INSIGHTS BLOG > For Smartphone Profitability, Focus on Software Beats Hardware

A recent NYT article, ‘Why Japan’s Cellphones Haven’t Gone Global” by Hiroko Tabuchi, presents a dichotomy in the Japanese cellphone market: while the technology is extremely advanced, the market has evolved in such a way as to effectively isolate the Japanese market from the rest of the world. This will become increasingly problematic for Japanese suppliers (of both hardware and software/content/services), since the Japanese market is shrinking.

Japanese cellphones are a gadget lover’s dream … [and] even the average person out there will have a superadvanced phone … The Sharp 912SH for Softbank, for example, comes with an LCD screen that swivels 90 degrees, GPS tracking, a bar-code reader, digital TV, credit card functions, video conferencing and a camera and is unlocked by face recognition… In the 1990s, they [Japan] set a standard for the second-generation network that was rejected everywhere else. Carriers created fenced-in Web services … [which] fostered huge e-commerce and content markets within Japan, but they have also increased the country’s isolation from the global market … But now the market is shrinking significantly, hit by a recession and a graying economy…

The article goes on to contrast Japanese smartphones with those in other locales:

Despite their advanced hardware, handsets here [in Japan] often have primitive, clunky interfaces ... Most handsets have no way to easily synchronize data with PCs as the iPhone and other smartphones do … The emphasis on hardware makes even the newest phones here surprisingly bulky. Some analysts say cellphone carriers stifle innovation by demanding so many peripheral hardware functions for phones…

Meanwhile, Japanese developers are jealous of the runaway global popularity of the Apple iPhone and App Store, which have pushed the American and European cellphone industry away from its obsession with hardware specifications to software.

At the same time, a recent WSJ article, “Apple, RIM Outsmart Phone Market” by Sara Silver, described how sales of Apple and RIM smartphones account for a small portion of global handsets sales, but an oversized portion of operating profits.

… iPhone's manufacturer Apple and BlackBerry's Research In Motion … accounted for only 3% of all cellphones sold in the world last year but 35% of operating profits, according to Deutsche Bank analyst Brian Modoff. The disparity will become even starker this year when, he estimates, the two will take 5% of the market in unit terms but 58% of total operating profits.

The article goes on to note that:

The two companies' outsize share of profits underlines the shift in the wireless industry toward feature-rich devices accenting easy-to-use software and away from an emphasis on hardware.

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What is it about the Apple/RIM smartphones that make them so much more profitable than the Japanese and other phones?

Both Japanese and Apple/RIM smartphones provide hardware that is rich in features. However, it is the contrasting nature of the features that is so important.

Japanese hardware features provide benefits to users that do not (necessarily) rely on the joint use of the hardware with supporting apps.

• LCD Screen that swivels 90 degrees
• GPS Tracking
• Bar-Code Reader
• Digital TV
• Credit Card Functions
• Video Conferencing and a Camera
• Unlocking by Face Recognition

In contrast, Apple/RIM hardware features (are designed to) facilitate use of apps

• Widescreen iPod: enhances use of smartphone for watching movies
• Intelligent Keyboard and Cut, Copy & Paste: facilitates typing
• Responds to Motion: enhances gaming experience
• Maps & GPS: enables apps to find anything
• App Stores: easy accessibility to content

Why is this focus on software so much more profitable than a focus on hardware?

Japanese smartphone developers focus on providing a “stand-alone” product. By making hardware features that don’t rely on the use of software, it’s true that they don’t have worry about getting other suppliers to provide a wide variety of content, and they don’t have to share profits associated with bringing their handsets to market with other suppliers. Japanese developers earn profits on their handsets each time they sell a handset to a user. But once a user has purchased a handset, the developers generate no more profits from that user unless or until he buys a new handset.

In contrast, the Apple/RIM model means that handset manufacturers are beholden to third-party suppliers to provide apps for their handsets, and they must share the profits generated by their handsets with the app developers. However, in this software-centric model, handset developers generate profits from users when users buy handsets, and they also generate profits each time a user buys an app. And by creating hardware features that facilitate and/or enhance the use of apps, the handset developers encourage apps developers to supply and users to buy a lot of apps.

This situation is akin to the classic Buy v. Rent model in economics. In economics it’s well-known that it’s generally much more profitable for sellers to rent their products/services to users over the life of the products than it to sell the products outright. That’s why vendors will use subscription/licensing models rather than outright sales of their products and services if and when they can get away with it.