Apple: Can a Leopard Change its Spots?

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November 19, 2012

Apple: Can a Leopard Change its Spots?

  • Apple is at a crossroads. After dominating the first decade of the millennium, the revolution that Apple started is shifting against it. The iPhone, with its single annual update and super premium price, has been run down from behind by a pack of rivals with segmented product ranges, 6 month product cycles and aggressive price points. Android phones now outsell Apple 5 to 1, and the iPad is on the same path, exacerbated by rivals willing to subsidize device sales in pursuit of e-commerce and advertising. At the same time, the nexus of the user experience is shifting off of the device and into the cloud, greatly disadvantaging Apple vs. its web-savvy rivals. Apple is moving to address these challenges by expanding its product line, accelerating its refresh cycles, integrating cloud-based apps and investing it its data centers, but these moves have led to uncharacteristic missteps – e.g. Maps -, will pressure margins, and require skills, assets and strategies beyond the company’s traditional DNA. The degree of difficulty for Tim Cook is very high and investors are likely underestimating the company’s long term vulnerability, even if current valuations are cheap relative to Apple’s near term growth and earnings power.
  • Apple caused a paradigm shift and reaped a windfall, but now faces strategic challenges that will require changing the company DNA. The wildly innovative iPhone revolutionized the way that consumers access and use the internet, bringing Apple extraordinary growth and margins, and making it the most valuable company on Earth. However, the sea change is shifting the opportunity from devices to cloud-based services, exposing Apple’s biggest weaknesses to its rivals’ greatest strengths. Winning will require substantial changes to the company’s product strategy, institutional skills, physical infrastructure, and perhaps, culture.
  • Android smartphones outsell iPhone 5 to 1 worldwide, while aggressive subsidies on new Android tablets threaten the iPad hegemony. Since the first iPhone in 2007, Apple has launched a single new model each year. Meanwhile, the Android ecosystem, starting 16 months behind but outspending Apple 4 to 1 on cumulative R&D, delivered a blizzard of differentiated devices and refreshed them on Google’s 4-6 month OS update cycle. Today, Apple no longer has the unequivocal “best phone”, it has no products for the highest growth segments, and it has lost volume leadership to Samsung. The same dynamics are emerging in the more nascent tablet market, with the added threat of Google and Amazon’s willingness to subsidize very low prices based on expected advertising and e-commerce revenue.
  • Apple is accelerating its refresh cycles and broadening its product line, but can only slow its market share losses while accelerating margin erosion. Recently, Apple broke with its tradition with a 6-month refresh for its flagship iPad, while simultaneously announcing the smaller and cheaper iPad Mini. Rumors are also circulating that an early update to the iPhone 5 will arrive this spring. A broader and more frequently updated product line will address Apple’s increasing vulnerability to being leapfrogged by competitive devices, but will truncate sales of devices before they enter the most profitable stage of their lives and will boost R&D spending. This dynamic is obviously bad for margins and will likely get worse rather than better over time.
  • Platforms are integrating cloud services as critical elements of the user experience, but Apple is far behind in the skills and infrastructure necessary. With the growing speed and ubiquity of wireless networks, portable platforms are augmenting their user experiences with cloud-based processing and storage resources. Integrated cloud applications, such as voice controls, maps/navigation or media streaming, can span across devices, tying users to a broader architecture, with significant revenue opportunities from advertising, e-commerce, subscriptions, and services. Apple, with device-centric legacy, is many years and billions of dollars behind Google, Microsoft and Amazon in the performance, capacity, reach and cost of its data center and network infrastructure. This leaves Apple largely dependent on fat product margins while competing against rivals willing to subsidize device sales to capture cloud-based revenues.
  • The slowly emerging opportunity for mobile platforms in the enterprise is huge, but Apple is poorly positioned to exploit it. The popularity of Apple devices amongst consumers have led some enterprises to adopt a BYOD (bring your own device) policy, but we do not believe that this model will have legs. iOS requires expensive proprietary hardware, it is closed to customized software development, it does not support legacy enterprise software, and the company has little experience with enterprise customers. CIOs will want to deliver work apps to devices within a uniform virtual window under their complete control, conditions anathema to Apple’s traditional approach. In contrast, the Android ecosystem is certain to accommodate enterprise IT (although version compatibility and security concerns will be a red flag), while Microsoft longstanding relationships and business friendly platform gives them the inside track.
  • Apple’s Thermonuclear War” is a costly and ineffective distraction – broad cross-licensing agreements are inevitable and beneficial to shareholders. Apple is prosecuting its IPR with 50 different legal actions in 10 different countries, spending hundreds of millions of dollars annually, and distracting its own management in the process. Despite a lurid Samsung jury award, which is likely to be reduced or even overturned, Apple has a near zero likelihood of stopping Android’s momentum with patent litigation. It would be far better off generating fat licensing royalties and competing on the basis of product acceptance in the market. Investors should hope that the recent HTC agreement is an about face in the company’s IPR strategy.
  • Apple must adapt or risk repeating its mistakes from the Macintosh era. Stepping up in an increasingly segmented and price competitive device market, while exploiting the cloud-based opportunities that will drive future growth and profitability, will require a strategic course change and substantial investment in the skills and infrastructure needed to win. History suggests that few companies are successful at institutional change on this scale, particularly without the motivation of a crisis. The alternative is a slow deterioration of Apple’s market share and margins, a fate not dissimilar to its own circumstances with the original Macintosh. Recent moves – e.g. iCloud, 6-month updates, the iPad Mini, etc. – are steps in the right direction, but the next several quarters will show whether Tim Cook is resolved to pick up the pace.

Apple at the Brink

Apple’s performance over the past decade has been heroic, raising its revenues by a factor of 25, its earnings by a factor of 150, and its market capitalization by a factor of more than 70. Along the way, the iPod and iTunes rolled the music industry; the iPhone upended the mobile phone business, wresting control of the wireless user experience from carriers, and introducing the app paradigm; and the iPad extended the iPhone metaphor to a larger screen, establishing a new way to consume media and internet content and threatening the future of the venerable PC. These innovations have been the primary catalysts behind the phoenix-like transformation that is remaking the entire TMT landscape.

Android hit the market 16 months behind the iPhone, prompting Steve Jobs to vow “thermonuclear war” but eliciting no change to Apple’s strategy. Apple refused to license its technology, offered a single new model each year, and maintained iron clad control over the apps and accessories for its products. Meanwhile, Google’s Android ecosystem – supported with OS updates every 4-6 months and collectively outspending Apple 4 to 1 on R&D – deluged the market with products across a wide range of form factors, specifications and price points, eventually running down the smartphone leader. Today, Android outsells Apple 5 to 1 worldwide, even competing successfully with Apple at the high end. With the recent arrival of Microsoft’s splashy Windows Phone 8 platform, and another wave of Android innovation expected for the spring, Apple’s margin-friendly single model, annual update approach is a serious competitive liability.

Meanwhile, the revolution is veering toward territory that will be extremely challenging for our hero. The fastest growth is at the lowest price points, where $150 Android smartphones are killing the feature-phone category. Apple is not equipped to go there and wouldn’t accept the margins that would be available. At the same time, Microsoft’s family of windows platforms is poised to dominate the slowly emerging enterprise market, where Apple’s closed architecture, expensive hardware and longstanding antipathy toward the needs of IT departments, would make it a hard sell, if it even had an enterprise sales force.

Moreover, the nexus of the user experience is moving off of the device and into the cloud. Apple is far behind in the skills, technology, and infrastructure needed to integrate cloud functions, an Achilles heel that is glaringly obvious in Apple’s now infamous Maps, but also evident in the disappointing Siri, the failing iAd platform, and the non-existent iTunes steaming music. Google has huge cost and performance advantages, born of its technical leadership and massive global scale, with Microsoft and Amazon far closer rivals than the relative neophyte Apple. These cloud capabilities are not only a point of differentiation, but also a significant long-term revenue opportunity. The iPad, not yet 3 years old and still holding nearly 60% of the tablet market, is seeing an assault by low priced tablets subsidized by Google and Amazon in anticipation of future advertising, media and e-commerce profits. Apple, with its fat margins and underwhelming presence in the cloud economy, finds its new iPad Mini competing with products more than 37% cheaper.

Tim Cook is in the horns of a dilemma – protect margins and retreat into a defensible niche, or attack with more products, faster updates and a bigger cloud presence. Apple’s recent moves suggest that he will play offense. The Mini segments the iPad line in two, while the 4th Generation iPad arrived just 6 months after the last update, with rumors that an iPhone 5 refresh will hit next spring. At the same time, iCloud and Maps are awkward steps toward cloud services that could portend streaming music, on-line video, and even search. However, broadening the product line and shortening development cycles will push R&D higher and gross margins lower, while pursuing cloud opportunities will require big infrastructure capex and building new skill sets. Perhaps most importantly, major changes to the DNA of a company born of brilliantly designed devices, premium prices and high margins will be necessary for Apple to win on this tack. These changes will be extraordinarily difficult, made more so by investors that will have to learn patience.

First, Some History

The launch of the Apple Macintosh is in the Pantheon of history’s greatest advertising, with a single television spot showing after halftime of the 1984 Super Bowl. 80 million Americans shuffled back to their living rooms with their plates of nachos and cold ones from the fridge to dystopian scene with armies of worker drones shuffling into a cavernous auditorium where Big Brother addressed them from a huge television screen. A single woman broke free of the crowd to hurl a hammer into the screen, shattering it in a blast of white light, over which a portentous voice-over announced “On January 24th, Apple Computer will introduce the Macintosh. And you’ll see why 1984 won’t be like “1984”.

The Macintosh simplified the PC, introducing a mouse controlled graphical user interface that was powerful and intuitive. The initial market response was strong, and Steve Jobs and the other Apple executives undoubtedly believed that they were on their way to unseating the IBM PC as the driving force of a computing revolution. Not so fast.

Exh 1: An Abbreviated History of the Mac

By late 1985, Microsoft had responded with the first version of windows, a relatively kludgey piece of software that added a mouse and opened applications as uniformly sized tiles. Two years later, the 2nd release of Windows fixed many of the most frustrating problems, moving closer to the Macintosh experience (Exhibit 1). Apple responded with litigation that ultimately failed to stop Microsoft from rolling over the Macintosh. By the early ‘90’s Apple was struggling, trapped in narrow niche markets like education and graphics design, with a platform market share that dwindled into the mid-single digits, while Windows rolled on. When the Internet bubble burst in late 2000, few observers would have believed that Apple would be the company to lead the tech industry from the abyss.

The Apple Decade

The first Apple iPod was released to the world on November 10, 2001. At the time, the MP3 music format had gained a foothold on PCs, but the first portable players were poorly conceived and hard to use. The iPod was a startling piece of industrial engineering, with stark minimalist look and a pared down, highly intuitive user interface. Most important, it was exceedingly easy to set up and use, right out of the box. The first versions worked with files ripped from CDs, which many users liberally shared on-line via sites like Napster and Kazaa. The rapid rise of file sharing piracy put the recorded industry into full panic mode, opening the door to Apple’s proposed iTunes store, opening its virtual doors in 2003, where music lovers could buy legal copy-protected digital songs. The combination of the iPod and the iTunes store quickly came to dominate the recorded music industry, with Apple taking more than 70% share of the global music player market and 80% of all music downloads, booking outrageous 30%+ gross margins on devices, and taking 30% of every song sold.

Exh 2: Quarterly iPod Sales, Launch to September 2012

Meanwhile, Apple had opened its first retail stores in May 2001, first as showrooms for its revived Mac franchise, and then to support the wildly popular and culturally influential iPod. Apple stores won awards for their cutting edge design, while introducing a number of retail innovations, such as the Genius Bar and mobile checkout. The stores also served to cement Apple’s image as an aspirational brand at the acme of cool.

Exh 3: Quarterly iPhone Sales, Launch to September 2012

By mid-decade, the success of the iPod brought a steady stream of rumors that Apple would move into the mobile phone market. Most analysts assumed that the iPhone would echo the design language of the iPod, perhaps even incorporating the iconic touch sensitive dial and menu driven operating system of that platform. The actual iPhone, launched in 2007, went far beyond that (Exhibit 3). If Apple had merely introduced its icon-driven touchscreen interface, it would have been a groundbreaking product, but its influence was so much more than that. The iPhone introduced the “app” as a shortcut to access web-based services with customized front-end application software. While web content was still available via a traditional browser, users gravitated to the convenience of apps, distributed through Apple’s tightly managed app store where Apple took a 30% cut of all revenues. The iPhone also integrated a number of important apps directly into the iOS operating system – mostly Apple’s own apps for calendaring, messaging, and other personal productivity programs, but also 3rd party programs like Google Maps and Amazon Shopping – and established a precedent for absorbing functionality into its platform.

The Garden Walls Came a Tumblin’ Down

The iPhone also changed the relationship between users, their wireless carriers and the devices. Until the iPhone, carriers maintained a strong hand with their handset suppliers, forcing poorly designed custom software upon them in the name of a consistent user interface, restricting users access to the internet in the name of conserving bandwidth, and subsuming manufacturer branding. Apple would have none of it, and found a launch partner just desperate enough to agree to its demands, along with an unprecedented level of subsidy on the retail price with contract. AT&T had found itself trapped in a dead-end technology, forced to transition all of its customers to a newly built network. In the process, they had burned piles of cash while losing a frightening number of its customers to arch-rival Verizon. Early in the process of developing the iPhone, Apple secretly signed AT&T as its initial partner – securing freedom from interference with its smartphone vision and that hefty subsidy in exchange for a three year exclusive on the product. Once launched, the die was cast. AT&T’s competitors could not continue to force bloat-ware and carrier curated walled gardens of web content once the iPhone demonstrated the alternative.

Exh 4: Quarterly iPad Sales, Launch to September 2012

The capstone of the Apple decade was the 2010 introduction of the iPad. Tablets had been in the market for a decade, but the windows-based products were unwieldy and unsuccessful (Exhibit 4). Apple had already proved in its touch-based iOS interface with the iPhone and adapted it for a larger screen. The timing of the iPad also coincided with a sharp expansion in the availability and speed of wireless networks, both WiFi and 3G wireless, and with the rise of compelling cloud based applications, such as streaming media, and social networking, which established the usefulness of an ultraportable, easy to use and wirelessly connected device for accessing those compelling applications, again, via platform controlled apps. To the surprise of many, consumers took to the iPad, eschewing home PC upgrades and shifting their daily web activity to the tablet. In its first 30 months on the market, the iPad has sold more than 98 million units worldwide, on a trajectory to swamp the consumer PC market within a couple of years.

iPod, to iTunes, to Apple Stores, to iPhone, to iPad – Apple’s innovations drove profound revenue growth and margin expansion. Between 2002 and 2012, Apple sales grew at a 37.6% CAGR, operating margins increased from -.9% to 30.4%, EPS grew at a 65% CAGR, and cash flows grew 56.2% on average (Exhibit 5). Investors responded in kind, increasing Apple’s market capitalization by 1,191,704 bp over the decade to peak at $662B earlier in the year as the single most valuable company in the world. Of course, at this point everyone knows all of this.

Exh 5: Key Apple Metrics on a Quarterly basis, 3Q02-3Q12

Source: Capital IQ, SSR Analysis

Macintosh Redux?

16 months after the iPhone turned the cell phone industry on its ear, the first Android smartphones hit the market. Android obviously followed Apple’s lead, either legally or not depending on who you ask, delivering a similar experience, albeit one roundly found wanting vs. the market leader by the reviewers at introduction. However, while Apple offered a single annual update to the iOS software running on its portable products, Google committed to a much more aggressive schedule, delivering a new version every 4-6 months (Exhibit 6). Google also recruited a who’s who of OEMs to build products based on Android, offering licenses free of charge to any and all partners willing to abide by Google’s fairly lax technical requirements. The result was dozens of companies, collectively outspending Apple 4 to 1 on R&D, delivering ranges of products and upgrading their devices two or three times a year.

Exh 6: Evolution of Major Smart Platform Versions, 2007 – Present

Apple felt the heat in a few ways. First, Google and its partners beat it to the punch on some technologies, such as over-the-air synching and software upgrades, or 4G LTE. Second, the Android ecosystem, abetted by Google’s no-fee licensing and tolerance for thin margins, seriously undercut the iPhone on price. Third, Android phones arrived in a wide variety of shapes and sizes, offering a full range of specifications along a laundry list of attributes. Apple touted the iPhone as best for everyone, but many real-world consumers saw value in a bigger screen or a physical keyboard and voted with their credit cards. Finally, Android was a lot more open – making it more flexible and customizable for the nerd herd of techies that care about such things and blog about them incessantly.

In its first few iterations, the iPhone retained its cachet as the world’s best phone, even as carriers shut out of the game helped to promote Android-powered alternatives. However, Android gained traction with those carriers and in lower price points, outselling Apple in volume by 2010 (Exhibit 7). Meanwhile, Android got better and better, smoothing the rough edges of the user experience, building a comparable library of apps, and showing up on truly cutting-edge hardware that often leapfrogged the iPhone on some attributes (Exhibit 8). In the spring of 2012, the Samsung Galaxy III launched with a strong case that it – not the iPhone 4S – was the best phone in the world, with its big, high resolution screen, 4G LTE radio, superfast dual core processor, removable battery, and 8MP camera. In 3Q12, the Galaxy III dethroned the iPhone as the world’s most popular smartphone model. The launch of the iPhone 5 in September evened the playing field, and likely vaulted Apple back into the sales lead for 4Q, but the Galaxy IV looms just ahead with another leapfrog next year.

Exh 7: U.S. Smartphone Market Share Trends March 2009 – September 2012

Gotta Catch’em All

At lower price points, which have been the fastest growing segments of the smartphone market, Android is running nearly unopposed. With the introduction of the iPhone 4, Apple began a policy of marking down its older models to broaden its line, but even at a discount an older iPhone is still an expensive phone. Android smartphones from multiple manufacturers are duking it out in emerging markets at prices the dip below $150 without subsidy. These devices are grabbing swaths of market share from the proprietary feature phones that previously inhabited this huge segment (Sorry Nokia). Next year, low-end price points are projected to drop to $100, opening another swath of the huge global market to Android and perhaps eliminating feature phones for good. With Apple’s taste for margins – iPhone gross margins are believed to top 50% – and lack of distribution deep into emerging markets, it is nearly inconceivable that it would make a play for these particularly cutthroat segments.

Exh 8: iPhone versus Android Major Releases

On a global basis, Android smartphones now outsell iPhones by more than 5 to 1, with Apple’s market share having dropped below 16% with a trajectory toward single digits (Exhibit 9). 30 months since its launch, the iPad still commands nearly 60% of the tablet market, but there are worrying trends here too (Exhibit 10). As with the iPhone, it has taken the competition time to catch-up to the quality standard set by Apple. The first Android tablets hit the market about 6 months after the iPad, but were rushed to market and employed a version of the software that was intended solely for smartphones. These products were widely panned by reviewers and sold poorly in that first holiday season, leading some analysts to write off Android as a competitor to the iPad. Six months later, the tablet optimized “Honeycomb” release resolved many of the scaling and performance problems inherent in the earlier tablets, and the Android ecosystem began a slow climb up Mount iPad.

Exh 9: Global Smartphone Market Share, by Manufacturer Q1-Q3 2012*

Exh 10: Global Tablet Market Share, by Manufacturer 2Q11-3Q12

The Christmas of 2011 saw the introduction of Amazon’s Kindle Fire, a sub-$200 7-inch tablet based on a highly customized version of Android. The price point, undercutting similarly sized Android tablets by more than $100 and the 10inch iPad by $300, was no better than break-even, but Amazon expected to use the device to drive profitable sales of e-books, music, video and even physical goods via the shopping interface which was front and center of its proprietary user interface. The Fire sold millions of units over the Holiday season and established a precedent for subsidizing device pricing in anticipation of future services revenue that would become even more important going forward.

The Ghost of Christmas Present

In 2012, Android tablets hit their stride. Google’s 10th major release of Android, nicknamed Jelly Bean, was designed ground up for both smartphones and tablets, and is at the core of most of the newest tablets. (N.B. major Android updates are named after sweets and come in alphabetical order, the next release will be “Key Lime Pie”) Google took a page from Amazon’s book to launch its own “Nexus” branded tablets, first in a $200 7-inch version that launched to glowing reviews in June, and second, with a bigger brother Nexus 10 priced at a 25% discount from the comparable iPad introduced in October, along with a hardware refresh for the Nexus 7. Teardowns suggest that Google has scant margins at these prices, but like Amazon, it intends to make it up on high margin cloud services, in this case, advertising (Exhibit 11).

Exh 11: Tablet Teardown Comparison, Apple vs. Android

2012 also brought a new competitor, risen from the dead. Microsoft introduced Windows 8, Windows RT, and Windows Phone 8 for PCs, tablets and smartphones, respectively. The new Windows versions, all sporting the innovative and differentiated Metro interface, have been well reviewed with the caveat that the available mobile applications are still scant relative to either iOS or Android. The key for Microsoft is its support for its own legacy applications – Office and Exchange chief amongst them – and for enterprise customers wishing to bring their own customized software forward. As a part of this, Microsoft has introduced its self-designed Surface line of tablets. Surface tablets focus on the specific needs of a mobile workforce, a segment relatively unaddressed by Apple, with native support for productivity applications and a clever lightweight detachable keyboard. The critical reaction has been mixed, with praise for specs, build-quality and basic design offset by criticism of the dearth of applications available for Windows RT at launch.

Windows Phone 8 is also hitting the market for Christmas with a relatively big splash. Both Nokia and HTC have serious high-end smartphones with major marketing support from Microsoft and its carrier partners. Wireless carriers have often expressed their interest in sustaining alternative platforms beyond iOS and Android, and their commitment to Windows Phone appears genuine and strong. The Nokia Lumia smartphones are touting a superior camera capability, wireless charging, high end specs, and distinctive styling at a relatively nice price. HTC’s 8X is lighter and sleeker than the Nokia at the cost of some bells and whistles. Both are reportedly selling better than had been expected, but the success or failure of Microsoft’s smartphone and tablet initiative will not be settled in the first quarter that the products are available. Microsoft’s real opportunity is the enterprise, where purchase decisions are made cautiously but where Microsoft’s longstanding relationships and understanding of the needs of IT managers make it a formidable competitor.

Ultimately, we believe that the enterprise market will embrace an architecture of portable devices networked to the cloud. Still IT managers are a very different customer than the consumer market. Apple’s locked-down, proprietary software and software are anathema to enterprise buyers looking for customized user interfaces, support for legacy applications and multiple hardware options. The popularity of the iPhone and iPad, particularly amongst the executive ranks, have prompted many organizations to support a BYOD (bring your own device) policy, but this is at best, a stopgap. Encouraging employees to use their own personal devices may have a modest benefit for capital budgets, but the policy brings with it myriad security vulnerabilities and limits a company’s ability to deploy customized software or establish a consistent user interface. With the falling cost of entry level smartphones and tablets, capital costs will fade in concern and most IT departments are likely to begin to insist on much tighter control of their users.

Where enterprise applications are to be supported on user-owned equipment, IT departments will insist on company controlled virtual windows, essentially allowing the device to toggle between work mode and personal, thus holding company access secure. Should an employee quit with company software on their phone or tablet, the IT department can wipe it clean remotely without endangering personal data. Microsoft understands this implicitly and will lead in delivering this functionality. Google will support it, but Android is burdensome to enterprise IT for its version fragmentation and loose commitment to security. Apple seems unlikely to allow a second, non-Apple virtual interface to run on an iOS product, makes it difficult to support legacy applications, and will not license its platform to other hardware manufacturers. This will greatly limit its ability to penetrate the nascent enterprise market as it grows.

What’cha Gonna Do When They Come For You?

Apple’s initial response to iPhone competition was litigation. The Walter Isaacson penned bestselling biography of Steve Jobs, revealed his fury at Google’s Android and his vow of “Thermonuclear War” to wipe it from the earth. With Macintosh, Apple had failed to patent many of its innovations and ultimately lost in its attempt to punish Microsoft for “copying” the look and feel of its user interface. This time, Apple had been meticulous in patenting everything that could be written down, abetted by an overburdened patent system that was amenable to rubber stamping even the most mundane concepts. As of the beginning of 2012, Apple had 50 different IPR legal actions underway in 10 different companies, with Android ecosystem leaders Samsung, HTC and Motorola (recently acquired by Google) in the crosshairs (Exhibit 12).

Exh 12: Mobile Patent Lawsuits as of November 2012

Unfortunately, patent litigation is a long and messy process, particularly in an industry with 4-6 month product generations. Rather than “Thermonuclear War”, Apple has been playing “Whac-a-Mole”. Each suit is particular to specific products made by a specific competitor that allegedly infringe against a specific set of patents. In the process of the case, patent claims are narrowed and even in the case of a victory, such as the lurid $1B in damages recently awarded to Apple against Samsung by a San Jose jury, the results are subject to a lengthy appeals process that can invalidate patents, reverse decisions or reduce awards. Meanwhile, the defendant is free to alter its product to “work around” the narrow patent claims and to sell the now non-infringing product with impunity. With this, IPR victories are Pyrrhic, doing little to slow the progress of competition, while costing both plaintiff and defendant tens of millions of dollars in legal expenses. We have written about this process extensively (see “Quick Thoughts: Thermonuclear War – The Only Winning Move is Not to Play”
http://www.ssrllc.com/2012/11/
and “Patent Wars!”
http://www.ssrllc.com/wp-content/uploads/2011/12/11.09.19-Patent-Wars.pdf
). Ultimately, the only real answer is to negotiate royalty bearing cross-licenses with the rest of the industry, a process that Apple had previously eschewed, but now embraces, at least as evidenced by its recently announced settlement deal with HTC.

Exh 13: Smartphone and Tablet Segmentation

A Touch, a Touch, I Do Confess …

Beyond the court room, Apple’s early response to smartphone and tablet competition was to ignore it. The strategy of introducing a single updated model each year is conducive to high margins – fewer models keeps development expenses down, while longer, smoother production runs deliver lower costs and thus, better gross margins the longer a model stays on the market. Two years ago, Apple opted to keep its older iPhone 3GS model on sale at a lower price after introducing the iPhone 4, a strategy that took advantage of the declining long term cost curve and gave it a bit more price point coverage without requiring additional product development expense. Apple has maintained this policy, which has protected a corner of its market share from the invading hordes, but development proceeds, it is more and more difficult to maintain products more than a year old as viable choices at what remains a relatively high price despite Apple’s discounts.

Then, this past October, Apple zigged instead of zagging. First, it introduced a new smaller tablet with an 7.9-inch screen called the iPad Mini – Steve Jobs’ famous ridicule of the idea of a smaller tablet be damned. The Mini cut corners to get its bill of materials down – in particular, the pedestrian pixel density and color palette of the screen gets low marks compared to the Nexus 7 and Kindle Fire HD. At a 60% premium to either of those two models, the Mini’s pricing will test consumers’ loyalty to the Apple brand. Still, the Mini segments the tablet market in two, a big step for a company previously committed to the idea of one-size-fits-all (Exhibit 13). Of course old habits are hard to break – the iPhone 5 was launched with a spiel ridiculing the Galaxy III for being too wide for one handed operation, the assumption being that all humans had similarly sized hands and that they all valued one-handed operation equally.

October brought another major departure from Apple’s business as usual. 6 months after launching “The New iPad”, Apple announced a hardware update that it termed “The 4th Generation iPad”, missing the opportunity to call it the “NEW New iPad”. The 4th Generation variant amps up the performance with a dual-core main processor and a quad-core graphics processor delivering roughly double the speed of its short lived predecessor. This change of pace was entirely unexpected, putting the flagship iPad back at the top of the category spec list at the expense of executing the product line change, truncating the profitability curve of the older model and annoying all of the loyalists who had bought the “New iPad” during its 7 month life span. The decision suggests a company concerned with competitive products and willing to engage on product specifications even at the expense of margins – the norm for most companies but a different way of thinking for Apple. Rumor now has it that Apple could take the same approach and introduce an iPhone 5 update in the spring, hoping to avoid the numbing lull that it had experienced earlier this year as the iPhone 4S aged, the Galaxy III surged and Apple buyers waited for the arrival of the iPhone 5 in the fall. Weak iPhone sales in 2FQ12 yielded a rare quarterly disappointment in April, compounded with lackluster guidance for its 4Q ending in September. With the Samsung Galaxy 4 expected early next year, an updated iPhone may be the only way to avoid a repeat performance.

It’s Gonna Cost Ya’

Adding new product categories and shortening product life cycles will add costs. Apple’s R&D, which it has run at a miniscule 2% of sales, will rise to support more engineers working on more product categories. Gross margins, which grow over the life of a product at least until they are discounted to make room for the new flagship, will shrink as the most profitable months of each product are truncated. Assuming that short product cycles and more aggressive market segmentation are the new normal for Apple is to assume that operating margins will contract. The alternative assumption is to view the Mini and the out-of-cycle refresh of the 10-iPad as aberrations. If so, Apple may hold onto its cost structure but give up more market share, as competitive devices leap over static iPhone and iPad models in their dotage. In the long run, we would argue that this is a clear losing strategy, returning to the mistakes of the Macintosh era.

Exh 14: R&D Spend by leading Smartphone makers

The tablet market is fraught with even greater peril than smartphones. iPhone price premiums are largely hidden behind the massive subsidy payments that it has wrested from wireless carriers in recognition of the higher than average ARPUs generated by the average Apple user. Tablets do not typically carry carrier subsidies, exposing consumers to the real price differences. Until recently, Apple could rely on the clear superiority of its product vs. would-be tablet competitors and its substantial volume driven cost advantages to reach its aggressive margin objectives. However, Amazon and Google have turned those market dynamics on their ear, designing attractive cutting edge products and selling them at cost in anticipation of gaining service revenues later. The value of the Apple brand will be sorely tested as consumers weight the Mini and its 60% price premium vs. the Kindle Fire HD and Nexus 7 this Christmas season.

All Cloud, No Silver Lining

The willingness of Google and Amazon to subsidize tablet sales leads to an even bigger threat to Apple. Apple’s business system is designed to take profits on the sale of devices. Its world leading skills are in the service of designing, manufacturing and marketing devices. The first iPhone, like the iPod before it, was designed to operate in tandem with a Macintosh which would manage applications and content and synch them to the device as it was regularly connected to it by Apple’s proprietary cable. Over the air synching, application downloads and software updates were an afterthought , implemented in response to criticism of its tethered approach in comparison to the RIM blackberry. The iTunes store was an early Apple cloud application, appearing in 2004, but its functionality was in service of the device. Song files were downloaded to a hard disk on a computer, initially in proprietary formats with hard DRM that limited the use of the files to the specific devices that were registered. Today, years after jettisoning the proprietary format and DRM, and with streaming services, like Pandora and Spotify, commonplace amongst mobile users, Apple remains pure to its file download roots.

Streaming music is the tip of the iceberg. Much of user activity on portable devices is tied to cloud-based resources – search, messaging, email, navigation, social networking, e-commerce, streaming video – these are primary applications, and Apple is not well positioned for any of them (Exhibit 15). In contrast, arch-rival Google was conceived from birth as a cloud company. The complexities of internet search demanded that Google invent a new approach to collecting, storing, indexing and recalling information contained on many billions of web pages, and in response, the company pioneered most of the important distributed data processing innovations of the past 15 years, and has been the employer of choice for top computer science talent for most of that time. With 36 major data centers worldwide, many hundreds of server collocation sites to cache commonly requested content, and millions of server cores at its disposal, Google’s distributed data processing infrastructure dwarfs all competitors and offers significant cost and performance advantages for the type of cloud-based applications at the center of on-line activity. (See “Cloud Data Centers: Bigger, Faster, Cheaper!”
http://www.ssrllc.com/wp-content/uploads/2011/12/12.07.30-Data-Centers.pdf
) Amazon and Microsoft, with applications of their own to support are Google’s closest rivals with regard to the capability of their infrastructure. Apple? Not so much.

Exh 15: iOS versus Android Apps and Features

Apple operates two data centers for its cloud services and is building a third. Apple relies on 3rd parties like Akamai to provide local cache server capacity. Apple is a top hirer of design and device software engineering talent, but is a Johnny-come-lately with regards to its data centers. Its relative lack of skills and infrastructure is apparent in the disappointing performance of many of its web-based applications, from Siri, to iCloud to Apple Maps. This is where Google and Microsoft will attack (Exhibit 16). Android partners can tout an integrated maps and navigation capability far beyond Apple’s clumsy effort, with links through to search, social networks, photo tagging, calendar, and other key functions.

Not only does Apple’s neophyte status in the cloud harm the competitive performance of its platform, but it also limits the company’s ability to exploit a wide range of opportunities to profit from its platform with associated cloud services. iOS and Android sit as gateways between users and the internet, with Apple’s brilliant app model allowing the platform owner to extract a toll on revenues generated through the device and to steer users toward the applications of their choosing. With hundreds of billions of advertising, e-commerce, streaming media, consumer services, and transactions moving toward the internet, the platform is positioned to cherry pick the best opportunities for itself. Because of this, Google has been willing to give its software away for free, and sell tablets at cost, as has device newcomer, Amazon.

Exh 16: Known US Datacenter Locations of Apple, Amazon, Facebook, Google, and Microsoft

Think Different

On its historical trajectory, Apple risks allowing this parade to pass it by, -an outcome unacceptable not only for lost opportunity but also for an inevitable deterioration in the value that Apple provides to its customers. Tim Cook recently signaled an acceleration in capital spending and a continued commitment to improving the performance of its cloud-based services. Ultimately, this is the only road to success, but it is a long road and a path not entirely consistent with Apple’s historic DNA. Apple will have to change

Change is hard. Real DNA change can’t be bought – acquiring Quattro didn’t stop Apple from botching its entry into mobile advertising with the poorly received iAd. Apple will need to invest in its data processing infrastructure, it will need to invest in its skill base, and it will need to raise its best computer science minds to the same rock star status currently accorded Jony Ive and his design team. Apple needs to reconceive of its product as an experience that transcends the device and to sell it as such – don’t differentiate on what the product is, but rather on what it can do. In that, competing on the resolution of its retina display or the thinness of a products physical profile is a long term losing proposition. (N.B. For reference, google “Motorola RAZR wiki”).

If any company can rise to this challenge, it could be Apple, which rose from the dead some 15 years ago. It seems to have recognized its vulnerability and it has management talent, business momentum, and its prodigious cash hoard to help it succeed. Given its assets and opportunities, there is a reasonable case that Apple, after its recent tumble, is more than worth the risk longer term. Unfortunately, Apple’s investors are a skittish sort and a message of comprehensive transformation might not be well received. Still, if Jeff Bezos can convince the equity market to wait patiently for Amazon’s profits, perhaps Tim Cook can do the same for Apple.

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