Amazon

In an Harvard Business Review post Rob Wheeler makes the case for the Kindle Fire as a disruptive innovation. I believe that it is but crucially I disagree that the Kindle Fire is a low end disruption.

My assessment of the Kindle Fire is based on the two attributes which Amazon highlights as the key selling points which offer a basis of differentiation and potential for asymmetric competition: a low price and a new browsing model. I believe that these two attributes result in two opportunities: one for low end disruption and another of new market disruption. I reject the first and tentatively support the second.[1]

The price

It's immediately obvious that the price point of the Kindle Fire is well below alternatives. That forms the basis of disruptive potential, but before we jump to analyzing the disruption hypothesis we should determine whether and to what extent Amazon profits from the device directly. Profitability gives us a clue to where Amazon will apply resources and thus establish its trajectory of improvement.

We know the margin on the Fire is low because we can calculate the bill of materials for 7" tablets. Gene Munster of Piper Jaffray estimates that Amazon "loses" $50 for each unit sold. We also know that the design Amazon used is essentially very similar to the RIM PlayBook and was sourced from the same ODM. RIM priced the product at $499 but has struggled to find buyers and is reluctantly dropping the price. We also can estimate that Apple with a product having more than twice the screen size is keeping modest (~30%) gross margins for at a price point approximately double that of the Fire. It does seem that Amazon does not have much or any margin to dip into.[2]

So the Fire can be classified as a low price product. Does that make it a low end disruption?

Disruption requires asymmetry but it also requires the ability to go up a trajectory of improvement along the basis of performance that a majority of users demand. The first condition is met, but what of the second? In a combined system where one asset is used to leverage another--the subsidized being sacrificed to benefit the profitable--success is conditional on one element being "good enough" while the other "needing improvement". Investment follows accordingly.

But investment decisions have consequences. The subsidized device is starved of investment while the profitable service is nurtured. We see evidence of short cuts in investment in the off-the-shelf nature of Kindle products: from a second-hand (unsanctioned) OS to a second-hand (ex-RIM) hardware. Meanwhile, Amazon spends heavily on capex for the infrastructure that delivers the profitable content.

If the hardware is indeed commoditized and cannot be usefully improved, then this model works. If, on the other hand, the hardware and systems software can benefit from dramatic improvements in technology then the model fails. The very asymmetry of a service vs. a product turns into the latter having all the advantages and the former failing to gain traction.

I'll give three examples of this how service model creates limitations which lead to a failure to disrupt a product model.

The Game Consoles

The first is the game console business. In consoles, the vendors maintain long hardware product life-cycles to recover their hardware investment and subsidy by maximizing the number of games attached to each console. If you plot product cycles you realize that the bigger the subsidy, the longer the hardware lifecycle. The result is a very wide turning circle which prevents innovation in new dimensions.

Consider that the Playstation or the Xbox could have been a low end computing disruption. The original Xbox was in fact a PC. It was supposed to bring PC dynamism to the console business and create a cottage industry of new developers building games on commoditized hardware. However by the second generation the Xbox was a locked down, custom architecture, pure gaming machine. Gone was Intel, gone was the PC architecture and gone was any dream of cheap development.

This is entirely due to the economics of subsidized hardware. It compelled Microsoft, the world's greatest software company, built on the open and cheap PC architecture to make closed, expensive hardware. Sony followed in kind as did Nintendo. Each generation of consoles was a sustaining improvement on gaming and had no ambition beyond gaming[3]. The subsidy and the dependence on an integrated content value network led to a distinct lack of disruption and an insular industry which continues to seek out increasingly immersive experiences for increasingly demanding customers while itself being disrupted by casual, mobile gaming.

The Set-top boxes

The second example is the TV set-top box business. There again, the vendors maintain long hardware cycles in order to recover subsides. There too, the main value driver is the content and its distribution which stipulates the architecture, and through subsidy, defines its evolution. This offers the vendor no motivation to improve the user experience[4], secondary uses or the absorption of new streams of content (like those the internet can offer.)

Again, the set-top box could have been a budding disruptive opportunity for Microsoft. They invested billions in the 1990s to acquire placement of software on set-top boxes in an attempt to penetrate the living room. And again Microsoft was not alone. Since then Tivo, Google and Apple and many others tried to attach cheap hardware to video streams. They all failed to get on a disruptive trajectory. And again, the blame can be placed on the stifling effect of subsidies and dependencies on services or content which dictate where the value and hence the investments should go.

The Blackberry

The third example is the RIM Blackberry. Although RIM made most of its money on hardware and was by no means subsidizing it, the differentiation of their product was undoubtedly its service value. Both as a corporate device with BES and as a consumer device with BBS, customers "hired" the product as a service. By being committed to this model RIM management became blind to the hardware and client OS software innovations coming down the pike.

Through their own admission, they could not accept a touch screen because it would make the messaging experience too slow and it is messaging that sells Blackberries. They could not accept apps (and hence platform orchestration) as a differentiation because their customers did not hire Blackberries for "lifestyle apps". Merely being differentiated as a service leads to blindness and enough hesitation that you run off the disruptive rails.

People ascribe myopia or incredible absence of mind to RIM's management but the opposite is true. They were deeply committed and observant of the things which made the Blackberry successful. It just happened to be something that stopped being relevant.

The iPhone

I'll add one more "bonus" example on this. The iPhone is also a subsidized product and it seems very successful. How come it won? The answer is in details. As I mentioned, the other products ended up in poor life cycles or incorrect motivations. The iPhone differs in that the lifecycle of the product is much shorter (2 years ownership with 1 year for product updates). The shorter lifecycle works for the iPhone because it has a very high service revenue base to dip into to offset the subsidy. Something none of the content models above could count on.

Consider that each game console subsidy needs to paid off by a handful of game titles whose royalties to the console maker are modest. Or that the TV box needs to ride on top a service that also has thin margins from a stable or slightly shrinking user base. In contrast, the iPhone enables vast new consumption worth thousands of dollars to the operator. This is the famous ARPU uplift that smart phones enable. Users are doubling their telecom spending when they move to smartphones.

The margins for Kindle content are thin. Very thin. Apple runs its content business at break even though it transacts billions of items per month. The amount of content that needs to pass through the Kindle ecosystem (with lower prices than Apple charges) will need to be astronomical to make it profitable on the shortened cycle time the iPhone enjoys. Thus the Kindle is likely to languish in a leisurely update cycle with users encouraged to hang on to their devices for years. This is the case at least with the original e-Ink Kindles. How eagerly awaited are new generations? How many users stampede to update the hardware or even upgrade the software? How many users have owned every version of the Kindle?

Service Scale

Finally one last point about services. As Amazon asserts, they see Kindle as a service, which, I concede, is asymmetric to a product business. The problem is that services don't scale as well as products. Consider that none of the content streams that Amazon will depend on are available outside the US. The Kindle has not been a strong seller internationally. This is because book rights are limited to national boundaries as are movie rights and song rights. Apple has only this week finally completed the rollout of iTunes music to all of Europe! A process that took almost a decade. And they are still unable to sell music in most of Asia and forget about movies or TV shows.[5]

The reality is that there are no global service brands. Not in telecommunications (operators are, at best, regional), not in Media (TV, radio, publishing are a local businesses), not in Banking (not even in commercial banking) and not in Retail (even Wal-Mart was humbled trying to export its disruption). The internet has not broken down any of these boundaries and even Amazon has modest reach outside the US for any of their franchises. Services are local but products can be global.[6]

To wrap up, this discussion on the asymmetry of device-based services to product models leads me to conclude that the Fire will not have the opportunity to disrupt the iPad or tablets in general. Amazon sees the hardware and software of a device as a commodity and the content and its distribution as valuable. This assumes that the device is "good enough" and will not require deep re-architecting or that new input methods can be easily absorbed. In short, they see the tablet as at the end of its evolutionary path. Apple sees the exact opposite. The iPad is 18 months old, and as they say in the ads, they see it as only the beginning.

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Notes:

1. Due to length of discussion, in this post I will make the case against the low end disruptive potential and use a second post to make the case for it being a new market disruption.
2. Presumably, Amazon will also distribute only through Amazon.com and thus not incur channel mark-ups. This means that comparisons with other tablets should be at a price nearer to 70% of retail.
3. Gaming networks and video streaming are extensions but neither leveraged open architectures.
4. See also discussion from June 2010 on the challenges to Apple TV that Steve Jobs enumerated.
5. Apps are another story. Because it controls the medium, Apple can and does sell apps in every country where the iPhone or iPad or iPod touch is available.
6. Note also that because of distribution through Amazon.com, the Kindle cannot reach as many buyers as a tablet selling through the tens of thousands of points of purchase that operators and retail shops offer.

 

While some mobile platforms are being withdrawn from the market, others are being introduced. The net is that there are more mobile platforms announced for 2012 than ever before. The following chart shows the lifespan of the platforms that I can recall.[1]

Amazon's entry is only rumored but I think the description of it is detailed enough to be credible. The day after the scoop with Amazon, Baidu announced the Yi platform. Baidu is the sixth most visited site in the world, so it's not a bit player and it makes as much sense for Baidu to have a mobile platform as it does for Google.

Aliyun is Alibaba's latest and it, like Amazon's, is positioned on commerce and shopping. I also included the platform underlying Barnes & Noble's Nook for consistency.

Many of the newcomers are Android-like or Android-derived platforms but cannot be rightly called Android as they are not licensing the Android trademark nor any of the proprietary part of Android. They may run some subset of Android apps but that is not guaranteed to continue.

It's also worth noting that many of the newer Android-derived platforms are being launched by Google's competitors and indeed seem to be designed to take value away from Google.

The epic struggle Android vs. Google is sure to continue.

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Notes:

1. The lifespan is bounded by the dates of public announcements of start and end of development efforts by the platform owner. It does not include times when products are still in the market or the platform is still supported.

The question of low end disruption should be a concern to any manager. It's one of the most important sources of growth and has led to a vast amount of wealth creation.

Apple was an early low end disruptor by selling personal computers at a fraction of mini-computer prices. Toyota also offered "cheap" cars as an entrant in the market. Pixar made blockbusters for a lot less than live action studios. Google offers good enough office software without a license. Finally Microsoft built its whole business on low-end business software at knock-down prices.[1]

All these entrants made fortunes often at the expense of entrenched incumbents. Disruption grows the pie but also transfers a lot of value away from existing competitors.

So it should not be surprising that new products like the iPad should be scrutinized for their vulnerability to low end disruption. Brian Caufield asks the question if Apple has any future with the iPad given the potential for $99 tablets.

The question is indeed why not introduce an ultra-cheap tablet, for example from Amazon, which makes up for the low price with an innovative business model like selling content or user behavior data. After all, game consoles are sold this way. This is the classic razor/razor-blade business model.

The answer to why not is actually not simply that the economics don't work. They might work some day even if they really don't today.

The answer to why not is that the iPad is not good enough.

Disruption (low-end or otherwise) happens when a product over-shoots the market. It makes sense to compete on a new basis, be it low price or convenience or customization, if the prevailing basis of competition has led the prevailing products to be more than good enough. If you look through all the examples of low-end disruption, you'll find that the incumbents were motivated to flee up-market and to continue to improve their products even though they exceeded the demands and expectations of mainstream buyers.

For the iPad to be vulnerable, it has to be way better than the mainstream users' needs. Which asks the question of what needs are being served. If it's book reading, it probably is more than good enough. But if it's replacing a laptop computer, certainly not. Being too feeble is the most common complaint about the iPad. Being a bloated over-functioned and overly complex solution looking for a problem is definitely not on buyer's list of concerns.

So on this basis, the iPad and other tablets pass vulnerability tests with flying colors. The product is woefully inadequate for mainstream computing.

The consequence is that people will yearn and beg for more functionality and will drop the last generation for the next without hesitation. This pattern of breathless upgrades is symptomatic of a product racing up a trajectory of improvements which are relevant to buyers.

So until buyers find the n+1 version of the iPad to be superfluous and over-specced, having too much battery life, too big a screen, too much storage and with more speed and bandwidth than needed, the iPad need not fear the low end.

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Notes:

1. Other classic low-end disruptors are: Wal-Mart, GE Capital, Toys 'r Us, Sun Microsystems, Dell, Hyundai, MySQL, Amazon, Visa, Embraer, E-trade, Macy's, Japan Steel, Circuit City, Home Depot, Yahoo Travel.

Andrian Georgiev, a reporter from the Bulgarian business newspaper "Capital weekly" wrote an article for which he asked me some questions. My answers are below. The article is available here (Bulgarian).
Q: How many tablets will be sold worldwide this year and in 2012?
A: We can only guess the answer. The total will be constrained by parts shortages for 2011, but my estimate [through the end of 2012] is over 100 million. Perhaps even 120 million is possible.

Q: Do you think Amazon is working on a tablet? Could it be a game-changer?
A: If Amazon (or Facebook or Baidu) were to build a tablet the greatest innovation will be in their business models. In other words how they make money. I suspect Amazon's hardware will be free or nearly free but users will be incentivized to buy content or other goods from Amazon. Similarly for other businesses that will take a hardware product and make it an accessory to their core business. In that regard the "game will change" because hardware will conform to "the application" above it. In other words, that the device will be an accessory to the service, not the other way around.

Q: Why is it so hard for manufacturers to create a tablet that rivals iPad?
A: The iPad is a collection of components. Some are easy to duplicate or to source. This includes memory, microprocessors, communications components. Other components are harder to find and may be expensive once found. This includes the right kind of batteries and the screen. Yet other components are impossible to find or duplicate. That includes software.

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Some additional thoughts:

The changing of the game may not happen for some time. "Feature tablets" (analogous to feature phones) will however be viable as niche businesses quite soon. I believe "conforming" operating systems will be more popular with tablet makers than with phone makers.

“It doesn’t matter how good or bad the product is, the fact is that people don’t read anymore,” he said. “Forty percent of the people in the U.S. read one book or less last year. The whole conception is flawed at the top because people don’t read anymore.”

The Passion of Steve Jobs - NYTimes.com

It was almost exactly three years ago that Steve Jobs dismissed the Kindle reader as a futile attempt to change user behavior.

Yesterday, Steve Jobs announced that the iBooks store served 100 million ebooks in its first 11 months of operations.

So do we have another example of Steve's classic misdirection where he dismisses a category only to enter and dominate it at some later time?

Let's look at the data. The chart below shows the sales ramp of three media types served by Apple: songs, apps and books.

At the same point in time (11 months post-launch) there were five times as many songs downloaded and 15 times as many apps downloaded as ebooks. You can see the relationship between different media consumption more clearly on a log chart:

The conclusion that can be drawn so far is that apps/songs show an order of magnitude more popularity than ebooks. Perhaps Kindle ebooks outsell Amazon music downloads, but we don't have comparable data from Amazon and it would be a challenge to compare the two Amazon media as they are packaged and dlievered in different ways (Amazon's digital music is not an integrated offering while their ebooks are.)

Books are a 400 year old medium. Songs only 100 years old and apps a mere 10. For three centuries, the book medium had a monopoly on solitary entertainment. The download data shows how quickly new media displace the old. Therefore, in this context, it's perhaps fair to say that Steve was right three years ago when he said "People don't read anymore."

Today he could add that people use apps instead. Many of the apps available are hired to do the same job for users: solitary, immersive entertainment.

In the previous article discussing the growth scorecard, I left open the question of how Apple's growth is reflected in its share price.

The approach to answering this question is to show how the share price correlates to that growth. The challenge for analysts has been that the company switched from subscription to current accounting for the iPhone (the largest component in its income statement). As they re-stated income and thus earnings, any historic review of P/E or other multiples of Earnings have to also be re-computed.

So this is what I've done:

The first chart shows Apple's price per share (blue) vs. its trailing twelve months earnings (green) and multiples of those earnings (15x and 25x).

The chart shows how Apple was priced well above 25 P/E before October 2008 and has remained within the 15 to 25 multiple bands since the winter of 2008/2009. This seems fairly reasonable and the stock's rise is a cause of celebration for many, but a cause for concern for some. Is this rise in price matching a rise in value?

To answer, we need a way to look at the valuation of Apple. One way is to plot the P/E ratio over time. That would show how the market perceives the value of the company (i.e. how many years' worth of earnings is built into the price) The chart below does that.

I took the additional steps of plotting the P/E excluding cash from the price to show "P/E Ex cash" in the orange colored line and I also copied the Share price line from the first chart on this one for contrast.

What the P/E analysis shows is that as the stock rose, it's P/E ratio fell. This means that the "valuation" of the company is quite a bit lower now than it was in 2006 and 2007. In fact, as a multiple of profitability, Apple's stock is nearly half as valuable now as before the recession.

Since valuation is usually correlated with growth, (P/E is often compared in a ratio with Growth) we need to see whether the P/E in the chart above matches the actual growth of earnings. Fortunately we have just measured growth with the scorecard.  Here are the two charts together:

What this shows is that while earnings growth did slow down in the lead-up to recession (with the hugely anomalous 3G launch spiking growth to 155% in Q308 causing the year-later plunge to 11%), growth picked up again in the depths of recession and has moved back to pre-recession levels. The only difference is that the multiple assigned to the stock has remained near recession lows. This is visualized by the blue line being mostly above the red line pre-crash and usually under it post-crash.

To put a finer point on this, I plot the ratio of P/E and trailing growth (P/E/tG) in the brown line below:

It shows that as a measure of valuation with respect to growth, Apple is trending down. A P/E/tG ratio of 0.4 and closer to 0.2 if we exclude cash shows very weak confidence.

The only conclusion I can draw is that the market does not believe that Apple has significant growth opportunities. A P/E of 20 with consistent 70% growth is, to be blunt, damnation. For comparison, Amazon just reported 16% growth in earnings and was rewarded with a P/E of 68.

Amazon notwithstanding, is Apple an anomaly? Is the disconnect between earnings growth and the stock price unique to Apple or does it apply to most other equities? Is pessimism about Apple a symptom of pessimism in general? I will suggest a way to answer this in a future article.

Yep, Amazon Launching Their Own App Store For Android Too.

No surprises here. Amazon, a retailer, is building a retail experience for apps. They are taking Android and throwing away Google's app store and a few other things as well and making their own tablet while at it.

Maybe they'll put Bing on it and Facebook too.

A survey of nearly 3,200 consumers by ChangeWave Research finds that 40% of people planning to buy an e-reader in the next 90 days expect to get Apple's iPad. The current leader, Amazon.com's (AMZN) Kindle, came in second at 28%.

link: E-Reader Buyers Coveting iPad Over The Kindle - Investors.com

This should be put together with data showing at least 15% of iPhone users showing purchase intent for iPad.

If we assume 45 million iPhone users by time of launch (42 million units have been sold as of end of December) and 15% would buy iPads it would therefore not be unreasonable to assume about 7 million iPads will go to iPhone users alone.

It's unfortunate that we cannot calibrate against installed base of Kindle users since Amazon has never released any sales figures.