This is why we can’t have nice things

Recently, a friend of ours at the Haas School of Business asked us to review a case study he was preparing to analyze the poor level of profits that handset makers suffer. As we worked through the analysis it became clear that this situation underpins the scary world we live in, where our devices and apps spy on us. Surveillance Capitalism, the for-profit sale of consumer tracking data, is a concept that should be familiar to most of our readers, and one that is of growing awareness among the general public. There is even a book on the subject now.

Put simply, only one handset maker sells its phones for a profit – Apple (of course). The last time we ran the numbers, Apple captured more than 100% of the smartphone industry’s profits, meaning in aggregate everyone else is losing money. Samsung’s and Xiaomi’s phones are somewhat profitable, but no one else is really doing that well, especially if you factor in all the fixed costs associated with the business (big engineering and design teams, for instance).

As we noted recently, it has gotten very hard to do this analysis as almost no one is reporting unit volumes anymore, and very few companies break out the profitability of their handset businesses. This lack of visibility is likely further evidence of the businesses’ poor profits. If these companies were raking in the cash, they would likely let the world know.

History is a guide here. Twenty years ago, the PC makers faced the same problem. Post the .com Bubble, their profits started to erode quickly. The volume players won out, but even they faced very tight margins. Constrained by their software dependence on Microsoft, and processor dependence on Intel, they had few ways to differentiate their products, and profits consequently dwindled. These companies faced $0 margins on their products. For a long time, the PC makers generated most of their profits through license payments they garnered from bundling software into their hardware. New users would find their PCs pre-loaded with ISP, Security and other lead-generating ads masquerading as applications. This became known as bloatware for its intrusive pop-up notifications and memory-reducing, processor-consuming background operations.

Something very similar is happening with smartphones today. Companies are bundling all sorts of applications into phones. These are intended to drive consumers to outside services or to grow the handset makers’ own services. Some of these are useful, many of them offer very low consumer conversion rates, but a few are downright malicious spying on users.

A decade ago, we spoke with a small handset maker in Shenzhen who sold into China’s domestic market and a half dozen random emerging markets (Ukraine, El Salvador, Uruguay, etc.). His business was always cutthroat, shipping largely $25 feature phones and $100 smartphones. Unfortunately, he did not have enough resources to be able to build his own brand. (He tried, over the years we brought him a dozen marketing text books.) At one point, he tried offering his own software service – messaging, contacts, etc. But he knew that the only path to revenue for these was through selling customer data to ad brokers and others. He told us that his customers would not mind because many of them lived in markets where the government already intruded on users’ privacy in many ways. To his credit, he was very uncomfortable with this business model and did not pursue it. He went out of business five years ago.

Some companies have managed to thrive despite this. For instance, Xiaomi makes decent margins on their phones and is overall profitable (and to their credit still breaks out their unit shipments). Xiamoi had the funds to build their own brand, and to branch out into an ecosystem of related products (home networking, fitness bands, etc.). We do not know if Xiaomi sells its users’ data, but they do install a lot of their own software on phones, trying to build an Apple-like software ecosystem lock-in.

Another way to profit in this business is to bundle phone sales with other products. For example, they can sell base stations and networking products with phones thrown in as an adder, as in “would you like fries phones with that?”. That being said, we do not know if Huawei’s handset business is actually profitable. We are not convinced that Huawei itself knows the answer to this question. Our point is just that there are someways to stay in the business.

However, for the majority of the industry, the hard, cold reality is that handset profits are non-existent. And the only way for these companies to remain viable is to sell out their users. The foundations of Surveillance Capitalism are built on this. And the only way out of this is to change the underlying economics of handsets. It is not clear how that would come about. Certainly, the rise in phone prices seen in recent years may help. But those phones are only viable for a small segment of the population.