Apple will lose the smartphone war: it’s time to sell

Apple has won the latest battle in the smartphone war.

A Californian court has ordered Samsung to pay Apple $1.05bn for infringing some of its patents.

A lot of people think this decision is a big win for Apple. Some think it gives the company a big advantage over Samsung – its biggest rival in the lucrative handset market.

Others think the ruling could be even more significant. They think that the real loser is Google. Stopping Samsung in its tracks will slow down the growth of Google’s Android operating system.

But we’re not convinced. In fact, far from being good for Apple, last Friday’s events may have revealed its Achilles’ heel – it’s simply too dependent on the iPhone.

Here’s why that could be a serious problem for the company – and its shareholders…

Just how strong is Apple’s moat?

There are many strategies you can use to make money out of stocks. But one of the most popular, used by longer-term investors such as Warren Buffett, is to invest in great companies and compound their returns (by reinvesting profits or dividends) over a long period of time to make money.

So how do you find a ‘great’ company? People like Buffett look for one characteristic above everything else. It’s called a ‘moat’. In plain English, this means you are looking for companies that can do things that others can’t copy.

If other companies can’t do what you do, it’s hard for them to take your customers off you. This allows you to make big profits.

So how strong is Apple’s moat? On the face of it, pretty strong – for now. As I wrote last week, Apple has a return on investment of nearly 300%.

How can it do this? It’s quite simple – it charges people a lot of money to buy its products. Apparently the gross margin (the selling price less the cost of making each phone) on iPhone sales in the US is a whopping 58%. So by selling each iPhone for $650, Apple makes $377.

It’s little wonder that Samsung and other companies want to take a share of this lucrative market. And little wonder that Apple is so desperate to stop them.

At the moment, it can sell these phones for more than twice what they cost to make. It can do this because lots of consumers think they are a ‘must have’ product. Indeed, during the first half of its financial year, iPhone sales accounted for over half of Apple’s total sales and a big chunk of its profits.

The trouble is, this leaves Apple very dependent on the iPhone. It means that each new version of the smartphone has to be much better than the last one to keep customers upgrading. A lot rests on the imminent release of the iPhone 5.

If customers start to be tempted by other smartphones, and Apple has to slash prices as a result, then it – and its shareholders – will have a big problem.

Seen in that light, Friday’s court ruling has hardly made Apple stronger. It may have scored a brief victory in the smartphone wars, but sooner or later, the danger is that competition and consumers will force down prices.

Even if Samsung fails to overturn the ruling, it only applies to the US market in any case. And it doesn’t even apply to Samsung’s latest popular model – the Galaxy SIII.

Apple’s moat is looking leaky

Apple’s problem is that together, Samsung and Google’s Android operating system allow people to buy phones that do a lot of what the iPhone does for a lot less.

In Asia for example, lots of people can’t afford iPhones. But mobile phone makers can use Android to give them cheap smartphones. This is why the Android operating system is on 60% of the world’s smartphones right now.

And other phones increasingly have features that make them more attractive than the iPhone in their own right. Samsung and HTC make phones with bigger screens and replacement batteries. They don’t tie customers into their software either (unlike iTunes). Throw in the fact that these phones are cheaper than the iPhone, and it looks like Apple’s moat has lots of leaks.

Google is a better bet than Apple

The real lesson for investors from the Apple-Samsung battle is this: companies are only as strong as their moats. Apple’s use of litigation to protect its moat is a sign of weakness, not strength. The over-reliance on the iPhone as a source of profits shows the fragility of Apple’s business model.

So who genuinely has the strongest moat in the world of smartphones, tablets and the internet? I’d say it’s Google – and Apple knows this. Google effectively owns the internet and the source of its profits – advertising revenue. This income is a lot more resilient than trying to sell consumer electronics products at high prices.

Giving away Android to mobile phone operators strengthens this position, which is why Apple wants to stop it in its tracks by the back door. Apple is trying to move away from Google by removing YouTube and Google Maps from its operating software.

But can it do without Google search? More importantly, can Apple keep charging high prices to tie people to its products? We don’t think it can. That’s why it may be time to sell Apple shares and buy Google (Nasdaq: GOOG) instead.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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