Apple vs. Google: Handicapping the Coming Battle for TMT Supremacy

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Paul Sagawa


June 30, 2010

Apple vs. Google: Handicapping the Coming Battle for TMT Supremacy

This note is intended to compare the strategic positioning of Apple and Google and to examine how the likely rivalry between the two is likely to shape the future of the TMT sector. We do not provide research coverage of either firm and no company specific investment recommendation is implied.

  • Apple and Google are the #1 and #4 largest US tech companies by market cap, and have appreciated 669% and 122% respectively over the past 5 years. It has become apparent that the two companies have targeted the same market real estate for future expansion, turning these erstwhile allies into increasingly fierce rivals. While the potential of these target markets is likely great enough to fuel both companies’ success for the immediate future, in the long term, we believe that their collision course will favor Google at the expense of Apple.
  • The opportunities over which Apple and Google will do battle are four of the six technology disruptions that we believe that will drive the evolution of the TMT universe over the next decade, and the two companies are the only players with a stake in more than three of them. Specifically, they will spar in smartphones, internet TV, cloud computing and telepresence. Given the ambitions of the two companies, it appears unlikely that both will be able to meet expectations simultaneously.
  • Our reasons for favoring Google in these battles are seven fold:
  1. Google’s open and royalty-free licensing policy has attracted an all-star team of hardware partners committed to its software platforms, while Apple will play alone.
  2. Google outspends Apple on R&D 2.5 to 1, not including the Android/Chrome related spending from its ecosystem partners, which likely double the resources committed to Google’s platforms.
  3. In smartphones, Google updates its platforms several times a year, with hardware partners competing with each other to push the leading edge and adapt to changing market conditions, while Apple has been content to do a single iPhone model and software upgrade each year.
  4. Google’s ecosystem approach means a variety of choices for consumers and a wider range of channels vs. a one-size fits all approach for Apple.
  5. Apple’s lone wolf approach and aggressive tactics is earning it a reputation as an industry bully, which could translate into less willing content and application suppliers and even damage perception of the company amongst users and the media.
  6. Google has far more comprehensive approaches for internet TV and cloud computing, opportunities that could be even more attractive than smartphones.
  7. The war will be fought on Apple’s home turf, forcing it to play defense for its iPhone, iTunes and iPod franchises, while Google’s on-line advertising stronghold will be unchallenged. As such, the risks of battle are asymmetric in Google’s favor.
  • The major knock on Google has been its inability to monetize its technology strength. Its many popular software products are largely free to developers, hardware partners and users. We believe this has been a choice made to maximize the adoption of its platforms by minimizing the perceived threat to its partners. Google retains the lucrative potential of charging for elements of its technology in the future. Meanwhile, the tide of consumer eyeballs migrating from channelized television to internet video will fuel significant growth for Google’s core advertising business.
  • Apple’s tight control has driven its recent success, with dominant device category market shares and extraordinary profitability. However, going forward, it may become a liability. First, the strategy leaves less opportunity on the table for others and aligns many potential partners – including content providers, applications developers, and telecommunications carriers – against it. Second, there is not a lot of room for increasing market share and even less for expanding margins. Finally, Apple’s strong handed tactics are subtly shifting the company’s image to that of a bully, possibly affecting consumer, media and industry enthusiasm for future innovations and bringing increased government attention. An eerily similar scenario played out 20 years ago with Windows vs. the original MacIntosh, and we note that the mobile device industry has history of rapid market evolution and dramatic reversals of fortune.
  • In the near term, the momentum of iPhone and iPad appears to outweigh the immediate prospects of the internet advertising market. As such, the relative performance advantage of Apple over Google may persist for several months. However, longer term, we believe that Google and its ecosystem are better positioned for opportunities in Smart mobile devices, Internet TV, Telepresence and Cloud Computing than is Apple, and that it will have many opportunities to monetize those opportunities. If so, Google’s success is likely to come at the expense of Apple, which could see market share and margin contraction.

Apple vs. Google

We believe that Apple and Google are headed toward confrontation across a wide-ranging battlefield in the most attractive growth opportunities in the TMT universe. While both companies are truly excellent, with well conceived strategies and extraordinary technical and market strengths, we do not believe that there is room for both companies to meet their own lofty expectations simultaneously. Eventually mutual success will give way to a zero-sum game where one of the two will gain the upper hand at the expense of the other. For many reasons, we believe that the relative winner is likely to be Google.

The World’s Most Valuable Technology Company

Everyone loves Apple. Bears who were cautious at $75, and reiterated at $150, are now bulls at $275. The iPad has sold more than three million units, or one every 2.3 seconds since it was introduced. iPhone 4 spurred fanboys to camp outside of Apple stores for days, as sales hit 1.5 million on the first day of availability. Media accounts of Apple products gush like film reviewers at a Meryl Streep retrospective. Apple is cool, and bringing its brand of cool to every corner of the world.

Apple’s cool has translated into astounding returns for its lucky investors. Apple shares are up 669% over the past 5 years and 90% over the past 12 months. Its sales were up 14.4% (Exhibit 1) despite economic turmoil in 2009, are on pace for better than 35% growth in 2010, and are projected to grow 17% in 2011. It earns 40% gross margins and roughly 30% operating margins in hardware businesses where double digit profitability is considered good. Apple’s iPhone has captured 15% of the global smartphone market defined broadly, but over half of the market for touchscreen equipped models and 70% of all mobile app downloads. Apple’s iTunes site is responsible for 25% of all recorded music sold in the US and an astounding 90% of on-line music downloads. The company that hit public consciousness more than 25 years ago as an underdog with groundbreaking alternative to the status quo, now finds itself as an overdog defending its own status quo against would-be groundbreakers.

Over the years, Apple has been mostly measured against Microsoft. Of late, battles have seemed increasingly one-sided – PC is bleeding market share to Mac, iPod and iTunes have trampled the sorry Zune, iPhone is rendering Windows Mobile irrelevant. Looking ahead, Microsoft no longer seems a worthy competitor in the markets that are expected to drive Apple in the next decade. Enter Google, stage right.

A Software Juggernaut Disguised as an Advertising Company

Google has been an important partner for Apple. Indeed, one of the signature applications for the iPhone at its launch was its seamless integration of Google Search, Google Maps and Google Earth, curiously reminiscent of the role of Microsoft’s XL and Word as applications then-exclusive to the original MacIntosh. Just as Microsoft turned on its one-time partner with the copy-cat Windows platform back in 1985, Google entered the smartphone operating system fray with the late 2008 introduction of the first Android-powered mobile from HTC, almost two years after the original iPhone.

Google’s performance has been exceptional compared to almost any firm but Apple. Shares have appreciated 122% over the past 5 years, although it is up only 11.1% over the past 12 months. Sales growth slipped to 8.5% during 2009 after 26.6% growth the previous year, with the recession-driven slowdown in advertising spending taking its toll. The March 2010 quarter showed a recovery to 23% sales growth and the sell-side consensus projects nearly 21% for the full year, with just over 15% growth projected for 2011. It earns 62.6% gross margins and roughly 35% operating margins, including 12% of sales annually invested in R&D. Google is capturing 3% of the total US advertising spend, but 30% of on-line ad revenue and 76% of search-related spending (Exhibit 2). With its acquisition of AdMob, Google now has roughly 24% of the fledgling mobile advertising market.

Google’s technology position is impressive, although to date, it has resisted charging for its software and services. It is the obvious leader in internet search, with better than 90% US share. Gmail has gone from zero to the third largest email service in 4 years, and with 27% annual growth in users, should surpass Microsoft’s Hotmail within the next year (Exhibit 3). Rescue Time, which tracks the usage of hundreds of thousands of leading edge computer users around the world, reports that Google’s on-line Apps business has overtaken Microsoft Office amongst its client base (Exhibit 4). The Android operating system overtook the iPhone, at least for Q1 2010, in the North American smartphone market with 26.6% market share. (N.B. The June release of the iPhone 4 will certainly reverse this for at least Q2, but Android’s market momentum is substantial). Google’s Maps, Earth, Translate, Voice, and Goggles sport industry leading technology in mapping, image processing, language processing, speech recognition and image recognition and are being embedded in a long list of products, services and web-sites. Google’s YouTube serves more than 43% of internet video traffic.

Clash of the Titans

In August 2009, Google CEO Eric Schmidt resigned his seat on Apple’s board of directors (Exhibit 5), where he had served for three years, citing increasing conflicts of interest and symbolically ending an era of cooperation between the two companies. Looking forward, the conflicts between the two companies will be pervasive. Of the six disruptive technologies that we believe will drive the TMT market for the next decade, Google and Apple are butting heads in four of them (Exhibit 6). The smartphone market (including the full range of portable wireless devices) is emerging as a mano a mano cage brawl between the phenomenon that is iPhone and the upstart Android OS, with the cast of also-rans – Windows Mobile, Blackberry, Symbian, and PalmOS – struggling for relevancy. Internet TV is in an earlier stage, but Apple has dipped its toe in the water with marginally successful Apple TV product and by leveraging its powerful iTunes franchise into video downloads. Google’s YouTube unit, synonymous with on-line user posted video, is aggressively pushing into paid video rentals and downloads, while its search capabilities, including its leading edge image and speech recognition technologies, position it to play a key role in helping viewers navigate the oceans of potentially available content. Telepresence is not at the top of the priority list at either company, but as high-end teleconferencing technology trickles to consumer applications, both Apple and Google are promoting personal video chat capabilities. Finally, Google has been a pioneer in cloud computing with its hugely successful Google Apps internet hosted productivity applications quickly taking market share amongst tech savvy businesses and consumers, and a strong application hosting platform that gives developers access to a toolkit of Google technologies. Apple has been less aggressive, but plays in the cloud via its MobileMe platform for its iPhone acolytes and its iWork suite of on-line productivity apps.

The iPhone Juggernaut

The iPhone is a phenomenon with 50 million cumulative units sold worldwide in the three years since its launch in 2007. With the likelihood that Verizon Wireless will begin offering the iPhone in 2011, investors are salivating at the prospect of adoption by some portion of that carrier’s 83 million subscribers and the inevitable churn of dissatisfied AT&T subscribers shifting to VZ once the beloved smartphone is available on the preferred network. The phenomenon also extends to the cleverly positioned iPad, which is unlikely to sell in iPhone volumes, but co-opts the adjacent eReader/Tablet market for another highly profitable Apple iOS product.

Along the way, iPhone has laid waste to a bevy of competitive platforms. Nokia, which still self-claims smartphone leadership based on its keypad operated models, has struggled mightily to answer the bell with touch screen models to match the iPhone ease of use and curb appeal. The Symbian industry joint venture, with majority ownership by Nokia, has been glacially slow to deliver even me too touch screen functionality, and Nokia’s first Symbian^3 model, the N8 due in September, will also be its last, as it shifts its high-end smartphone focus to an open source Linux based operating system called MeeGo, developed in combination with Symbian and Intel. With iPhone’s prodigious head start, vibrant application market and momentum from the powerful Apple marketing machine, it is not clear that the Finnish phone giant has enough runway to get back in the game for this round.

Research in Motion, whose Blackberry has ruled mobile corporate email access for as long as most sell-side analysts can remember, has a big bet on the table in its soon to be available OS 6.0. This OS is intended to resolve serious drawbacks – slow hard to use browsers, lack of applications, clunky user interface, etc. – with which Blackberry users have coped due to the mandates of their employers. Early reviews have been mixed, but skew to the optimistic end. With corporate users begging their IT departments for email access via iPhone, this version feels a bit like a make or break in RIMM’s play for the high end smartphone user. We also note that Research in Motion has been a bit of a lone wolf, defending its email turf on its own, without strong hardware or software partners. Nonetheless, Blackberry remains the North American market leader in smartphone sales (Exhibit 8) despite Apple and Google rhetoric, and will either be a formidable competitor or a significant source of market share for others to take depending on the reception to this next round of products based on OS 6.0.

Microsoft’s Mobile Windows has been the OS of choice for phone makers bereft of their own proprietary OS and what a heavy millstone it has been. Mobile Window’s market share has dwindled to less than 4% of the US market, despite years of support from the likes of Samsung, LG HTC and Motorola (Exhibit 9). Like Nokia and Research in Motion, iPhone has forced Microsoft back to the drawing board. Mobile Windows 7 has been previewed as a dramatic departure from the ten years and 11 code releases that came before. While a complete overhaul is long overdue, Mobile Windows suffers from fairly onerous licensing terms, particularly measured against Android’s royalty-free availability. Applications developers may give Mobile Windows 7 a pass, given meager market volumes and Microsoft’s less than stellar reputation as partner. With much baggage weighing it down, it may be difficult for Microsoft to make much of a run.

Hewlett Packard’s recently acquired Palm business has seemed as if on life-support for years, as the smartphone pioneer never recovered from a major channel inventory glut at the bursting of the 2000 tech bubble. The most recent iteration, featuring a Linux-based platform called WebOS, holds just 2.4% of the North American market and scant sales outside of it, insufficient volume to draw the attention of applications developers. Without an unforeseen Hail Mary play from new owner HP, it may be that time will run out for Palm, just as it did for proprietary smartphone OS programs from Motorola, Samsung and others.

The Androids are Coming, The Androids are Coming!

Of course, the iPhone phenomenon is not entirely unprecedented. The four year run of Motorola’s RAZR from 2003 to 2007 yielded some 150 million units sold and the #12 place in PC World Magazine’s list of the “50 Greatest Gadgets of the Last 50 Years”. The early struggles of Microsoft Windows vs. the first MacIntosh models are also a cautionary tale – it took 5 years until the release of Windows 3.0 in 1990, but Microsoft and its ecosystem eventually delivered competitive functionality and gained dominance. That said, the iPhone has its raft of applications and its integration to iTunes and MobileMe as barriers to brand switching for its famously fanatical user base.

The intriguing alternative to iPhone is Google’s Android. In functionality, it is similar to iPhone, behind in some areas – e.g. multi-touch “pinch to zoom”, speed and ease of navigating about the phone’s functions – and ahead in others – e.g. integration with Google applications, device and carrier choice, frequent updates. However, in the long-run we believe that the scale may increasingly tilt in Android’s direction for several reasons. First, Google is building a formidable team of hardware partners – HTC, Motorola, Samsung, LG, Garmin, Sony Ericsson, Sharp, ZTE, Huawei, and Dell amongst others – all of whom are putting significant development dollars in furthering the state of the art for Android devices (Exhibit 10). In contrast, Apple brings out a single version each year and must bear the entire development cost of the iPhone ecosystem within its own R&D budget.

The second factor is variety. Apple’s single model strategy keeps its brand message uncluttered and its scale economies high, but demands conformance from a global mobile user base used to a cornucopia of choice. Android’s royalty-free licensing has attracted an all-star team of manufacturers that have already begun to engage in an aggressive game of one-ups-manship that leaves no market niche unfilled. You like a physical keypad? There’s an Android phone for that. You want an 8 megapixel camera with optical zoom? There’s an Android phone for that, too (Exhibit 11). You want a big screen GPS phone with Garmin turn-by-turn directions? Yep, another Android phone. You want an iPad-like tablet? Samsung is readying one for market, based on Android.

Third, Android is open source and application developers have unfettered access to the user base, while Apple requires developers to use only its approved software tools and strictly regulates whether apps can be sold to users. With the exception of games, which often have long development cycles, most all of the popular applications on iPhone have versions, or at least analogs, on the Android Marketplace (Exhibit 12). Longer term, we believe that freedom will drive more and better innovation.

Finally, we consider distribution. In exchange for generous subsidies from its carrier partners, Apple has been judicious in expanding its distribution network. In the US, this means that iPhone users have been stuck with AT&T. Google largely leaves the negotiations with carriers to its hardware licensees and demands no special subsidy kickbacks. Thus, Android phones are finding their way to every carrier, meaning more points of distribution, more co-marketing spending and more choice for users. Of course, it is rumored that Apple will deliver a CDMA iPhone to Verizon in 2011. If true, it would likely yield incremental market share to Apple, including a potentially sizeable bump from AT&T iPhone users churning to Verizon, but could come with lower subsidies from the notoriously hard-bargaining Verizon, which will pit it against Android phones with another 6-12 months to push development and build momentum.

While we expect the iPhone 4 to continue Apple’s global smartphone market share landgrab, we expect Android to grow even faster. As the conflict progresses, the first casualties will likely be the other alternative platforms – WebOS (Palm/HP), Mobile Windows 7, Symbian/MeeGo, and Blackberry – all of which are either proprietary single company systems with all of the drawbacks, but none of the market momentum of iPhone, or available for license at terms far less attractive than Android.

In the end, we suspect that Apple’s “go it alone” strategy will leave iPhone as an extraordinarily profitable, but minority platform, considerably behind the Android ecosystem, in much the same way that MacIntosh ceded leadership to Microsoft’s me-too Windows OS.

There’s TV in That Thar Internet!

Over the next several years, we believe that there will be a steady migration of viewers from traditional channelized television to video delivered via the internet, and that eventually, internet TV will become the primary source of video entertainment in the US market. Both Google and Apple appear to share our enthusiasm.

Google acquired internet video leader YouTube in 2006 for $1.65 Billion. Under Google’s ownership, YouTube has increased the sophistication of its advertising offerings and its volume of paid ads, and continues to dominate internet video, delivering more than 43% of all web video traffic. It has also begun to delve into paid streaming and downloading of movies, ala Netflix. Behind the scenes, YouTube’s overwhelming leadership in serving video content, combined with Google’s mastery of content distribution and its world’s largest array of distributed computing power, rumored to comprise more than 100,000 servers, give the company a fairly significant scale and experience advantage as professionally produced content follows viewer eyeballs to the world wide web.

Of course, that’s not all. Google has also announced its Android-based platform for set-top-boxes, not so imaginatively titled Google TV. The platform is open-source, sports a fully capable browser (including support for Adobe’s Flash) allowing users to select content off of traditional cable/satellite, from material recorded on DVRs in the household or off of the entire internet, including, of course, YouTube. This approach also leverages Google’s eponymous search service, and its world leading technology in voice and image search – with these capabilities, users could search for videos with specific content, even if they had not been tagged with the appropriate keywords required for a text-only search. The first Google TV box is expected from Logitech in the fall at BestBuy, but the technology is available to all comers.

In contrast, Apple CEO Steve Jobs has famously termed the company’s AppleTV foray as “a hobby”, deflecting criticism over the tepid response of the box that ties household televisions to the iTunes music and video distribution business. Certainly this is no ringing endorsement for a product that appears under powered and under-featured compared to the new Google product. Once again, Apple’s instinct has been to tightly control the hardware, software and services, an approach that limits its ability to leverage partners and broaden its user experience, an apparent liability for AppleTV. In video as in other arenas, rumors swirl around Apple, which is said to be interested in acquisitions to bolster its position in internet TV.

Music Begets Video

Apple’s approach has not been a liability in its domination of the recorded music market. iTunes has a whopping 90% share of on-line music downloads and a nearly 27% share of the entire US recorded music market. iTunes began distributing video in 2005, and by 2009 users had downloaded 250M TV episodes and rented or purchased 33M movies. While this sounds impressive, it is useful to note that YouTube streams more than 12 Billion videos each month – of course, most of these are free (Exhibit 13). iTunes video business is well integrated to the iPhone and iPad platforms, which will drive incremental growth. This is likely Apple’s best way into internet TV and it will be interesting to see how well it plays with content creators who may crave the Apple user base, but are fearful of suffering the fate of the recorded music industry, which has seen its profits destroyed by the iTunes juggernaut.

To summarize, while both companies are following vaguely similar paths into internet TV, Google is moving faster and with far greater enthusiasm. Leveraging its content service network, massive server farms, video leadership, advertising expertise, and ecosystem of hardware partners, Google could dominate this potentially massive global market. Apple may be genetically opposed to the actions that may be necessary to catch-up.

Peek-a-boo, I See You!

Video Conferencing has been the killer application that has been just around the corner for over 30 years. AT&T first demonstrated its Picturephone at the 1964 New York World’s Fair, but at its peak never attracted more than 500 total users. AT&T was back with a $1,000 VideoPhone in the early ‘90’s but that too was a commercial failure. Face-to-face video calls via wireless phones have been available almost from the start of the 3G era, but have been only modestly popular. High-end Video Conferencing has achieved some measure of success, but only recently with the technical advances inherent in Cisco’s Telepresence systems and the weight of that company’s marketing push has there been significant traction.

The barriers to widespread video conferencing can be boiled down to convenience, quality and cost, although there remain skeptics who maintain that people just prefer not to look at others while talking to them. Convenience has been a major issue – video calls have been difficult to set up, have typically required both parties to have special equipment, and follow a confusing array of incompatible standards. Quality is starting to be less of an issue, as faster network connections, better displays, and higher resolution cameras are becoming widely available. Cost may be nearing a breakthrough. Cisco’s success with telepresence at the high-end is generating market volumes that could allow technology to hit mass-market price points. Cisco itself has hinted at consumer affordable systems in the near future, and value-added applications such as on-line education and tele-medicine could help drive adoption.

We think that mass-market adoption of telepresence will be a major growth opportunity for the next decade, and both Apple and Google are dabbling. Google has developed a cloud-based application called Google Talk, integrated into its Google Apps suite. This free software enables users to launch video conversations directly from their browsers, is available for plug-in to both PC and Mac platforms, and is compatible with a wide range of camera options. Apple offers its own video communication platform called iChat bundled with the OS X operating system bundled with every Mac computer (Exhibit 14). It has also launched its FaceTime platform bundled on the newly released iPhone4. Unsurprisingly, FaceTime is restricted to conversations with other iPhone 4 users.

It is difficult to call an advantage for either company at this early stage. Neither emphasizes this capability as part of its products, although it has been integrated into both of their offerings for many months. We suspect that both would step up the pace of development should the consumer telepresence market develop as we expect. At the same time, both may be losing valuable time in driving the evolution of de facto and formal standards to their favor and giving Cisco an unusually wide berth to address user needs.

Send in the Clouds, There Ought to Be Clouds

The relentless improvement in network speeds and costs, both wired and wireless, has driven us to the point where it is feasible for users to access servers on the web as though the resources were on their own devices. In this world, a new computing model has emerged, where applications and data are hosted in big, fast, efficient and cost-effective server farms on the internet. This relieves users and their organizations of many responsibilities and costs, while giving them flexibility to use what they need, to adopt application upgrades as soon as available and to switch platforms if necessary.

Google is a key player in this evolution. Its on-line suite of applications called Google Apps include its popular Gmail email service, along with calendar, word processing, spreadsheet, presentation graphics and more. Google’s growth in this area has been exceptional. Gmail has been growing rapidly, recently surpassing AOL for third place and on a trajectory to take second place from Microsoft’s Hotmail within the year. Of course, Yahoo remains out of range at more than double the size of its nearest competitor, but the coherence of Google’s overall strategy relative to the market leader suggest that current of change will remain in Google’s favor.

In the business arena, Google Apps are gaining favor with the most savvy users of technology. RescueTime is company that provides software for businesses and individuals to measure and evaluate how they use their computing resources. It also aggregates data from its users to yield detailed portraits of the behavior of its client base. While this analysis is certainly not representative of the average Joe, it is an extraordinary glimpse of the changing activity of sophisticated computer users. Recently, RescueTime published statistics that showed that these advanced users were shifting away from Microsoft Office to Google Apps at jaw-dropping pace, with more than 75% of users accessing Google Apps daily vs. just over half using MS Office (Exhibit 4). Little wonder then, that Microsoft has moved to offer its Office 2010 release in a cloud-based version, in addition to the normal client software offering.

Given the momentum behind Google Apps, the company is pressing to broaden its suite of offerings. Rumors abound that Google will offer a serious social networking alternative to Facebook within its application suite. It has also been rumored to be interested in the customer relationship management (CRM) software market, currently led by cloud computing pioneer, either via internal product development, or through acquisition, perhaps even of itself. Google has also launched a service called Google Apps Engine, which provides hosting, tools and consulting to organizations looking to move their own applications into the cloud.

Google’s cloud application strategy is reinforced by its Android OS and Chrome browser play at the smartphone, tablet and desktop level. Devices with Google client software can be tuned to Google Apps to take advantage of performance benefits inherent in the integration of cloud-based applications with local execution. To that end, Google’s Chrome browser recently passed Apple’s Safari for third place in total browser market share after less than two years of existence, in many cases running as the primary browser on Apple devices (Exhibit 15). New tablet devices from the likes of Samsung and Dell running Android and Chrome are expected before year end to further Google’s cloud strategy.

It’s All About the iPad

Apple has been quiet on the software side of the cloud. It has launched its own on-line application suite called iWork, but has not pushed very hard and as such, has made little progress in penetrating the market. It has also created a service called MobileMe, which allows consumers with multiple Apple devices to manage data and applications across its platforms. This service is popular amongst heavy Apple users, but is relatively unknown to the casual iPhone/iPad consumer. iTunes also behaves as a cloud service, enabling cross connection of music libraries across devices and likely beginning streaming music and video in the near future. However, to date, Apple’s seemingly half-hearted cloud strategy is emblematic of the company’s core philosophy that hardware is crucially important and that the best place to keep, manipulate and use data is on your computer.

Apple’s real cloud strategy appears to be the iPad. Designed as something of an intenet access panel, it depends on network based applications to drive functionality. However, given Apple’s generally blah offerings on the applications side beyond iTunes, the iPad may well end up supporting Google’s own applications agenda as a entryway to Google Apps.

In Pursuit of Excellence

The developing war between Apple and Google is particularly interesting given the contrasts in the business philosophies between the two companies. Apple’s approach has been largely consistent for the 35 years that the company has existed, owing in part to the lengthy tenure of many of the company’s leaders. A quote from Apple COO Tim Cook summarizes its approach: “We believe that we’re on the face of the Earth to make great products, and that’s not changing. We’re constantly focusing on innovating. We believe in the simple, not the complex. We believe we need to own and control the primary technologies behind the products we make, and participate only in markets where we can make a significant contribution.”

We take away several points from this quote, which we believe accurately frames Apple’s behavior over the course of its existence. First, Apple is very focused on products, specifically, hardware devices. All of its other activities – applications, services, etc. – are engaged in support of Apple’s devices. Second, Apple is extraordinarily innovative in the design of its products and its approach to selling them – that is obvious to even a casual observer – and it is institutionally proud of that fact. Third, the company believes that simple is better. It is willing to leave out functionality to achieve simplicity and it is deeply opposed to any one, users included, changing the look, feel and basic operations of its products. Fourth, it is not really interested in partnerships or collaboration. Apple will insist on total control, soup to nuts, and is willing to go it completely alone if need be. Apple co-designs its own custom chips, writes its own software, aggressively curates the applications suitable for its products, provides the services to deliver content to its devices and even operates its own retail stores. What partnerships it has formed have typically been straightforward supplier or distribution deals. Finally, Apple is cautious about entering new markets unless it is really certain that it has an edge to exploit. It has also been historically reticent to do acquisitions other than to add incremental talent and/or technologies to existing Apple initiatives (Exhibit 16).

This philosophy has served Apple exceptionally well over the past decade, with the bold stroke of the iPod driving iTunes as the dominant music distribution service and spurring a new generation of users to turn back to the venerable Mac platform. This, of course, begat the iPhone, the iPad and the rest yet to come. However, a longer view of history reminds us that the lone pursuit of the perfect product has not always yielded the world domination that investors have come to expect of Apple. Windows did crush the original MacIntosh. The PalmPilot revealed the Apple Newton to be an embarrassing clunker. AppleTV is a yawn, while YouTube and Netflix prosper. Apple is an extraordinary company, but it is not infallible. Its strategy leaves just scraps on the table for would be partners and it appears to have gained a reputation for being a bit of a silicon valley bully, naturally aligning much of the industry against it. Its ultra high margins – 27% plus EBIT across its hardware dominated product line – give it little leverage to boost future profitability. Finally, a healthy element of Apple’s success has been its position as a trend setter – Apple is cool. It is not easy to stay cool.

Google is All About Large Numbers

Google’s business philosophy is close to inscrutable. It has published a list of “Ten Things We Know to Be True” with truisms like “Focus on the user”, “Fast is better than slow” and “Great just isn’t good enough”, but offers little in the way of how the company might exploit these truths in the future (Exhibit 17). Google, largest core competency would appear to be software development – search algorithms are the firm’s chief claim to fame – but it also distributes content, sells advertising, runs the world’s largest network of servers, operates its own core network to achieve speed advantages over competitors and dabbles in hardware designs to boot.

Observing Google, it appears to believe in the power of many. Google spends 12% of its revenues on R&D. Apple spends just 3.2%. In dollars, this is a nearly 2.5 to 1 spending difference. At the same time, Google’s liberal licensing policy has enticed many others to spend on its behalf. HTC, Motorola, Samsung, Logitech, Dell, Sharp, Sony, Garmin, Dell, LG, Huawei, ZTE and others are all working on products that feature Android. Qualcomm, Broadcomm, MIPS, Intel, ARM, et al. are all spending on merchant semiconductor solutions tailored to the needs of the rising operating system. The spending of these companies is additive to the research and development advantage that Google maintains (Exhibit 18). Partners also help pay to market the Google brand and help find distribution channels for Google technology.

Google also appears to believe in the power of size. Google stepped up to buy YouTube for $1.65B in 2006, instantly becoming the largest source of video traffic on the web. While analysts fretted about near term monetization and dilution, Google filled its core network, leveraged its servers, and positioned itself for internet TV. Google’s strategy of giving much of its technology for free has devastated many would-be competitors – free search, free maps, free applications, free browsers, free video, free operating system licenses, etc. Little wonder that Google either dominates or is reaping market share from every market it has entered.

Yes, But Google Can’t Monetize Any of This, Can It?

All of this market share, even if entirely devoid of direct revenue streams, helps Google immensely in its one money making business – advertising. As of a year ago, Google had a 30% share of on-line advertising, up more than 500bp YoY, but less than 3% of total advertising revenue (Exhibit 2). By embedding itself in more corners of the electronic economy Google can increase its share of on-line, but more importantly, grab the lion share as advertising dollars continue to flow into the internet from traditional media, particularly as viewers increasingly watch internet video rather than channelized TV. The advertising opportunity alone could be worth tens of billions in high margin revenues for Google.

But that’s not all. Google doesn’t charge for most of its technology. It doesn’t mean that it couldn’t charge or that it won’t. Google could charge for its applications – Microsoft certainly charges for Office. It could charge to license its operating software – once embedded with market share leadership, it could be difficult for manufacturers to change. It has already started charging for some video downloads, will do the same with music and electronic books, and could charge to distribute applications for others. It could charge for handling web traffic over its network. It can and does charge for hosting applications on its servers. It could charge royalties on its substantial patent base. It could charge other companies to embed technologies like search, navigation, speech and image recognition, translation, etc. in their products.

Google’s reticence to monetize its technology portfolio and its “do no evil” stance have allowed it to appear less threatening to the TMT universe than alternatives like Microsoft or Apple, and as such, embed itself into all corners of the internet in a way that will be very difficult for others to attack. It is somewhat reminiscent of the strategy Microsoft itself used in the early ‘80’s when it was working with IBM on OS2 and enabling the nascent MacIntosh platform with an exclusive on Word and Excel, all while secretly working on Windows. As Google’s penetration peaks, we are confident that it will have ways to monetize it.

Not in My Backyard!

The Apple-Google conflict will not be taking place in neutral territory. Apple is already deriving 18.5% of its sales from iPhone, another 11% from iTunes, and nearly 7% from software (Exhibit 19). Add in 22% of sales from the iPod portfolio, which is being cannibalized by iPhone even as we speak, and over half of Apple’s sales are on the table. In contrast, Apple’s push into mobile advertising brings just 1% of Googles existing revenue into play, with another 3% from Google Enterprise under minor threat from Apple’s business initiatives. The other 96% of Google revenues come from search advertising and other on-line ads, none of which is threatened by Apple. Essentially, Google has invited a mob and given them all free shovels to play in Apple’s sandbox. The risks are asymmetric in Google’s favor.

Definitely Not Now, But Soon

In a vacuum, both Apple and Google look to be world beaters. Both are world class companies with exceptional records of achievement and clear competitive strengths facing extraordinary growth opportunities with obvious synergies to their core franchise businesses and organizational capabilities. Unfortunately, those growth opportunities are the same for the two companies who are approaching from opposite sides. We believe that the advantage against those opportunities – smartphones, internet TV, consumer telepresence and cloud computing – lie with Google for several key reasons:

  1. Google’s open and royalty-free licensing policy has attracted an all-star team of hardware partners committed to its software platforms, while Apple will play alone.
  2. Google outspends Apple on R&D 2.5 to 1, not including the Android/Chrome related spending from its ecosystem partners, which likely double the resources committed to Google’s platforms.
  3. Google updates its platforms several times a year, with hardware partners competing with each other to push the leading edge and adapt to changing market conditions, while Apple has been content to do a single iPhone model and software upgrade each year.
  4. Google’s ecosystem approach means a variety of choices for consumers vs. a one-size fits all approach for Apple.
  5. Apple’s lone wolf approach and aggressive tactics is earning it a reputation as an industry bully, which could translate into less willing content and application suppliers and even damage perception of the company amongst users and the media.
  6. Google has far more comprehensive approaches for Internet TV and Cloud Computing, opportunities that could be even more attractive than SmartPhones.
  7. The war will be fought on Apple’s home turf, forcing it to play defense for its iPhone, iTunes and iPod franchises

While our preference for the longer term is clear, the conflict between the two companies will take years to play out, and several months for the tide of battle to become more apparent. Meanwhile, there is little in the immediate term to threaten Apple’s sales momentum, given the euphoria over the release of the iPad and iPhone 4. Apple, and its key component suppliers – Broadcom, Cirrus Logic, Infineon, National Semiconductor, Samsung, and Toshiba, amongst others – should see strong unit volumes even in an uncertain global economy.

Google’s short term performance hit a speedbump over the past year, as the weakness in the global economy slowed advertising spending. While the US market has firmed and the strong shift of ad spending from traditional media to the internet favors Google, an international economic slowdown has a bigger impact on it than it does on Apple. Nonetheless, the secular trend toward internet advertising and the massive opportunity to monetize more of its technology leadership as these industry changing opportunities unfold position Google and its partners to deliver extraordinary long-term growth.

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