I’m sorry to say Spinoza has been far from my mind, Bento. While you have been emulating him, coughing nobly on a sickbed, Baruch’s little mind has been awhirr with work and stocks and which ones to buy and avoid. Thus lack of posting.
But lately Baruch has noted that AAPL stock has been on a tear in anticipation of the iPhone v.2 launch this or next month. Then he read this rather good post on business models by Baruch’s fiancée, Equity Private, who opined that with its superduper iPhone, Apple had broken free from the bonds of Porter’s 5 forces and the domination of conventional wisdom, and had redefined the handset industry. I had to disagree with her. I worry her analysis is too US-centric, because from where I sit quite the opposite seems true. I hope she will punish me severely for my insolence, and expect to enjoy it.
Yes, iPhone is the most elegant and sophisticated and user friendly phone on the market, it has set the agenda for the whole industry, and will be viewed for ever after as a watershed in the industry. Blah blah. But really, none of that matters, because iPhone v.1 was really an attempt to remake the business model of the handset industry, to redfine the rules in a way that nullified the advantages of the incumbents like Nokia and Samsung (Motorola is sadly no longer relevant, except as a cautionary tale). In this they have failed. Two bits of news make me think this:
- 3G iPhone is going to be subsidised by AT&T to sell at $199 with a 2 year contract, according to Scott Moritz at Fortune
- Vodafone, which semi-publicly rejected the harsh terms offered by Apple to take iPhone v.1, has announced its non-core-European (ex GB, DE and FR) properties will carry iPhone. Since then we have had a rash of similar carrier announcements from SingTel, to Telecom Italia. All are likely non-exclusive.
1) is rumour, 2) is fact. But both indicate Apple’s business model for v.1 may be a thing of the past.
I have long argued that the iPhone venture is Apple playing a weak hand as best it can, and that there is a very real chance it will be its undoing. Although it may not feel like it, and there’s likely still good news to come in the short term, overall risks for Apple have increased. They have lost the initiative and are playing by others’ rules. They are now swimming in a pool of sharks. Follow me, gentle reader:
It’s all about margins. In its iPod franchise, Apple has reigned supreme, developing a 100% owned closed system used by millions. The “halo effect” of the iPod drove Mac sales. Over the past 6 months Apple’s EBIT margin has been a rather tasty 20%. But as iPod dies, this margin will tend to go down. The strategic imperative of finding a replacement for the iPod and the importance of the handset as an emerging computing platform means that, as so often in technology, “things must change so they can stay the same”. Clearly, from Apple’s perspective, they needed a beachhead in mobile handsets.
However, handset market EBIT margins are structurally lower than what AAPL shareholders are used to. You can, with the scale that comes as number 2 or 3 in the industry, if you are lucky, earn a 12-13% EBIT margin, exactly where Samsung and Moto were. Nokia’s is about 20% in a good quarter too, but it owns 40-50% of the market. So iPhone, were it to be successful, would be seriously dilutive for many years to come.
Happily for Apple, pure smartphone players tend to have better margins, as their GM base is higher. For instance Taiwanese HTC earns 23% But it has a special (hybrid OEM/ODM if you really want to know) business model where it has avoided having to pay so much in marketing to date, and has a lower R&D cost base in Asia. So not much chance of Apple copying that successfully. Research in Motion, at a whopping 29% EBIT margin, is much more the thing. So Apple cheerfully set out to rip off RIM. RIM’s business model is a beautiful thing: it combines the leverage of a smartphone hardware model with the recurring revenue from subscription to its push email service and software upgrades. It has a lock on the business market, and legions of addicted users prepared to pay whatever it takes to keep getting their fixes, and upgrading to the latest models.
So Apple had to fix it that the operators taking the iPhone pay them up to $30 a month (no one really knows) of the service revenue generated by an iPhone user, an unheard of imposition without a specific, value-added-service (like push email) offered by the vendor. Unsurprisingly, most operators (like Vodafone) said no. But a few said yes. This was the proposition: in return Apple would offer national exclusivity to the operators taking it, on all future iterations of the iPhone, for up to 4 years. Apple, moreover, as fake Steve Jobs would put it, is like, inventing the frigging mobile internet, dude. Nothing else would supply the same combination of hardware beauty, browsing, and multimedia goodness. Not only would the operator have a monopoly on iPhone users, the operator would get a ton more revenue from the iPhone users.
Those operators could only make their margin if they didn’t have to subsidise iPhone, like they do with like every other smartphone in the world. But that’s OK, says Apple, because we’re Apple. That unique user experience, plus Apple’s general brand wonderfulness, will mean that the user would be happy to pay an unheard retail price of $600, £369, or EUR399, plus a 2 year high end contract.
Well, they weren’t. Apple cut price across the board 60 days into the life of iPhone, after disappointing sales. Even after that, inventory built up in Europe, because Europeans simply do not pay a lot for their smartphones, and 2G is just, well, so 2002. Only now, after successive price cuts, has that inventory started to shift. Not even in the US, a benighted cellphone market 2 years behind the rest of us, did things go very well. Apple Stores quickly sold out. But AT&T shops selling with a contract never ran out of stock, even though all the iPhones sold in the US were supposed to run on AT&T, because half the iPhone buyers were box-breakers, shipping them off to Asia and the Middle East to be unlocked. My mate in Taiwan’s got one. He loves it, but AT&T, O2, Orange and T-Mobile (DE) aren’t making a penny off him. This, I think, made the operators very cross. Apple got the hardware sale, but the recurring revenue in the business model? Me no think so.
And then — this makes me giggle — the Apple frigtards pissed off the operators by selling the iTouch at the same time, a wifi-enabled iPhone lookalike without the cellular service, bypassing their new partners altogether. Operators already suspect they will become the “dumb pipe” of the wireless web. The smarter ones know that this is the fate imagined for them by Apple, that Steve Jobs is the scorpion in the story, and they are the proverbial frog. So they were less likely to respond positively to Apple in its hour of need by instructing its staff to push iPhones extra hard when they stopped selling. They could sell RIM and HTC more easily instead, without risking their future. Did you know that iPhone LOST global smartphone market share in Q1 08, Bento? Down 26% in units quarter on quarter? I am really not making this up.
So here we are on the cusp of the 3G iPhone. Apple’s business model is in tatters, it has inadvertently pre-sold at lower profit into Asia, and much much worse, it has completely pissed off the operators it is married to in its 4 key markets for the next few, critical years. It clearly has to switch business model, and the only one available is the traditional mass-market, hardware-only one from here on in. You think AT&T is still going to pay away monthly ARPU and subsidise the unit after this? You think Vodafone saw the success of iPhone v.1 and said, golly we got to get us some of that, name your price Mr. Jobs?
Confusingly, I think now that Apple is (to use a charming phrase given me by some earthy Oregonian friends) “stump broke”, it has a window to build some scale. At the same price as an HTC, hell, I’d buy a 3G iPhone. I can finally see it taking off. But it’s just a window.
I have written before that the handset market is a kleptocracy. Starting from Q1 next year, I would expect a bunch of touch models from Nokia, RIM, Samsung, HTC and LG. These last 3 have vaguely iPhone-like models out now, actually, and its just a start. The Koreans are the masters of copying and improving on your hardware before you can. This is the nice part of the tag team, and they can sort of be pushed around because they lack a software edge. Der Hammer, as the Germans call it, comes when Nokia gets on your case. They’re a bit slower, and are busy right now finishing off Motorola and Sony-Ericsson. They have the ability to come up with a software experience closer to iPhone’s. They copy all your features too, but worse, head you downmarket, offering your features at prices you never could. RIM will likely just mosey along, with its untouchable edge in enterprise, eating chunks out of iPhone’s (and everyone else’s) addressable market. This is the pool of sharks Apple now has to swim in with its new hardware-only business model. I haven’t even mentioned Google’s Android and the cheap Chinese knock-offs.
And this is what amazes me about the pickle Apple has got itself into — because they signed exclusivity with 4 operators, they have to do it with, like, 1/4 the distribution of their rivals! They’ll be fighting this titanic battle for handset survival with one hand tied behind their backs. Each of the other operators in these key markets are not going to stop selling handsets, and will be panicked they will lose high value subs. They’re going to go cap in hand to RIM or Nokia, saying please can you do a touch screen model with a great browsing experience for us? Special deal for you, my good friend, we give you full price and subsidise your brains out. AT&T on the other hand will be saying to Apple, look here, you screwed me and I hate you. Give me special price and stop selling at Apple Stores or I give your shelf space to PALM.
So this is what I imagine will happen: a flattish reception to the 3G iPhone launch in May or June (I hear it looks identical to iPhone v.1, and may not have GPS or a 5 megapixel camera), followed by amazing initial volumes of 3G iPhone. But then, probably in 1H 2009, Apple handset share starts to get ground down, unless they cut price, or can find something amazing to put in a new model. Software and hardware advantages in handsets do not persist. Apple’s marketing and R&D costs will inflect upwards, while GM is more likely to fall than rise. Indeed price is the only way, medium term, I can see for Apple to gain the scale it needs to make iPhone a viable business. There is no scenario I can see where Apple will earn a 20% EBIT margin from iPhone, this year, or next year, or the year after that. 12-13% would be impressive. That would translate into a 300bp lower group EBIT margin, more if it cannibalises iPod. Not good for the share price. That’s a base case. Much worse would be a failure. Apple has made it clear it is in the handset business to stay. Presumably that would mean a semi-permanent loss-making drag, and a detriment to the overall brand which would potentially put the Mac business in danger.
So hopefully I have offered a reasonably convincing alternative argument to my darling Equity Private’s, and the current optimism.The business model trumps the hardware in this case, I think. I have been wrong before, and maybe I am too cycnical, imagining motives by the light of my admitted anti-Apple bias. But I have been proven fairly right about my cynicism about iPhone v.1 so far, wouldn’t you say, Bento?