The Big Problem With Samsung's Galaxy S5

The Samsung Galaxy S5 is a fantastic phone according to the critics. It offers a superb camera, fast processor, great screen, and an improved software stack over the prior-generation Galaxy S4. Heck, there are even reports that this phone is dramatically outselling its predecessor at the same point in the initial ramp. That being said, despite the positive press the phone has been getting lately, people are missing the Big Problem with the Next Big Thing.

Higher cost structure + lower selling price = profit fail
It doesn't take a genius to know that the Galaxy S5 has a materially higher cost structure than the Galaxy S4 that came before it. A larger screen, a faster processor, fingerprint sensor, and more goodies don't come cheaply. According to IHS iSuppli, the bill of materials for the S5 adds up to $256. This represents a $20 increase over last year's Galaxy S4, which reportedly cost $236 to build.

A $20 hit to gross profit isn't all that terrible until you realize that Samsung is offering these phones at a reduced price relative to their predecessor at launch. Indeed, it looks as though while the Galaxy S4 cost $700-$800 at launch for the 16GB/32GB models, the S5 costs between $600 and $700. This means that Samsung is effectively taking a $120 gross margin dollar per unit hit.

Some profitability puts and takes
While the gross profit per unit picture isn't particularly pretty, Samsung does have something nice working for it: a toned-down marketing/advertising budget. With the Samsung brand firmly established as the No. 1 Android player, and with the company's already-extremely high market share, the marketing theatrics that were employed with previous-generation Galaxy S products appear to be no longer needed.

Depending on how much Samsung can save on the operating expenses, the company may not have to sell the roughly 17% higher units to compensate for the 14% drop in gross profit per unit to stay at gross profit neutral. Further, even if the highest-end Galaxy S line sees a decline in gross profit taken as a whole, the Samsung brand will still trickle down, which could drive sales of lower-cost handsets on the basis of the "halo effect."

Apple's big iPhone looms
So Samsung is now likely to see gross margin pressure at the high end of the smartphone space, but it could end up seeing market share pressure from a larger iPhone from Apple come September. While Samsung's brand is powerful and the Android ecosystem is quite robust, there is probably a fairly large subset of Samsung's customer base that would love to move back to iOS if only the iPhone were offered in a larger screen size.

Indeed, with a 4.7-inch iPhone 6 apparently on tap for September and a 5.5-inch model apparently slated for the end of the year (probably launched with the new iPads/Macs), Apple could take meaningful share from Samsung at the high end. Of course, nothing is guaranteed, but this assumption is predicated on an iPad Mini-like effect, where Apple took pretty significant share of the "small" tablet market fairly quickly once it had a product in the market.

Samsung's profitability could come under significant pressure
With the race in handsets becoming fiercer, driving higher bill of materials in order to differentiate and compete, the gross margins of these phones are likely to continue to come down for all players. Samsung has a structural advantage in that it sources most of the critical components in-house, but that doesn't mean that other players can't do some damage to Samsung's gross margins. Indeed, the higher bill of materials and the lower selling price are signs of things to come for Samsung and the rest of the Android players. Can Apple avoid the same fate? We'll see come the iPhone 6.

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Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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