November 19, 2012 – Apple: Can a Leopard Change its Spots?


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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.

For our full research notes, please visit our published research site.

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