Dan and Horace talk about innovations in emerging economies related to mobile service and how they might foreshadow changes in the developed world. We also discuss why some industries seem to be exempt from disruptive innovation and suggest that there are boundaries societies set to how value can be re-defined.
This show pushes beyond the boundaries of company and industry analysis and touches on the limits or "sound barrier" of innovation itself.
On October 27th, Nintendo published half year results for the fiscal year ending in March 2012. Management stated that the company lost over $900 million with a negative outlook. Nintendo cited weaker than expected sales of Nintendo DS hardware and 3DS software and Yen appreciation as the main reasons for the miss. Is this the end of Nintendo?
Before we look more closely, here is a quick summary: The company is exclusively involved in selling game hardware and software. Their console platform is the Nintendo Wii, which will be followed by the Wii U late in 2012. The Nintendo DS and Nintendo 3DS are the company’s portable game consoles. The Wii and the DS are nearing the end of their product cycles. On the software side, the company is known for gaming titles such as Super Mario and Zelda. Nintendo also pioneered the licensing model to allow third-party developers to produce games for its hardware products.
A closer look
The good news for analysts is that Nintendo publishes their estimates for hardware and software unit sales. This allows us to measure management predictive accuracy. The red line (management forecast) should be as close as possible to the dark green pillars (realized unit sales in the fiscal year).
Until CQ1 2009 devices sales grew in excess of forecasts. A similar pattern can be found for consoles and game titles. After Q1 2009 forecasts have been always higher than results, and more worryingly, the deviation between forecast and sales is widening. Management missed and lowered forecasts for two consecutive years. Management's hope for an increase on the back of initial 3DS sales in the launch quarter (CQ1 2011) did not come to pass and they subsequently lowered forecasts again in the following two quarters.
Looking at all categories, management lowered forecasts almost continuously. The deviation remains the largest in the portable hardware business segment indicating that management was largely surprised about the development.
What caused this reversal of fortune?
Two years earlier the iPhone had launched and by CQ1 2009 iOS reached an installed base of about 38 million, half the number of Nintendo portables in the same period. Furthermore, in CQ1 2009 Android phones came to the market. Smartphones (light blue area of the chart below) sold before (and after) the debut of iOS, but the iPhone redefined the category and an avalanche of smarter phones running iOS and Android followed (blue and orange area). Portable gaming devices from Nintendo and Sony declined ever since: 17% in 2009, 31% in 2010 and already 16% in the last twelve months.
How do the game players stack up?
We already looked at the installed base in the chart above. iOS and Android have outsold Nintendo portable units by a factor of 2.1x and 1.6x. Furthermore, we can see (in the charts below) that the two main mobile platforms have 14 to 26 times more game (and entertainment) titles available. Nintendo and Sony also publish unit sales of directly sold software titles. For Android and iOS we know the cumulative app download statistics. By taking the share of Septembers’ paid and free app downloads as a proxy, we can conclude that also by this measure Android and iOS dwarf Nintendo and Sony [1]. The reach of iOS and Android is further underlined by the more than 500 million downloads of Angry Bird game titles - first released only two years ago - for any platform having sold more than twice the amount of Sony’s cumulative portable game titles and almost as many as Nintendo’s cumulative games titles since Q2/2007.
Who else has skin in the game?
Besides Nintendo, Sony, Apple and Google, who else is making a push into mobile gaming? Before investigating, let’s first have a closer look at Sony. Sony, just like Nintendo, is also active in stationary gaming segment with the PlayStation franchise. The Sony group also has access to entertainment most notable through Sony Pictures Entertainment and Sony Music Entertainment. Furthermore, Sony recently decided to buy Ericsson’s stake in the mobile phone joint-venture Sony Ericsson and is making a push with Android to bring its gaming titles as a differentiator for its own products to the platform. And the other major suspects? Microsoft, also active in the stationary gaming segment with its Xbox franchise, is pushing to bring the Xbox experience to mobile phones with Windows Phone. Amazon has retailed software and games for years and has started to distribute software and games via direct download on its own Kindle devices but also for the Mac. On the Kindle, Amazon is relying on a forked Android version on which it leverages its eBook and other entertainment assets. And then there is Facebook, a social network that wants to be on any platform or device. Out of 800 million users, 350 million access Facebook via a mobile device. Around 50% of Facebook members play games on the desktop. With Project Spartan, Facebook is aiming to bring the desktop experience to the mobile device including a stronger focus on gaming and video.
The competition between Apple and Google is already asymmetrical. Including the other contestants in the competitive landscape reveals Nintendo’s key weaknesses in the portable gaming market: attraction as a platform for developers in terms of ease and reach, pricing of hardware competing with operator-subsidized mobile phones and the jobs-to-be-done or value preposition. The new generation of mobile devices is standing against Nintendo’s dedicated approach. Although slowly adding features such as a browser and “app store” to its portables, Nintendo devices fall short in the variety of jobs-to-be-done compared to smartphones, let alone making a call.
Average selling prices and financial impact
With this market pressure one would imagine that average selling prices decreased for Nintendo portables. But for the last three fiscal years average selling prices for portables have increased, all things equal, mainly due to new product launches. Game title’s average selling prices have remained relatively flat. Note that these are wholesales prices for hardware and a mix of retail and wholesale prices for games. In 2011, for which we do not have data yet, the price of the newest portable, Nintendo 3DS, was lowered from its U.S. debut of 320 250$ in February to 170$ in July which will have a negative impact on ASP going forward.
The effects of Nintendo’s rigid strategy and the fast changing competitive landscape are manifested in the devastating financial performance over the recent quarters with LTM sales, gross margins and EBIT margins declining starting from CQ4 2008 and even accelerating to decline after CQ3 2010.
Furthermore, even though the company has recognized its own difficulties, Nintendo has no intention of adjusting its strategy:
CEO Iwata on the question of whether Nintendo plans to bring its game library to other platforms:
This is absolutely not under consideration. If we did this, Nintendo would cease to be Nintendo. Having a hardware development team in-house is a major strength. It’s the duty of management to make use of those strengths. It’s probably the correct decision in the sense that the moment we started to release games on smartphones we’d make profits. However, I believe my responsibility is not to short term profits, but to Nintendo’s mid and long term competitive strength.
Although realized and obvious, the disruption’s invisibility is often manifested in the paralysis of the incumbent.
Conclusion
According to Isaacson, Steve Jobs apparently always worried who could eat Apple's lunch. The lunch of the iPod, he concluded, was ripe for mobile phones. Subsequently, Apple entered the mobile phone space. Google followed. Since then more powerful mobile phones have eaten the lunch of the dedicated gaming device. The jobs-to-be-done and their priorities in people’s life have not changed, but the tools people use to get them done have. Permanently.
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Notes:
Estimated by multiplying total cumulative app downloads with September’s share of game downloads: For iOS ranging from 72-80% based on Top 150 free and paid app downloads, for Android ranging from 38-47% respectively. This is a very crude estimation, but the gist of it is that 4% for iOS and 11% for Android game downloads as percentage of cumulative app downloads would outsell Nintendo.
Every quarter Apple's management issues a "guidance" or forecast of their own earnings in the following quarter. Over the years, this figure has been nearly useless because not only is it not accurate, the error itself has been wildly variable. I plotted what I call the Earnings Guidance Deficit for Apple based on the formula (Actual EPS diluted - Guidance)/Guidance.
The higher the value in the bars above, the more the company underestimated (or under forecast) its performance. Note that during the recession the company routinely offered guidance at half the level they actually delivered. After the recession they returned to a more reasonable ~30% under-reporting.
The problem with this analysis is that there is such a high volatility in this factor that we can't count on it to predict where earnings will fall. Even if we saw a range bounded at 30% to 60% the usefulness of this would be very low as that is far worse than the range that analysts can get through other means (Deagol's accounting of analyst error). The best thing we can say is that the range seems to be bounded by 30% and 150%.
Rather than using this history for precision, perhaps it makes more sense to assume that the lower bound offers at least some limit to the possible value of next quarter's earnings. Maybe it can give us a "sanity check" for our own estimates.
For the next quarter Apple guided $9.30 per share. If we assume a 27% "deficit" which is at the lower end of the range above then the earnings are likely to be about $11.8.
That's equivalent to an 84% growth in earnings year/year. It would also imply $33 for the 2011 calendar year. At the current share price of $384 that implies a P/E of 11. That happens to also be the P/E for Apple at the trough of the recession in January 2009.
In other words, if the stock price does not rise (or falls) from the current level by the time earnings are reported in late January, then the P/E for Apple may drop to less than 11 on growth of 83%. That's a sanity check all of its own.
I recently posted a comparison between the profit capture of phone vendors in 2007 and the most recent quarter:
The idea was to show what a disruption looks like. A phenomenon where an entrant with none of the advantages of incumbency takes the profits away from companies privileged with ideal market access and knowledge.
The view of profit shift is the ideal view since it shows the "bottom line" impact and thus the denouement rather than more nuanced sub-plot. However, we don't always have access to profitability data. Sometimes we only have access to revenue estimates.
Fortunately revenues have a similar story and are often a good proxy. Consider how the evolution of revenue shares occurred in the same market:
Revenues for Apple and HTC combined doubled from 17% to 33% for the third quarter over three years.
Note the similarity between this evolution and that in the mobile games market (data courtesy of Flurry):
The increase of revenues fro iOS and Android games nearly tripled over a two year period. Although we cannot say the same for profitability as the profits are not comparable since they allocated differently between platform and developer depending on platform, we can say that iOS is certainly driving vastly more value than Nintendo.
Sony and Nintendo may take some comfort from their console businesses which have not felt the same impact from mobility, but one wonders how long those franchises will last. Using an iPad with screen mirroring to a large screen TV already shows promise.
In the recently posted US Smartphone Landscape I used comScore's data to paint a picture of the growth of smartphones in general and the shape of the mobile platforms in the US. The source was survey data measuring the installed base. If we compare the installed base sequentially, we can get the increase (or decrease) of a particular platform. Comscore reports monthly but we can also summarize the data at a quarter-by-quarter basis.
There is another source however for the US market, at least for the iPhone: operator activations. They report iPhone activations, shown below.
Can we use activations together with installed base data to learn something about the market? Yes, with some caveats.
First, it should be noted that install base should account for all sorts of devices. They could be new, old or hand-me-downs or purchased used. Changes in install base would come from addition of new devices but also from devices being discarded and users leaving the platform. Activations on the other hand include units new units but also those which have been re-activated after initial sale because they were either sold or given to other users. As far as I know operators do not report "net" activations so lost users are not included.
When the formulas are combined[1], what we get is the change in installed base is equal to Activations minus "discarded" iPhone, where "discarded" are both iPhones put aside in favor of a new iPhone or put aside in favor of another phone.
Since we have installed base change data and we have activation data we should be thus able to derive the number of iPhones being "discarded" or put out of use every quarter as the difference between activations and change in installed base.
That allows the following chart to be built:
The green, dark blue and orange areas are given inputs and the light blue area representing discarded phones is derived.
This is an interesting (new) piece of information. What it suggests is that at least in the US the discard rate, i.e. number of phones being discarded over number of new phones is about 50% (56% on average over seven quarters.)
It's a rate I find surprising because I expected more of the phones to be re-used. But more surprising is that it leads to some surprising and possibly implausible behavior at AT&T.
If you look at the last three quarters, you can see that Verizon activations are very nearly equal to the increase in install base. As all Verizon users are new, they are certainly not replacing iPhones, so the green bars next to the yellow bars imply that all those new users are Verizon users. But that means that all the activations through AT&T were to replace existing phones and that AT&T only added a bit more than one million iPhone users in nine months.
In quarters prior to Verizon's launch, the AT&T discard rate was a modest 60% on average and after Verizon launch it went to 81%.
What does it mean?
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Note:
The following diagram shows the derivation of "discarded" units.
This is the cascading view of Apple's financial performance in the third calendar quarter. It only includes information that is already in the income statement but shows the relative growth of the individual product lines, their cost structures and the relationship between fixed (Operating) expenses and their variable (cost of sales) expenses at a glance.
In the past I would publish current and year-ago data, but in this quarter's summary I present three years' history of quarterly data. Note that the full view is quite large (2,220 x 886 pixels).
Here are some handy tips on how to read the chart:
The "top line" is the size of the first column in each quarter's chart.
The "bottom line" is the size of the last column.
The blank areas are what Apple pays suppliers.
The red area is what Apple pays to the government.
The Pink and pale blue area is what Apple pays its "exempt" employees. (Other Income and Expense is also included but is nearly invisible).
The Green area is what is declared as earned and becomes the "E" as part of the P/E ratio. (Note that not all of this goes to the Cash account as the cash flow statement will reveal).
The colored areas in the first column labeled with product name and "GM" (for gross margin) represent what Apple keeps from the sale of each product after paying expenses tied to producing that product.
The ratio of sold areas to the corresponding white areas below in the first column represent the margin (as a percent) per product line
You can observe the trend over three years by tracking each of these quantities from left to right.
The scale of the chart is shown by the line near the top representing $30 billion.
comScore published the latest data regarding US smartphone installed base. To summarize:
Penetration reached 37.4%, an increase of 2.9 million or 1.24 points of percentage.
Approximately 650k consumers switched from non-smart to smartphones every week during September
Based on trailing average of six months' growth, 50% penetration will be reached by end of September 2012, though the trend is for accelerated adoption (see chart below).
Of the platforms available, Android reached 39 million users, RIM 16.5 million, Apple 24 million and Microsoft about 5 million. Smartphone non-consumers dropped to 147 million. Among platforms, here are the shares and total users:
In terms of user gain/loss here is the tally:
Android and iOS have continued to increase consumption fairly consistently while RIM has moderated user losses. Microsoft has also shown the fourth consecutive month of usage increase having increased users by 440k since May. The new Windows Phones seem to have at least stopped erosion of user base though that base is still nearly a third of RIM's.
Overall, smartphone non-consumption continues to be the largest competitor though one which is steadily losing.
Even though China may overtake it in the new few months, the US is the largest smartphone market and it's a good leading indicator of the way the industry in evolving. It's also being measured by multiple observers[1] and we thus have a better chance at understanding the rate at which change is happening.
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Note:
Nielsen reports that 43% of the phones in use in the US now are smartphones in the US with Ages 25 to 34 having 62% penetration.
As shown in the yesterday's post, in the third quarter, overall mobile phone profitability declined. The eight vendors I use as a proxy showed a total net profit of $8.51 billion, down slightly from $8.57 billion and a drop of $9.01 billion in the first quarter.
Overall, the industry dropped by 1% sequentially but is still up 30% over last year and has a 20% compounded growth rate over a three year period.
Nokia returned to profitability, though at $180 million it's only about 2% of the top eight.
Motorola remained in the red with a small loss of $20 million, an improvement over the $90 million loss of the previous quarter. Motorola is being acquired by Google after an accumulated mobile operating loss of $4.69 billion since the beginning of 2007. It's unlikely we'll receive any updates on performance thereafter.
Samsung had a great quarter with a sequential increase of 19% and year-on-year growth of 130%. The total profit amounted to 25% of the peer group.
Sony Ericsson broke even with about $50 million in operating profit. Like Motorola its performance was barely break-even during the last four years and its also disappearing from our list of independent vendors as it becomes part of Sony.
LG had its sixth consecutive quarterly loss and is now appealing to investors for more capital to continue operating as a smartphone vendor. Raising dilutive capital seems a radical approach and not one that inspires confidence.
RIM had a sequential reduction in profit of 35% and y/y reduction of 30%. The company is exhibiting clear signs of decay and the stock market is valuing the company below book value.
Apple profit dropped by 19% but grew 43% y/y during a transitional quarter. The growth remains 43% compounded over three years.
HTC has a 1% sequential increase but a 78% y/y growth.
To illustrate the performance in terms of profit, pricing, volumes and margins, I developed the following chart.
The solid areas representing profit are operating profit/phone in the vertical axis and volumes shipped in the horizontal. The blank areas above are the cost of goods sold per phone and the combined solid and blank represent the average revenue per phone.
Some of the areas are over-represented due to the lack of resolution available.
Using before-and-after pie charts for positive profits, we can see how the entrants (RIM, Apple and HTC) went from 6% of profits to over 73% four and a half years later.
I feel that this is somehow the end of an era. I've written before about the brutality of this market, listing 13 companies which were either merged or acquired or disappeared in the last decade. Now both Motorola and Sony Ericsson will soon be added to the list. On average, it's as if one phone vendor has disappeared every year for fifteen years.
And it's still not over. RIM is also becoming a going concern issue, and LG has a big question mark above it.
Of course, ZTE and Huawei and Lenovo are joining the list of competitors but I note that they are not focused on mobile phones. They are opportunistic phone vendors, depending on other businesses to compensate for the risks inherent in phone sales. It's interesting to note that neither Apple nor Samsung are pure phone plays.
In fact, of all the phone brands only RIM and HTC are exclusively phone-only companies. It may indicate something profound is happening. The notion that the development and marketing of phones as an activity independent of other business models may be coming to an end.
A few years ago, around the middle of the last decade, the mobile phone market was characterized by the rivalry between a few established vendors. These were Nokia, Samsung, LG, Motorola and Sony Ericsson. These incumbent companies had a broad portfolio of devices including smartphones and feature phones and basic phones. Many also sold networking equipment and were deeply engaged with their customers, network operators.
There was also a set of entrants who offered only smartphones. They were quirky. HTC was a a prominent "ODM" or original design manufacturer who built phones for companies who added their brands and sold and supported the product. HTC made phones and PDAs for operator brands and for some large PC companies. It also began to sell phones under its own brand. RIM was also offering products that had evolved from pagers into email appliances with added voice capabilities. But RIM's products were not very good as phones. Voice was so poorly integrated that many people carried both a BlackBerry and a voice phone. Then there was Palm with something called a Treo which promised many things but did not quite deliver.
In 2007 something happened which changed the industry. It took a few years to even realize it was happening but by the time it was obvious, it had changed to such a degree that huge companies found themselves in financial distress. This chart illustrates the effect.
In a few short years the rivalry between incumbent handset makers has evolved into a rivalry between mobile platforms where the incumbents were caught in an increasingly unprofitable role of hardware integrators. Motorola is now being absorbed by a search company. Sony Ericsson is being absorbed into a consumer electronics company. Nokia is going through a potentially existential crisis and even abandoned its platform. Acquisition talk surrounds LG's phone efforts. Samsung is prosperous but sill at the mercy of its software suppliers. Even the entrants are starting to feel beleaguered. RIM, the oldest pure play smartphone company is trading below book value and has regressed in value to 2004 levels. Palm evaporated. A view into the changes is the rankings of the companies in terms of volumes, sales and profit as shown below.
How did large, powerful, smart companies let this happen?
It happened despite having a clear, front row view of the transition of the industry from mobile voice to mobile computing. The shift in the basis of competition from "connecting people" to "connecting people to data" ended up being a classic disruptive trap. Many will argue that it was the failing of individual managers. Perhaps, but how did they conspire to fail simultaneously?
When you see disruption happening, it's natural to seek out a cause, a pivotal magical "force" or event that enabled the weak to humble the strong--the proverbial sling that enabled David to defeat Goliath.
My hypothesis is that The Primary Cause for the shift of profits from Incumbents to Entrants has been the disruptive impact of a new input method. I illustrated this with the help of the January 2007 slide presented by Steve Jobs at the launch of iPhone.
Each new input method led to not just a disruption but new platforms and new business models. Each new "sling" victimized a set of historic companies. Mainframe and minicomputers, consumer electronics giants and now telecoms.
Just like David's sling, these technologies are not powerful in and of themselves, but rather, the way they are used makes them unpredictably sinister. The context of using capacitive touch on a handheld device rather than on a table-top makes it disruptive. Coupling it with high-speed mobile networks and powerful but efficient microprocessors made it into a force.
That is now ancient history. The consequences and repercussions are still being felt and weighed, but the smart money should be focusing on the next shift. From the time frame in the diagram above, it's clear that the cycle time between "Revolutionary User Interfaces" is shrinking. It's been five years since multi-touch. Is the next "RUI" already here? Is Siri the next RUI?
There are many things going for it:
It's not good enough
There are many smart people who are disappointed by it
Competitors are dismissive
It does not need a traditional, expensive smartphone to run but it uses a combination of local and cloud computing to solve the user's problem.
It is, in a word, asymmetric.
My disruptive hypothesis for Siri is that it shifts the competition from platforms positioned on a device to a "coupled" super-platform dependent on broadband and infrastructural computing.
Just after collecting enough data and observing patterns in it that give us clarity, It looks like things are about to change all over again.
Dan and Horace talk about the tension between relying on data and using intuition to make strategy decisions. We also apply this dual approach to think through the next evolution of user interaction and the jobs we might hire mobile computers to do for us.
This is a quick note that I'll be speaking at the Apple Investor Summit, March 15-16, at the Los Angeles Convention Center. My topic will be the analysis of Apple's capital structure for strategic insight.
Apple co-founder Steve Wozniak and Walter Isaacson, Steve Jobs' Biographer, will be keynote speakers.
The organizers are offering a Friends, Family & Followers VIP discount pre-sale from today until Friday, November 4th. Go to www.appleinvestorsummit.com to register at the discounted rate and check out the other speakers.
