Dan and Horace are back to discuss the latest news from Nokia, RIM, HTC and Sony and what they have to do with each other. We touch on the distinction between market and product orientation and meander into the question of what is the value of the enterprise vis-a-vis the product it sells and what management has meant and what it should mean. We even tackle the history (and future) of history.
Nielsen has already noted that more than half of US consumers have smartphones. comScore's data seems to point to that threshold being crossed sometime this year.
If that point is crossed then it would mark the smartphone as one of the most rapidly adopted consumer technologies of all time. I plotted the time it took for a set of technologies to reach 50% penetration of US households.
I also showed the time it took for some of the technologies to reach 80% penetration.
The obvious question is how long will it take for smartphones to reach saturation in the US. Saturation level would be above 80% for individuals but closer to 100% for households. A conservative estimate would be another seven years. An aggressive estimate would be five years. That implies that between 2017 and 2019 smartphones will be the only mobile phones Americans will use. That would be equivalent to a user population of about 300 million.
Note that some like Internet and home computers have not reached 80% penetration in the US.[1] [2] When or whether smartphones will overtake computer penetration in the US is an open question. I believe that, like cellphones have in other markets, smart devices will overtake computer consumption and thus penetration and even bandwidth consumption.
There are significant technical and marketing challenges for reaching the "second half" of the market, but, as in all the other technologies listed above the incentives are in place to overcome these challenges. What's most remarkable about smartphones is the speed with which obstacles are overcome. For such a complex and inter-dependent technology, the speed of adoption and value creation is unprecedented.
The value network creation rate is also staggering. The App Industry went from inception to billion dollar valuations in a matter of three years. Entirely new business models and experiences are being created almost daily. What used to be a glacial process of innovation diffusion can now be observed in near real-time.
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Notes:
The question of when smartphones began penetrating the US is somewhat debatable. I contend it was either 2004 or 2005 when the BlackBerry and Treo brands began to be widely available. Although there were smartphones in production as early as 2001 (or even 1998 if we choose to include the GeOS based Nokia Communicator) their availability to US consumers was very limited.
One of the arguments made for the cause of the increase in Apple's share price of late has been that dividends would attract more institutional investors and provide more liquidity to Apple's shares. Can we test this argument?
We're not dealing with speculation. The decision to start paying dividends was made three weeks ago. It makes sense to assume that this new information has been absorbed by the markets and market participants have adjusted their positions. Funds that were previously restricted in their investment in Apple due to its lack of dividend policy, could now go ahead.
However, as the following chart shows, the share price climbed continuously before and after the dividend declaration of March 19th (shown in red). Trading patterns did not show unusual highs or lows. In fact, after March 19th the trading volume decreased on a weekly basis.
The other indicator is institutional holdings. The share of institutional investors as percentage of all outstanding shares did not increase significantly, and has been in an overall decline since late 2010.
But this lack of visible response to the decision should not be surprising.
Dividends are a tool to adjust capital structure based on optimal investment decisions. Dividends do not add value. The value of a company reflects the perceived net present value of all free, future cash flows. Whether the cash is in or out of the company is immaterial to its value. In either case the cash belongs to shareholders.
What the market is reflecting is fundamentals, not any change in liquidity due to "more buyers" available. For a long time the fundamentals were not accepted as sustainable. The best explanation for the rise in the share price is therefore that the company's future is now becoming clearer and a cloud of doubt is being lifted.
In August 2007, during the HD format wars between HD-DVD and Blu-ray format, Toshiba offered Paramount and Dreamworks $150 million to produce HD versions of their movies exclusively as HD-DVD.[1]
This type of deal is equivalent to an "advance" offered to a book author. The DVD manufacturer pays studios up-front cash for the right to make its DVDs. From an accounting point of view this is treated as an advance that the manufacturer recovers by selling the DVDs back to the studio's video division in the same way a publisher earns back the advance it gives an author.
In this case, the payment was so large and the sales of HD-DVDs so small that Toshiba was unlikely to earn back the entire advance. The way the deal made any sense for Toshiba was that it was exclusive: the studios could not continue to release their movies in Blu-ray. The deal was done explicitly to hobble a competitor and create "critical mass" of content for its own format.
But then in March 2008, Toshiba threw in the towel and abandoned the HD-DVD format. The way the deal worked, the studios got to keep almost all of the $150 million. They then re-released all their movies in the Blu-ray format. The only "cost" to the $150 million windfall was that there was a nine month delay in the eventual release to Blu-ray--a small price to pay for an emergent format without a large install base.[2]
Platform owners go to great lengths to ensure "content" for their platform. They will, essentially, finance an ecosystem when there are barriers to entry or when competing ecosystems are far more lucrative.
This scenario for movies is being played again with Netflix, Hulu and other distributors who need to fill their pipelines. Netflix's content acquisition costs are exploding and putting the whole company's future in doubt.
But this scenario is also being played out with app developers. Most recently, news broke that developers are receiving payments from Microsoft for Windows Phone ports of popular apps. In mobile platforms, apps are the new content and developers are the new studios. It's also a practice that is not without precedent[3].
This is as it should be. The value of the platform lies mainly in what is built on top of it just like a foundation is not much use without a house on it. However, the practice of "priming the pump" with cash payments for porting is not ideal. Like spiffs, those who receive payments may become used to it and withhold development if there is no payment. Also, those who did not get payment offers may feel shunned and retaliate in kind. Those who receive payment may become cynical about it and may not put in the extra effort (or, more probably, outsource) to make the work spectacular.
Or, like Paramount, they may just take the money and run if/when the platform fails.
Paramount made $250 million more from three "replication output" deals: $50 million from Toshiba for agreeing to release Titanic on DVD in time for Christmas sales, $150 million from Panasonic for agreeing to allow them to take over video replication from Thompson, and $50 million from the law firm Ziffrin, Brittenham and Circuit City stores for agreeing to support the DIVX format. Paramount got to keep the money even though DIVX never launched.
Although it's never been reported that Apple pays developers for building iOS apps, some developers do benefit from promotional placement and visibility during launch events and from early access to devices or SDKs under development.
Canaccord Genuity analyst Mike Walkley writes in a note to clients today. “In fact, we believe iPhones are outselling all other smartphones combined at Sprint and AT&T and selling at roughly equal volume to all Android smartphones at Verizon.”
That's useful data. Mainly because we can use it in combination with comScore data that tracks a different market measure. comScore's MobiLens service tracks US mobile installed base. By measuring the difference between their stats one month to the next, one can measure the gain in a particular platform.
Comparing that gain with the sell-through rate in the same period can yield a figure for the number of units sold as upgrades vs. those sold to new users.
The latest comScore data (period ending February) shows that Android added 2.87 million users to its base while iPhone added 1.52 million. If we assume that Android sold a minimal number of replacements (due to the limited time in use of bulk of units) and round up to 3 million for February, and if we assume that Apple sells as many iPhones as Android (which is what Walkley suggests) then we can conclude that in the US roughly half the iPhones are bought as replacements for existing iPhones.
Extrapolating this to global markets may be risky but already we can begin to form a picture of how the iPhone franchise is becoming an annuity-based business.
Apple likes to point out that "half of Mac buyers are first time buyers." In the case of the iPhone perhaps they could also say "half of iPhone buyers are repeat customers." At this stage in the platform, that's a powerful statement. If the repeat customer rate is high then it suggests strong loyalty but it also may suggest poor competitive position vs. non-consumption or alternate platforms. If the repeat customer rate is very low it may suggest competition vs. non-consumption but it may also suggest low loyalty. It all depends on the overall growth in the market and size of installed base.
The following chart shows the overall market growth and the position of the various platforms within that growth.
Note the time scale is slightly more than two years. This suggests that the vast bulk of Android units in use (grey area) consists of first use units. New purchases are going to first time buyers. In contrast, the shrinking RIM total implies extremely low sales as the age of the base is far older than the time scale. iPhone base is both growing and being upgraded.
As we reach 50% penetration of smartphones, platform churn will become a significant component of market performance. The loyalty and "stickiness" of Android will begin to be tested. Current surveys show reasonably good satisfaction ratings for Android phones (around 60%) while iPhone's are even higher. But let's keep in mind that RIM's satisfaction and the loyalty of their customers was exceptionally high a few years ago. The rate of evaporation of goodwill toward the brand is breathtaking.
The longer term test of mobile platform performance will be in the recurring purchase rates. Loyalty must be earned and preserved. I.e. "You come for the product, you stay for the ecosystem."
So far, the iPhone seems to be getting a passing grade while Android has yet to face the test.
Horace talks again with Dan Abrams about film budgeting, Kickstarter, pre-production, location, technology for production, and a surprise announcement. We also discuss the project-oriented nature of movie production vis-a-vis "pipelined" product development, the history of studios and how they evolved, Pixar and much. much more.
Philip Elmer-Dewitt published a table from Piper Jaffray's Gene Munster which has some interesting details. Munster has taken a four year "tech sector" view of value creation (and destruction) and tried to see if there is a bound on the value Apple can continue to capture. This "share of value" is one of many approaches to bounding an opportunity. You could consider "share of wallet" by measuring disposable income, or "share of eyeballs" by measuring screen time available or even "share of GDP".
The attractive part of the share of value of industry is that we have an implicit way to see winners and losers, or the transfer of wealth from one group to another. I charted the data published as follows:
Seen in this context, Apple generated nearly as much value[1] as RIM, Nokia, Sony, Dell, HP and Microsoft destroyed. The rest of the sector generated $233 billion of value but if it were not for Apple, the tech sector would have declined by $168 billion.
As a result, Apple went from being 5.6% of the value of the sector to being nearly 17%. The argument goes that its share of value could still increase further even if the overall sector does not. At 30% of current total value, Apple would be valued above $1 trillion.
My observation is that the conservation of value exhibited in this data is not the entire story. What is gained by Apple should be more than what is lost by others. The disruption under way has had victims but the net value created should be more than what they lost. The iPhone and iPad should be competing with non-consumption, bringing new value into the sector from other sectors or from non-productive capital. Perhaps they are and the losses by the cohort arrayed above are incidental, but there is likely to be a blend of competition and new market growth.
Does the analysis satisfy?
Perhaps. It's one more perspective into the puzzle. Growth rates, market sizes, technology improvements, brand and satisfaction analysis as well as jobs to be done are all offering perspective views. I would say there is consistency in the data but they should all be weighed with vigilance.
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Notes:
Market cap is the perceived net present value of all future cash flows discounted to the present for a publicly traded company and hence defines the value created by the firm. It's measured by markets so there is room for error but it's the best measure available and has historically been accurate over long periods.
At the end of 2011 Apple's net property, plant and equipment (PP&E) was $7.8 billion. This reflects $12.34 billion gross PP&E net accumulated depreciation and amortization of $4.5 billion. The depreciation and amortization increased by a total of $533 million and the gross PP&E increased by only $572 million. I say "only" because in the previous quarter PP&E increased by $1.42 billion. If we assume that this growth is equivalent to capital expenditures for the quarter, it's also a very small amount given the company's stated intentions to spend $7.1 billion during the fiscal year.
The gap is illustrated in the following chart:
The blue bar in the 2012 year represents the company's stated intentions (from the 10K). The Yellow bar in 2012 is what has been spent so far as measured by the change in reported asset values. Given that the company has been exceeding their targets lately, one should expect the yellow bar to reach as high as $8 billion after another three quarters.
Another view into this data is provided by the following chart.
The beige bars represent the quarterly change in asset value and the green bars are the depreciation expenses for the same quarter. This view also shows a significant slowing in spending.
In the past I showed that CapEx, especially spending on machinery, equipment and internal-use software correlates with iOS device production during the next quarter. It's not a relationship that helps much in quarterly predictions due to the elastic nature of product transitions. There were quarters when spending and output were de-coupled, for example spending in March and June 09 quarters was far lower than one would expect for the 3GS launch quarters that followed.
We will have to keep an eye on the change in asset value to be reported for CQ1 to see how the spending ramps up during the year. At this time the company needs to spend at least $6.5 billion in three quarters or over $2 billion per quarter to meet its target for the fiscal year (ending October this year). We have to see whether and why Q1 (fiscal) was too low.
This discussion is also affected by the discussion on Apple's other balance sheet item: cash and cash equivalents. The magnitude of its assets is staggering: $100 billion in cash, $7.8 billion in PP&E, $3.47 billion in acquired intangible assets (mainly patents), and $896 in Goodwill (acquisitions). With this much "capital" the company does not make use of any debt facilities.
In this regard Apple is also an apparent anomaly. As it gets subtracted out of indexes because it weighs too much or skews "reality" so Apple and its balance sheet is causing a warp in "time-space" of capital markets. The traditional relationship between financiers and operating companies assumed some form of symbiosis but as the credit crisis has shown some have not kept their part of the implied bargain.
So we have to ask yet another unsettling question: what is the value of capital markets when their products are commoditized by relatively unsophisticated CFOs?
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Notes:
This is the material accompanying the third case discussion at Asymconf. Participants are encouraged to read it at the material linked before the show.
Charles Arthur, writing for The Guardian, has noted that court filings seem to be revealing Google's Android revenues. If this is the case, we have a significant breakthrough in understanding the economics of Android and the overall mobile platform strategy of Google.
The new data is a reference to a settlement offer Google made to Oracle of $2.8 million and 0.515% of Android revenues on an ongoing basis. The key assumption to make this data useful is that the $2.8 million offer represents 0.515% of revenues to date.
In other words, that revenues from 2008 to end of 2011 multiplied by 0.00515 results in $2.8 million. That implies that revenues from 2008 to 2011 were $544 million.
I think that's a fair assumption. I don't see why Google would offer a higher or lower royalty rate for years 2008 through 2011 than for years after 2011. The offer would seem to be 0.0515% in the future as well as retroactively in the past.
If we work with this assumption then the next question is how to distribute this $544 million over the four years 2008 through 2011? The installed base of Android has grown exponentially and it would seem logical to assume that revenues have followed in a similar pattern. Here is a chart of installed base given activation data supplied by Google.
If we assume revenues were distributed the same way we would get something like this:
The sum of the bars in this chart equals $544 million and the ramp is approximately the same as the installed base. The relationship between the first graph and the second is a multiple equivalent to the revenue per device.
Therefore a second assumption is that revenue per device remained fairly constant. In this model the revenue comes out to be about $1.70 per device per year. It's possible that rev/dev/yr. is increasing as Google services are discovered by users. It's also possible that the rev/dev/yr. is decreasing as later adopters are less likely to engage as early users. I just don't know how to adjust this value so by leaving it at the average, I can avoid introducing more assumptions.
Now we can stop and look at this figure and do a test. Does $1.70 make sense as a device revenue for Android? Google had spoken about targeting $10/device/yr. but we have no indication that they are nearly at that level. If they did achieve that level, with an installed base of 300 million, Google could be collecting $3 billion a year in Android income. Are they getting it?
As of October, Google mentioned that it had a $2.5 billion "mobile run rate". But we know that this figure is not only from Android. Mobile includes all mobile devices and services including those running inside iOS, Symbian, BlackBerry, Windows Phone, etc. They could be counting ads on all mobile browsers as well as ads running inside all apps on all platforms. Furthermore, Google also testified that iOS accounts for two thirds of their mobile search revenues[1].
Adding run rate to the Android revenue chart results in the following:
So the step is to take the "run rate" figure of $2.5 billion and assume, as Charles Arthur did, that iOS income is what is left after taking out the Android part[2]. I also noted that Google previously mentioned a run rate of $1 billion and I will assign that run rate to 2010 and $2.5b to all of 2011. Since we know the number of iOS devices in use for years 2010 and 2011 we can calculate Google's revenues per iOS device in use.
If we thus combine all the data we know (revenues derived from settlement offer, units in use, run rate and iOS installed base) we get the following revenue profile:
This shows a positive trend for Google: revenues per smartphone per year is increasing. However, the growth is coming from non-Android devices which means mostly iOS. Revenues per device for Android is probably declining.
The story for iOS revenues however is not all rosy for Google. Google has to pay for that revenue. The mechanism is a payment that Google makes to Apple for the prominent and default placement of Google search on Safari.
We don't know the terms of the arrangement but if we assume $2/device Google needs to shave $2 from the top of the chart above with that money going to Apple (attached as iPhone/iPad service revenues.)[3]
That still leaves a healthy $8.33 in 2011 as operating income from mobile with $1.70 or so coming from Android.
However, to make this operating income into bottom line profit, we have to extract the R&D and SG&A associated with mobile at Google. This would be, therefore, Andy Rubin's yearly budget.
Andy Rubin has stated in the past that Android is profitable. That is certainly believable. The budget would have to be about $400 million/year in 2011.
Charles Arthur concluded that Google obtains four times more revenue from iOS than from Android. My estimates indicate that in 2011 the revenue ratio was closer to 5 but if we subtract the cost of those sales in the form of payments to Apple then the ratio could well be four to one.
Many of these figures begin to "hang together" as we balance assumptions about costs, revenues and statements made in public. There is a consistency within a comfortable margin of error. If that is the case, then the economics of Android begins to take shape.
My take is that it's not a bad business. But it's also not a great one. As long as there is exponential growth in units, Android will improve its position inside Google relative to iOS. But from Google's perspective, iOS is today a bigger business. And iOS is not standing still. It's growing not only in terms of units but in revenue per unit.
Strategically, and historically Android was never one thing. P&L considerations were not the only (or even at all) factors in investment for Google. Having a hedge against hegemony of potential rivals, having a means to learn and develop new business and having a role in defining the post-PC computing paradigm are all probably bigger considerations than profitability.
So in terms of returns, Android is sustainable. However, in relative terms the value created leaves much to be desired. Whereas Android generates $1.70/device/year and thus an Android device with a two year life generates about $3.5 to Google over its life, Apple obtained $576.3 for each iOS device it sold in 2011[4]. The economics of Android are nothing like the economics of iOS.
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Notes:
This figure is also not conclusive as search is not the only form of revenue on a mobile device but it does imply that Android is not the majority of Google's mobile revenues.
Clearly this is overstating iOS as the non-Android income is broken up between several platforms. We can only say that iOS is the vast majority of non-Android income.
Assuming a $2/device payment model means Google paid $312 million to Apple in 2011 and $171 million in 2010. This would go toward boosting Apple's revenue per iOS device. Naturally, if this distribution cost is higher or would be subject to re-negotiation then it could vary widely.
The iOS figure includes accessories and licensing of trademarks but excludes income from App Store, iTunes music, movies, TV shows, iBooks, greeting cards or textbooks.
RIM’s CEO, Thorsten Heins was quoted as saying, “We plan to refocus on the enterprise business and capitalize on our leading position in this segment. We believe that BlackBerry cannot succeed if we tried to be everybody’s darling and all things to all people. Therefore, we plan to build on our strength.”
RIM's latest quarterly results show a continuation of the decline in sales that began in Q1 2011.
Here are the highlights:
Smartphone units declined 26% y/y and 21% sequentially. Over a four year period the company still shows a positive growth of 20% compounded, though that is far below industry average
The smartphone revenues were down 29% y/y and 23% sequentially.
Including service revenues, the revenue per smartphone dropped to $346, a drop of 4%.
I estimate the phone operating margin to be less than 5%. The company swung to a net negative operating margin due to write-downs of tablet inventory but the phone business managed to break even.
Operating income from phone operations dropped to the lowest level in five years.
The company is still generating cash flow and has a cash reserve of over $2 billion.
Seen in isolation, the company is clearly struggling but does not seem to be on its last legs. But no company should be seen in isolation. As part of a competitive market, the company is in far worse shape. The following chart shows the AMP index which measures relative performance through a blend of market shares.
This chart does not include the latest quarterly data but if it did it would be sure to show a continuing decline. The AMP index actually shows RIM peaking in Q1 2009, well before the volumes peaked.
It's within this context that we need to evaluate the new CEO's strategic shift. In the quote above we have the first significant strategic departure and split from the past. Should it inspire hope or despair?
The idea of focus has huge benefits. Focus and the art of saying no are keys to greatness. However, you only succeed if you focus on the right thing. "Enterprise" is not the right thing. It's not a valid target. Enterprise support is a feature, not a product. I don't mean that as opinion, but as a point of fact. Focus on a set of customers whose only characteristic is a job description is missing the whole point of focus.
Focus needs to be positioned on a job a brand needs to be hired to do. The idea should be to solve an open problem which is either too complex or too uneconomical for anyone else to solve. Corporate buyers have problems to solve but the BlackBerry no longer offers unique or defensible solutions. Furthermore, corporate buyers are themselves being dis-intermediated from the computing purchase decision. Sometimes this process is called "consumerization" but it is more plainly explained as "commoditization". The selection of tools for workers by a group that claims to understand their needs better than they do is an archaic concept.
This was true even in 2005 when RIM began targeting consumers. It was then that they saw the writing on the wall--that their enterprise business was being commoditized. All of RIM's growth since has been in consumer segments. By abandoning that trajectory RIM is effectively giving up on growth. And giving up on growth is simply giving up.
