Commoditization, the steady erosion of value in higher-priced products, is banging furiously on doors at electronics OEMs. This holiday season, we'll see how well these companies can successfully stave off the scourge.
Interestingly, product and technology innovation -- the same weapon OEMs rely upon to help secure high profit margins -- is also partly responsible for price declines. Not even Apple Inc. (Nasdaq: AAPL) is immune to the problem of value erosion. In fact, Apple's business strategy is based on finding new ways to keep customers engaged, primarily with design-oriented updates to its products. Next-generation iPhones and iPods, for instance, often involve aesthetic improvements and software add-ons meant to create the impression of significant technological advances.
Staying ahead of the commoditization curve is certainly a priority for Apple executives. The company made this clear in its latest annual filing with the US Securities and Exchange Commission. Here's how Apple puts it:
The company's products and services compete in highly competitive global markets characterized by aggressive price cutting, with resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers.
How should an OEM respond to these demanding market conditions? Apple said it has "to ensure a continuing and timely introduction of innovative new products and technologies to the marketplace." That strategy has worked brilliantly so far, but competitors are nipping at Apple's heels and in most cases using the same technique to increase their market shares, as Apple noted in the SEC filing:
By contrast, many of the company's competitors seek to compete primarily through aggressive pricing and very low cost structures. Additionally, the company faces significant price competition as competitors reduce their selling prices and attempt to imitate the Company's product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer.
Recently, even Apple has had to cave in to the pricing pressure in a bid to keep market share in the smartphone market. As competitors crowd into the smartphone segment with a wide range of offerings, Apple is coming under pressure to also be a player in the low end of the market; the company is now selling the older version of its smartphone, the iPhone 3G, at a giveaway price while churning out higher-margin products like the iPhone 4S for its richer customers.
While news reports often focus on surging demand for the iPhone 4S the reality is that, even as customers in China wait anxiously for it, demand is even higher for Android-based devices, many of them selling at a heavy discount to the Apple product. Apple has therefore authorized AT&T Inc. (NYSE: T) to offer the iPhone 3GS free to subscribers in the US so it could play in the lower-end of the smartphone market.
This development masks the unpleasant truth that the process of innovation also holds the kernel of commoditization; that is, pricing for high-end products tends to decline within months of release, throttling margins and forcing companies to accelerate the update process. It's a vicious circle -- in order to stay ahead of pricing erosion, companies must introduce new products, a process that in itself further drives down prices in most cases.
Where does globalization come in? As more people around the world seek to get connected to the Web, pricing is sliding, too. While consumers in the West queue up to pay hundreds of dollars for the new iPhone 4S, for instance, consumers in other parts of the world can't imagine paying anything close to this. So, OEMs and researchers in poor countries are developing stripped down PCs, smartphones, and tablets that perform essentially the same functions.
These products, including the Aakash tablet PC developed by Indian technologies, lack the brand name or proprietary software of companies like Apple, Google, or Samsung. They use basic components offered by many of China's equally less known suppliers, driving pricing down to a point where some of the poorest people in a country like India can afford the same products available to Western buyers. For an interesting take on this phenomenon, see "The Last Person," an article by Thomas Friedman in The New York Times.
Someday, many buyers will find the Aakash tablet or another similarly cheaper device appealing, lured perhaps purely by the pricing but, who knows, perhaps by the functionalities, too.