Research

Thanks to @jtk0621 via twitter I was able to obtain a quarterly view into Samsung's SG&A expenditures by cost category.

The value of this data is in being able to understand why Samsung SG&A as a percent of sales remains fairly constant. To recap, the discrepancy with Samsung's SG&A is that it has grown in proportion to rapidly rising sales. Normally, when sales grow, SG&A grows but when sales grow very rapidly, SG&A grows a bit more slowly since it's primarily a function of headcount and hiring is necessarily organic and hence slower as a process.

The contrast is shown in the following comparison between Apple's SG&A and Samsung's SG&A as a percent of sales. [For more detail on Samsung revenue composition see: The Cost of Selling Galaxies].

Apple's SG&A has declined as a percent of sales, as one would expect, but Samsung's hasn't.

I have hypothesized that the reason for this might be in the practice of "outsourcing" many marketing functions. As Samsung expands promotional efforts, it does so partially by hiring people but even more so by farming out a lot more work. In this way, if and when sales subside, it can pare costs. This practice ensures that it's not exposed to a huge cost structure that is hard to control. The downside to this approach might be obtaining "quality" marketing as oversight is still depending on inside teams who still have limited resources.

To test this hypothesis, I looked at the types of costs it reports and divided them into two categories:

Category 1 are what might be considered "internal" costs which are in function of employees or operations. These costs are:

• Salaries
• Retirement Benefits
• Commissions
• Depreciation
• Amortization
• Freight

I graphed these costs over time below:

Category 2 costs are those which can be "outsourced" and are in function of budget items. These are:

• Advertising
• Sales Promotion/Marketing
• After Service Expense
• Public Relations
• Other

I graphed Category 2 costs below:

In both cases I created year-sized buckets summarizing these expenditure categories.

It becomes apparent at first glance that through the period shown (2009 through 2012) Category 2 costs grew much more rapidly than Category 1. In 2009 Category 2 were less than 1 but the order was reversed in 2012. On a yearly basis Category 2 nearly doubled while Category 1 grew by about 40%.

When seen in this context, the hypothesis is proven. The growth in Samsung SG&A has been driven by a vast expansion of primarily Advertising and Sales Promotions.

It's hard to get an appreciation of the scale involved due to the lack of comparable SG&A category reporting from other companies.  What we do have however is that US companies typically report their advertising spending on a yearly basis.

So taking only the Advertising figure from Samsung Electronics, we can get the following comparison with Apple, HP, Dell, Microsoft and Coca Cola.

In this context we can see that while both Apple and Samsung grew their  advertising almost at the same rate, doubling their budgets during the last four years, Samsung Electronics has a far higher ad budget. More than four times higher, actually.

Regarding Sales Promotions however, the comparison is far harder to make. I haven't any way to guess how much Apple spends relative to the $5.3 billion Samsung spent.

 

From the initial product launch until the end of 2012, AT&T has activated 72 million iPhones. Verizon began selling iPhones four years after AT&T and managed to activate 26 million since. Sprint began nine months after Verizon and has activated 8.5 million.

In proportion of their subscriber bases, the activations are shown in the following graph.

 

I identified the reported iPhone activations with blue areas while the sum of green and blue areas represent total subs at the end a the given year.

I also took the liberty of forecasting 2013 data in order to try to estimate T-Mobile's contribution.

The method used was to look at the percent of total subs that each operator has been activating. Accounting for the limited sales period for Sprint in 2011, the sales patterns are consistent across the carriers. The longer the product is available, the higher the activation rate.

Therefore I estimated that in 2013 T-Mobile USA will sell about 10% of its subs base an iPhone. That would make its contribution to iPhone sales about 3.4 million.

It would also imply US sales among the top operators of 53 million iPhones in 2013.

That itself is 17% of 320 million subs.

So perhaps it's time for Apple to celebrate. This year, after six years, Apple will have completed entry into its first major phone market. The rest of the world will not be as quick.

As part of a continuing series on the iTunes economy I described how iTunes fits within Apple's overall revenue and cost structure. The operation is a modest contributor accounting for single-digits percent of revenue and operating margins.

One additional question is how does iTunes compare with other non-Apple retail businesses. The obvious comparable businesses are Google Play and Amazon's digital content businesses. Unfortunately we can't compare iTunes with Google Play because Google does not reveal any details about Play revenues (or units sold/downloaded or payments to developers or any other data.)

Also unfortunately, we can't compare iTunes with Amazon digital sales because Amazon does not provide that detail either.

What we do have is Amazon's overall revenues (and operating margin.) So that's what I have compared:

Since we have Amazon's overall retail revenues it seemed fitting to also add Apple's physical store retail data on top of iTunes for additional perspective.

Here are some observations:

1. Since 2008, Amazon's sales grew by a factor of 2.18. Apple's combined iTunes+Retail grew by 2.14x.
2. Apple's gross retail revenue was $11.1 billion in Q4, 52% of Amazon's overall revenues.
3. Apple's operating income from retail in 2012 was $6.8 billion, over ten times Amazon's $676 million.

Although Apple's overall retail operations are only about half of Amazon's they are far more profitable on an operating level. They are also growing at a similar pace. Amazon as an equity is priced at approximately twice sales. By that ratio, Apple's retail business would be worth $70 billion. Of course, that valuation presumes that, as with Amazon, operating profits are disposable.

In the last few posts I estimated the iTunes economy in some detail. In absolute figures, the revenues and cost structures of iTunes are substantial:

• 6.3 billion transactions in the last quarter
• $4.6 billion consolidated revenues (including software & services)
• $3.3 billion in content payments
• $650 million in operating income

However, as a part of the entire Apple revenue model, iTunes appears to be a small contributor. The following diagrams shows where revenues came from and where they were spent during the last quarter

A few notes:

1. Click on image to enlarge. The graph was produced using an iPad and it is rendered at iPad retina resolution.
2. The data covers only the Fourth Calendar Quarter of 2012.
3. For scale reference, "Dev Payments" equals $1 billion (as marked.)
4. When zoomed in, each pixel represents about $50 million (vertical dimension).
5. Revenues shown are "gross" and therefore greater than reported. See post on iTunes Revenue Recognition. �The same reason affects the total Cost of Sales (COS).
6. Sources of revenue are ranked according to size. Note that Music is higher than iPod or Peripherals and Apps are higher than Software.
7. Different Cost of Sales components are also ranked by value.
8. iTunes which is the sum of Music, App, Software, Video and books makes up about 7% of overall revenues but 10% of costs of sales and hence contribute about 4% (est.) of total operating margin.

A three year view of the same data is shown below:

The following is another excerpt from a report titled "iTunes Business Review" which will soon be available for purchase through the Asymco Store. If you are interested in the product please get in touch.

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iTunes store will be 10 years old next month. From its inception Apple has stated that it aims to run the store "at break-even".  The business has grown so rapidly however that its profit-free nature has come under severe pressure.

The reasoning goes that as more media types have been added costs have increased but revenues have increased even faster. Consider the estimated gross revenue base as shown below:

What is known as iTunes today has quintupled in seven years. Although cost of content sales are likely to have been preserved as a ratio (about 30%) the vastness of transaction volume (estimated at 23 billion item transactions in 2012 alone) implies that there are some significant economies of scale.

This implies that the operating costs are spread more evenly and that therefore the possibility exists for some operating margin.

Put another way, at break-even the cost of operating iTunes stores would be about $3.75 billion. It's hard to imagine this level of operational expense for digital content.

For this reason, management has begun since 2010 to suggest that at least the App Store is run "a little over break-even". How little is a good question. A one percent operating margin (from gross revenues) would imply as much as $45 million margin. I estimate 2% is possible on Apps and 1% on Music.

That's $150 million in margin content. Heady stuff.

However, since folding its Software group into iTunes (the blue area in the graph above) the margin picture changes dramatically.

The Software group is one of the forgotten heroes of Apple.

Apple’s software division “Apple Software” is responsible for the following products:

• iWork which includes Pages, Numbers and Keynote. These are available through the Mac App store at about $20 per product and the iOS App Store for $10.
• iLife which includes iMovie, iTunes, iPhoto, GarageBand. The OS X versions are available free with new computers but they are also available as paid downloads for OS X through the Mac App Store at $15 each and for iOS devices through the App store at $4.99 per app.
• OS products including downloads of iOS and OS X. These are mostly free but some OS X updates are not free (typically $19.99 for new version including the server version of OS X.)
• Professional tools which include the following products: Final Cut Pro (Video editor $299.99), Logic Pro (Music editor $199.99), Aperture (Professional Photo workflow $79.99), Compressor (additional features for Final Cut Pro $49.99), Motion (video transition editing for Final Cut Pro $49.99)
• Administration and development tools which include:  Xcode integrated development environment which is free Apple Remote Desktop which is priced at $79.99.

All these products are now sold through either iTunes App Store or Mac App Store. They used to be sold as traditional boxed software for many years but Apple has transitioned them all to be download-only and folded them into the catalog of third party apps while lowering prices.

My estimate is that Apple’s own software generated $3.6 billion in Revenues in 2012. As you can imagine, this is a high margin business  which grows at nearly 20%/yr. Although I estimate that the software business has been overtaken by the Apps and Music businesses in gross revenues, it keeps an operating margin similar to that of Microsoft or about 50%.

This means that iTunes inclusive of Apple's own Software generates as much as 15% operating margin on gross revenues. That's over $2 billion a year.

So much for breaking even.

An excerpt from a report titled "iTunes Business Review" which I'm currently writing:

Revenue Recognition

Before proceeding it’s also important to understand one more detail: The company does not report all transactions through iTunes as revenue. To quote the 2012 Annual Report (10 K):

For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations.

What this means is that App revenues are only reported at the 30% level that is retained by Apple. The 70% paid to developers is excluded from Apple’s financial reports. The same is true for other products for which it considers to be acting as an agent. The difference seems to be mostly in cases where Apple does not define the end user pricing. This is mostly true for ebooks however that may not be true for all book titles.

This distinction between “gross” revenues and “reported” revenues is maintained in this report but both are presented for consideration. Gross revenues are needed for comparing the media businesses against each other and for competitive assessment but reported revenues are needed to test assumptions against ground truth.

This can be explained with an example:

If a song sells for 99c then Apple reports all 99c as Revenue and then pays the record company about 70c and uses 30c to operate the store and pay for transaction costs. In the case of music it means the Gross Revenue is 99c and the Reported Revenue is also 99c.

However, if an app sells for 99c then Apple reports only about 30c as Revenue. It does not consider the portion paid to developers as revenues for itself. It spends a portion of the 30c to pay for transactions, hosting, and the time testing and accepting the apps. In the case of apps and books it means the Gross Revenue is 99c and the Reported Revenue is 30c.

So if Apple sells one song and one app then the Consolidated Gross Revenue is 2 x 99c or $1.98 but the Consolidated Reported Revenue is only $1.29 (99c + 30c).

The difference in accounting is sometimes called "agency" vs. "wholesale" and it applies in some retail businesses. Another term sometimes used for used goods is selling items "on consignment".

The reasoning for why some media are treated one way or another is cited in the Annual report as "the Company does not determine the selling price of the products and is not the primary obligor to the customer". In the case of Apps, the price is set by the developer and the developer is obligated to deliver on the promise. Apple acts as transaction processor and they don't consider that they ever owned (and hence never sold) the app. Note that this accounting is probably discretionary. They decided to do it this way and it's not clear that it was necessary to do it this way by any regulation.

This distinction between two treatments of revenue makes it difficult to understand the complete story behind iTunes.

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If you're interested in the full report, contact me directly.

UPDATE:

Apple’s rationale can be partly justified from a reading of a Financial Accounting Standards Board statement titled “Reporting Revenue Gross as a Principal versus Net as an Agent” (Emerging Issues Task Force Abstract EITF 99-19 http://www.fasb.org/pdf/abs99-19.pdf) a portion of which is quoted below.

“Indicators of Net Revenue Reporting

15. The supplier (not the company) is the primary obligor in the arrangement— Whether a supplier or a company is responsible for providing the product or service desired by a customer is a strong indicator of the company's role in the transaction. If a supplier (and not the company) is responsible for fulfillment, including the acceptability of the product(s) or service(s) ordered or purchased by a customer, that fact may indicate that the company does not have risks and rewards as principal in the transaction and that it should record revenue net based on the amount retained (that is, the amount billed to the customer less the amount paid to a supplier). Representations (written or otherwise) made by a company during marketing and the terms of the sales contract generally will provide evidence as to a customer's understanding of whether the company or the supplier is responsible for fulfilling the ordered product or service.

 

Screen Shot 2013-03-10 at 3-10-11.05.14 PM

2013 will see two billion phones shipped to over 4 billion consumers. Contrary to the common assumption that larger markets sustain more competitors, this rapidly growing market is profitable for only two device vendors. Horace Dediu seeks answers to this paradox at the Harvard Business School Technology and Operations Management Digital Seminar Series. Self-recorded live on March 7, 2013, 45mins, 22.5Mb.

Download for iPad and iPhone: here. Requires Perspective app from Pixxa.

This interview took place on the eve of the launch of the Galaxy S4. Anouch Seydtaghia is Deputy Head of the Economic & Finance Section chez Le Temps Geneva, Switzerland.

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Q: How can you explain that Samsung organizes such a huge event in NY for the S4?

A: The S4 is a very important product as it's probably the second most profitable mobile phone in the world. Samsung is trying to position it as a premium product and is using every means available to do so.

What are your thoughts about the huge marketing budget of Samsung?

Samsung's marketing budget has been a constant percent of their sales (approximately). As sales have risen, the budget has risen. This is not considered a normal situation if sales grow very rapidly but Samsung seems to consider x% of sales to be appropriate spending level. Note that Apple's marketing has fallen as a percent of sales while its sales have grown dramatically.

If we read the media, we see a lot of speculation about the features of the future S4. Can we now compare that to the expectations before a new iPhone?

There are speculations about all phones, from Nokia to HTC and BlackBerry. I don't see the speculation to be different between all the major companies.

Can Apple regain the lead in the smartphone market? If yes, how?

Apple had leadership in the phone market for two quarters (see graphic below.)

It's a myth to think that Apple was dominant for any extended period of time. The top spot is very difficult to obtain unless a company has a large portfolio of products which are sold in all markets. Apple has less than half the operator distribution of Samsung and keeps only one new product in the market each year.

Apple also has a very high price due to the distribution model it uses for the iPhone. The primary buyers are operators who made large volume purchase commitments a few years ago. The iPhone strategy can be summarized as "skimming" where they pick the most profitable customers rather than "penetration" where there is a focus on market share. It's therefore very surprising that Apple was able to ship as many phones as it did.

Is there a difference between what Samsung and Apple invest in R&D?

Of course, but we don't have details. Samsung Electronics has to develop semiconductor processes and build large fabrication plants. Apple has a vast software engineering operation. Apple has iTunes and web services while Samsung has appliances and TVs. The two R&D efforts are vastly different.

What could be the new features in the next smartphone?

The most important innovation in smartphones will be a product that is not a smartphone. The category will be eliminated through a disruptive approach just like all other technologies that have come before it. My expectation is that when it comes it won't be recognized as important or relevant.

As a follow-up:

- Thank you very much! So do you mean that for Apple, marketing is just 1% of sales?

It's difficult to compare the two exactly.

We don't have specific data on Apple's marketing. We have either Advertising or SG&A (which includes marketing.) Samsung reports “Marketing Expenses” every quarter but these figures appear to be the sum of Ad spending, Sales Promotions, Public Relations and a portion of “other” expenses as a part of SG&A.

You can see a comparison here:

What seems to be happening is that Samsung increases its spending in proportion to sales while Apple grows marketing a bit more slowly.

Basically, Samsung is treating SG&A as a "variable" expense which is tied to sales whereas Apple is managing it as organic growth.

The difference might be that Marketing at Apple is mostly an internal effort and thus depending on headcount while Samsung might be spending mostly externally. If costs are internal then it would be hard to pare them down if sales slow whereas if they are external then they can easily be made variable.

I've received comments suggesting that Samsung's approach is unorthodox and that the quality of marketing cannot be maintained if it grows as quickly as Samsung has grown it. This is a matter of speculation however.

Two days after I posted a reminder that Google had not updated their Android activations for five months, Google updated their Android activations.

The new total is 750 million. My expectation (based on a rate of activation acceleration of 30,000 activations/day/week) was 800 million. Google did not update their download rate but it can be derived. Between September and March the average has been about 1.4 million/day. I had previously estimated that the rate of activation was 2 million/day.

This is a modest increase from the 1.3 million/day that was reported in September implying that activation acceleration has slowed.

After resetting the acceleration to 5,000 activations/day/week my new forecast for 1 billion activations moves to the end of August.

Coincident with this update on activations, Google reported that Andy Rubin has stepped aside as the head of Android and that Android and Chrome would be under the same management.

Putting aside the exit of the founder, the implications of the merger with Chrome will need significant contemplation.

Google occasionally reports data regarding Android. Very occasionally. The last time we had some data was in September 2012 when we learned that activations were running at 1.3 million per day and that a total of 500 million total activations had taken place.

As of today, being March 2013, the time between updates has reached five months. It's the longest gap so far. Benedict Evans also notes that it's been five months since the data regarding screen size stats has been updated on the Android developer site.

But we have to live with what we get and, in the absence of an update, the pattern of growth in Android, if sustained, looks like this:

It implies that 800 million Android activations have taken place to date and the rate is about 2 million per day. One billion activations could thus happen by June.

There is however another set of data regarding Android which is updated more frequently. The comScore mobiLens survey covers the US and provides updates on a monthly basis. That data shows that Android users in the US reached about 68 million as of the end of January. See the updated data below:

I included the install base and share of total users as reported. Combining the comScore data with Google's activations gives the following picture of US as a percent of global Android (orange circles represent US base and blue circles the precent of total activations that the US might represent)[1].

The data implies about 9% of Android usage is in the US. The more startling thing is the difference in growth: it implies that with a US growth rate of only about 13.3k/day, global growth is 150 times faster than US growth. In other words, that 0.6% of new users are in the US and that 99.4% of Android growth is outside the US.

That's an interesting story. But it's even more interesting that this is not the case with the iPhone. The iPhone is growing considerably faster in the US than Android. One can see this more easily with a graph of the US mobile platform net user gain rate as shown below:

 

Looking at the the same contrast between global and US, from Apple's financial reports, in the fourth quarter the global "activation rate" (i.e. sales rate) for iPhone was 525k/day (nearly one quarter of the extrapolated Android rate). The comScore data suggests the US gains are running at 106k/day. Therefore we can calculate that about 20% of iPhone growth is in the US and 80% is outside the US.

Even accounting for some potential error in the Android estimates, the contrast is quite stunning: 1% vs. 20% share of growth suggests something is very different about the US with respect to the two platforms.

My suspicion is that it has something to do with the fact that the US is one of the few (but largest) market where the iPhone is available as a "low end" offering. At a minimum price of $0 (with a contract) many consumers are finding the iPhone attractive relative to a $0 (with a contract) Android phone. This price parity (illusory as it may be) allows iPhone to grow even faster than Android in this particular market.

One wonders what would happen if such price parity were present globally.

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Notes:

1. Android activation data as reported by Google includes tablets but excludes many unofficial Android builds e.g. Amazon Kindle and many Chinese phones and tablets that don't register with Google services. comScore data includes only primary devices used by consumers and excludes corporate purchases and devices whose primary users are younger than 13 years.

This is a reminder that I’ll be speaking at the Harvard Business School Technology and Operations Management Digital Seminar Series on ”The evolution of value chains in a computing markets measured in the billions of units per year.”

For the abstract see this post.

When: It's taking place at 3:00 PM on Thursday March 7th.

Who can attend: The talk is open to the public, seating is limited.

Location: The Cotting House on the campus of the Harvard Business School (map linked), Boston. There is parking in the main lot with entrance across from the Harvard Stadium for $14/day.