the fray the average selling prices of Android phones fell off a cliff. And that is precisely what Google wanted – competition on price. This allows consumers to get Android phones almost for free and again increases Android’s platform share compared to iOS. More users on Google’s platform – more revenue for Google. That puts a lot of pressure on the ASPs and profit margins of the manufacturers – hey that is competition.

I think we are beginning to see this effect on the results and forecasts of some of those smartphone manufacturers. Today HTC announced a cut to its forecast for the fourth quarter revenue estimates by 25%. I repeat – by 25%! That is a lot I think. I took a quick look at the numbers of HTC and built two charts. The first one is HTCs quarterly revenue and Gross Profit.

What you can see in the chart is the divergence of Sales from Gross Profit which means that while over time HTC is selling more phones it is doing so at the cost of lower profit per phone. I did not dive too deep into this but I think the reason for the lower profit per phone is a simple economics one. To sell more phones in a market where HTCs product is not that well differentiated and the supply of Android phones is exploding you can really only compete on price. With that in mind I present the second chart – HTCs gross margin evolution.

I know that this is just a rehash of the previous chart but it illustrates how basic economics work. When the market for any product becomes highly competitive and has little differentiated competitors the pressure on the markets profitability increases. This was my prediction from June and why I said that Nokia has better chances with Microsofts Windows Phone 7. Rest assured if WP7 would spread the same way Android did the same would occur with the manufacturers of WP7 phones. For now though great WP7 phones are scarce and there is a window of opportunity for manufacturers to get a piece of the early profitable pie.

A similar problem that results from this is sales. While you can keep your sales growing by lowering prices you will not be able to win a price race to the bottom. Eventually your prices will be low and your sales we still fall because of over supply. That is what I think we are seeing in HTCs sales forecast cut. Not only did Apple release the iPhone 4S but more direct competitors like Samsung, LG and Motorola are releasing more and more new phones putting pressure on everyones sales numbers.

In conclusion one can see why Apple keeps its software tight and tries to do its own thing. While they may loose market share to the onslaught of millions of Android phones their margins seem to be protected. They simply have a better answer to the question why you should buy an iPhone over an Android phone than price – It is simply different.

Note1: I will try to do a similar post on Apple’s margins just to show the difference.
Note2: For HTC’s 2011 Q4 Revenue I used their forecast of about 104 million and the margin of the previous quarter.