Apple Squash

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:

  1. 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
  2. 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?

 

 

Advertisements

9 thoughts on “Apple Squash”

  1. I generally dont leave comments on blogs , but this one deserves it.

    It takes a brave man to go against conventional wisdom, but you hit the nail on the head.

    Plus, a Spinoza fan, impresive

  2. Yes, Insomniac. I am a lone voice, crying in the wilderness. Thanks for making an exception and commenting on post everyone seems to be ignoring.

    Obviously the stock goes up first, however.

  3. Screwing AT&T post-launch very likely was part of Apple’s business model from the beginning. So it’s a bit hard to argue that Apple now finds itself blinking and bewildered, and wondering what to do next, with a failed business model on its hands. More likely, the current situation is unfolding according to plan.

    The sales channel through AT&T is nice, but hardly essential: Apple is a consumer electronics company and they have plenty of other sales channels. This item is moving off the shelf due to consumer pull, not middleman push.

    What Apple does better than anyone else is creating a user experience that consumers crave. This is not at all easy to get right; the world is awash with hard-to-use electronic devices with clunky interfaces and too many buttons (you probably own some). Before you bet on an iPhone killer, consider the singular lack of success of would-be iPod killers.

    Not to mention Apple will likely have a thicket of IP protection in place. Resizing windows with a pinching motion of your fingers? Patent pending, undoubtedly.

    Nokia sells more handsets in a week than iPhone has sold since launch, and they are betting big on emerging markets, including (surprise) Africa. In any case, a plain old mobile phone is a different animal than an iPhone: consider all the people you see walking down the street while talking into their phones. You can’t do that with an iPhone, and you can’t shrink an iPhone beyond a certain size because its screen has to be legible. Ordinary mobile phones and iPhones are fundamentally different product categories. In other words, it’s not even clear that Nokia sees competing directly with Apple as its top priority.

  4. anon, forgive me if I seem a bit direct, but I fear you may be persisting in error:

    You write: “Screwing AT&T post-launch very likely was part of Apple’s business model from the beginning.” you are probably right, but this just shows how arrogant Apple is. Screwing your key distribution partner is not generally thought of as smart.

    “the current situation is unfolding according to plan.” You think the plan involved losing market share in Q1? 3 quarters into the life of the handset?

    “Before you bet on an iPhone killer, consider the singular lack of success of would-be iPod killers.” The MP3 player category was dominated by subscale hardware only guys. Apple got an immediate scale advantage it could surf on. It was a one-in-a-million shot that worked. Mobile phones are a much harder market to dominate, with smart, deep-pocketed scale players.

    “Patent pending” maybe, but no-one in this market cares. Samsung and LG won’t. Plus there are other patent families to cross license. Synaptics has been doing this for a while. Plus it must be FRAND licensed. By the time we get to the end of a process like this and find out if you are right or not, years will have passed. Nokia prefers thumbs, by the way.

    “consider all the people you see walking down the street while talking into their phones. You can’t do that with an iPhone” Really? It’s even worse a product than I thought!

    “it’s not even clear that Nokia sees competing directly with Apple as its top priority”. Oh yes it is. I met them. They told me. It’s the only thing they get asked at conferences, “when are you going to have a iPhone killer?” The CFO must be sick of it. Have you seen the stock?

    But anon, thanks so much for commenting. I consider this post to have been my magnum opus, something people will have talked about long after AAPL has filed for Chapter 11 or gets bought out by IBM for $25 (pre reverse split). “Oh you know, Baruch? Who that guy who nailed Apple before anyone else? ” That’s what they’ll be saying. I am baffled no-one cares.

  5. Many a “brave” man have been ruined by their contrarian convictions in the face of market optimism – often it doesn’t matter how right you are!

  6. well with AAPL there are lots of things you can do to not get hurt. don’t short it for chrissakes, or at least not until Q1 09. or go neutral in it until then if you are long only and it is yr benchmark. remember, the volumes are going to be so strong in 2H relative to iPhone v.1 they will make your socks fly off. hell, i may even go long!

    long AAPL short HTC. now there’s a trade!

  7. Google’s Android is worth more than a one-sentence non-mention.

    Mobile phones have GPS chips, which enables all kinds of location-based services and advertising. It’s no coincidence that Google has invested a lot of money and effort into mapping. They are implementing StreetView into Android, with the ultimate result coming close to an early form of augmented reality.

    See: http://www.alleyinsider.com/2008/6/apple_and_googles_awkward_mobile_marriage_aapl_goog and especially the associated YouTube video.

    Ever watch American football games on TV? You can see the first-down line painted in yellow… but it exists only on your TV screen, not on the football field itself. Now imagine that sort of thing all over downtown Manhattan, with virtual yellow arrows painted on the sidewalk, guiding you to the nearest Thai restaurant, and Google collecting a fee for sending you there.

    Google is notorious for lack of focus, but I think they very much see this sort of this as absolutely central to their long-term future. A future where a computer isn’t something that sits on a desk, but something you wear.

    If there’s an iPhone killer here, it’s Google, not Nokia. Nokia’s efforts here will be like the Microsoft Zune MP3 player to Apple’s iPod, easily defeated. By contrast, in some medium-term future Android-enabled devices might even be subsidized down to zero price as Google and the mobile phone operators split the ad revenues, and how will the iPhone hardware sales compete with that?

    Still, Apple is very clever at making devices that click with consumers, that just “feel” right. They own the consumer, they have a big head start, and their prospects are excellent if they have a plan to respond to Google’s strategy.

  8. Android is vaporware, until I actually see the 1st handset. So far, it keeps getting delayed, and the the developers kit is . plus there is NO FRIGGING WAY I or anyone else wants ads on their phone. I will PAY not to have that, which, i guess, is what I and everyone else does now.

    Google is your enemy and mine, they are a hegemonic swarm that needs to be defeated. Luckily the operators hate and fear them even more than they do Apple.

  9. Ha! too funny …
    Are you for real?

    Are you a 12 year old?

    Have you anything to state that includes and displays a modicum of intellectual capacity?

    Why did I waste five minutes of my life reading the above twaddle?

    Why am I even posting a comment?

    Who will win Euro 2008?

    Magnum opus?
    Well, the same old sostenuto banging on the anti Apple drum dismisses the music, the innumerable solecisms elevating out of this heady and solipsistic work eschews any visual artistic value; which only leaves literature … Some where between a tragedy and fiction.

    A tragic fiction, maybe?

    Please feel free to answer my loving questions, I know that you want to and you know you want to.

    You will wont you?

    I still have that jar of condiments for you.

Comments are closed.