dollar

Our agreement with Microsoft includes platform support payments from Microsoft to us as well as software royalty payments from us to Microsoft. In the first quarter 2012, we received a quarterly platform support payment of USD 250 million (approximately EUR 189 million). We have a competitive software royalty structure, which includes minimum software royalty commitments. Over the life of the agreement, both the platform support payments and the minimum software royalty commitments are expected to measure in the billions of US Dollars. The total amount of the platform support payments is expected to slightly exceed the total amount of the minimum software royalty commitments.

From Nokia's Q1 2012 financial interim report

The figure of $250 million for Q1 is the same as the amount Nokia received for "platform support" in Q4 2011. This means Microsoft has paid $500 million over two quarters. During the same time frame Nokia shipped approximately three million Windows Phone devices. The average cost to Microsoft to acquire a Nokia Windows Phone user is therefore $167 per user. This is down from $250/user in the last quarter.[1]

If the royalty is equivalent to a license fee then the more interesting question is how and when will the royalty payments nearly match the platform support payments as expected. This might give us an estimate of what both parties are expecting from the relationship.

If the payment schedule of $250 million per quarter is maintained through 2014, Microsoft will have paid $3.25 billion to Nokia. This is well within the "billions of US dollars" range that is cited above. (The minimum would be $2 billion which would mean payments through the end of 2013).

We also need to estimate the royalty payment structure. One figure that has been circulating for a long time is that Microsoft prices Windows Phone (and its antecedent Windows Mobile) at $15/unit. It's an aggressive price point for a mobile software license and should be subject to volume discounts but let's assume it's correct. If it is correct then the only remaining question is how quickly will Windows Phone units grow at Nokia?

One way to begin is to calibrate WP growth to iPhone growth. For the first two quarters iPhone and Lumia have sold at rough parity.[2] iPhone sold 1.4 million in its first quarter (including opening weekend sales of 270k in previous quarter) while Nokia sold "approximately" one million Lumias in its first quarter[3]. In the second quarter Nokia cited 2 million Lumia units and Apple had 2.3 million iPhone sold in Q4 07. So far Lumia is slightly under the iPhone ramp, but let's give it the benefit of doubt.

If we  apply iPhone growth rates to Lumia then we have the following sales forecast for Nokia's Windows Phones:

This looks like healthy growth, as was the iPhone's. However, this "iPhone growth" pattern only results in about $1.4 billion in payments in exchange for $3.25 billion from Microsoft, leaving a deficit of $1.9 billion in the "platform support" balance.

To erase the deficit, I tried an approach where I assigned 3 million and 4 million for Q2 and Q3 shipments respectively then applied a constant (y/y) growth rate thereafter. Solving for a figure of growth which results rough parity with platform support payments gives us about 250% growth. The resulting sales profile looks like this:

This ramp would result in 210 million Windows Phones shipped over about three years. It would also generate nearly $3.2 billion in "royalties" for Microsoft offsetting $3.25 billion in "platform support" payments by Microsoft to Nokia.

There are many assumptions in this, royalty rate and length of contract chief among them, but the key question should be a sanity check: is this a feasible product ramp. It's certainly far faster growth than Apple has been able to achieve. On average Apple obtained about 160% quarterly y/y growth. It also exceeds the growth rate that Samsung has been able to achieve (165 to 170 million smartphones shipped from a standing start three years ago). It implies 150 million units shipping in the third year of sales and nearly 50 million in a peak quarter. It assumes perhaps as much as 20% market share in smartphones in 2014. It's certainly ambitious.

But even if it's achieved, it's only a break-even point for Microsoft's relationship with Nokia. It would imply that payments to and payments from Nokia would be in balance. The road to (dare one say it?) profitability for Microsoft in mobile would just begin to be visible at that point.

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Notes:

1. What the quote above also reveals is that Nokia is also expecting to pay back some of these "support payments" in the form of "royalty payments" for the software. That's an interesting word choice as usually an OEM would pay a license rather than a royalty for software. I'm not sure if this implies anything but it may.
2. See also Charles Arthur's analysis of comparable growth ramps for mobile phone platforms here.
3. This figure was cited "to date" in a March statement so actual calendar Q1 may have been less, perhaps 650k.

 

As previously described in an earlier piece on the transistor, there is a theory that underlies much of what this web diary is about. Telecommunications is undergoing wrenching change. And not for the first time. The history of the industry is filled with disruption and thus with drama that leads to fine storytelling.

One such great story is that of Western Union and the telegraph.

Western Union was formed as a company in 1851 and ten years later had completed the first transcontinental telegraph line. Following on that breakthrough, it introduced the first digital real-time data service, the stock ticker, in 1866. Business boomed and by 1870 it was the world's most powerful telecommunications company.

By any standards it was innovative: it offered remarkable and revolutionary telecom data services, a century before the Internet. But in the century that followed why didn't Western Union become the leader in voice communications, ceding that position to the Bell companies?

Alexader Graham Bell did not invent the voice telephone with the intention of toppling Western Union. In the language of today's technology entrepreneurship he hoped Western Union would be his "exit". He pitched the phone to them as an improvement to their core telegraphy business. Bell offered the patents for the telephone to Western Union for a mere $100,000, roughly $2 million in today's dollars. In other words, today the deal would be: two million dollars to own all voice IP.

Western Union passed

Now why would they do that? Imagine you are an analyst at Western Union advising management on technology acquisition and M&A. What process would you use to evaluate it? First, most obviously, you would try to get feedback from marketing and sales. They should go out and survey their customer base to find out who would be interested and how much they would be willing to pay.

The sales force would naturally seek out their best customers and ask them first. Those customers were the stock ticker users. They were extremely voracious users of the ticker tape system. It should be no surprise why we have "ticker tape parades"--there was enough of the stuff lying around offices in New York to shower down and flood Broadway end-to-end". Ticker tape was a boon to merchants and traders. Chicago would know what's happening in the New York stock exchange instantaneously. Price data was traveling at the speed of light.  The sender and receiver were in lock-step sync. To suggest to these customers a voice product would sound like a step backward. Why would they want to talk to the other party? The data was coming on tape and it was also recorded for posterity. Speaking with the other person meant confusion and delay and a mess of record keeping.

The word from the customers would be a resounding negative.

Second would be the business model.  How would you charge for voice? Data was subscription based, and the fees were huge. Voice would be metered and the price low. If targeting consumers, telegrams were priced by the word, but you couldn't price voice by the word. Marketing would stare back at you as if you had committed a judgement error.

Thirdly you would look at the cost side. Operations would give you more bad news. Voice technology was different enough that it needed new infrastructure. Switchboards, operators, handsets and new power and insulator requirements were all expensive and had no clear return. Voice was a loser all around.

So the decision was perfectly reasonable, smart even.

This is not to suggest that Western Union did not accept any new technology or invest in it. For decades after the phone, Western Union continued to invest in innovation: It introduced an electronic payment system (called money transfer) in 1871. In 1914 it offered the first charge card and in 1923 it introduced teletypewriters. Singing telegrams followed in 1933 and fax service in 1935. Intercity wireless microwave communications were introduced in 1943. Telex came in 1958 and the product of marketing genius, the 'Candygram' in the 1960s. By 1964 its network was all wireless using a transcontinental microwave system. Western Union became the first American telecommunications corporation to maintain its own fleet of geosynchronous communication satellites, starting in 1974. The fleet of satellites, called Westar, carried communications within the Western Union company for telegram and mailgram message data to Western Union bureaus nationwide.

And it wasn't lacking in talent either. Western Union had the best telecom managers in the business and was raking in profits to fund expansion. It attracted the best and brightest engineers for generations. Western Union probably passed on hundreds of other inventions and ideas, and rightly so.

So what happened to WU?

It's still around. However, due to declining profits and mounting debts, Western Union slowly began to divest itself of telecommunications-based assets starting in the early 1980s. Due to deregulation in the US, Western Union began sending money outside the country, re-inventing itself as "The fastest way to send money worldwide". In 1987, an individual investor acquired control of Western Union through an outside of chapter 11 process that was a complex leveraged recapitalization. After several other changes in ownerships and moves through bankruptcy, WU is now a public company with an enterprise value of about $12 billion based entirely on international money transfer business.

3G as a disruptive technology

Today we've come around full circle. Whereas voice was disruptive to a data network provider in the 20th century, data is disruptive to a voice network provider in the 21st. The mis-application of 3G network technology to sustain voice-oriented business models gives one a strong sense of déjà vu.

The telecom world moved swiftly to 1G and 2G cellular voice. Each new generation of mobile telecom was sustaining the core business model of subscriptions feeding centrally managed networks and symbiotic device vendors benefiting from handset and switching system upgrades. Standardization, international expansion, lower price points and network effects made this industry the most ubiquitous technology distributor the world had ever seen.

3G however was different. It was effectively mobile broadband data. It enabled data services to be de-coupled from the network operators. IP protocols did not require the servers to be located on operator premises or even to be managed or monitored by them. Devices could be general purpose computers not specific purpose communicators. Incumbents did not adapt to this well.  They continued to build business plans according to a central-switch blueprint.

So although incumbents did not reject the smartphone as a technology, they tried to make it sustaining when plainly it isn't. They essentially tried to cram it into their business models.

The struggle to keep the service structure of telecom centered around the network operator will continue, but short of pulling the plug on 3G and LTE, there is little that the incumbents can do to stop it.

So what's the lesson?

Some technologies are embraced and some are rejected. You can't fault every rejection and you can't praise every acceptance. The most likely reason for embracing something is that it helps grow your existing business. The most likely reason for rejection is that it may harm your business. Even acceptance sometimes leads to mis-application in sustaining the core rather than planning for its demise.

The decision on how to handle something new and potentially disruptive requires a different sense of what's right and wrong about it.

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Photo: Former headquarters of WU, located at 60 Hudson, New York.

Following up from the last article on the global phone units sold over the last three years (Visualizing the winners and losers of three years of smartphone share growth), we take a look at the sales in dollar terms over the same period.

Remember that in the article on units, the pure-play smartphone entrants HTC, RIM and Apple grew from a combined unit share of 1.3% in Q2 2007 to a combined unit share of 7.7% in Q2 2010.  That's a 6 fold increase in volume share. Quite remarkable for companies lacking the vast resources and industry connections of the incumbents.

However, when we look at their performance in value (dollar sales) vs. units sold, the performance of the entrants begins to look miraculous.

The sales figures can be obtained from the company reports, though I caution that not all vendors publish data and data published is in local currencies. Fluctuations in exchange rates may lead to differences in reports of sales from different sources.  For the sake of consistency, I omit all "other" vendors and focus on the top seven: Nokia, Samsung, Motorola, LG, Sony Ericsson, RIM and Apple.

First, the cohort's overall performance is shown in the following graph:

I again annotated Nokia and RIM and Apple with actual sales (USD) figures for some perspective.

The first thing to note here is that the whole industry sees a low rate of growth (unlike in the units picture). Total sales in Q2 2007 were $29 billion and total sales in Q2 2010 were about $32 billion. A mere 12% growth over three years and only 4% compounded over three years. Total units in Q2 2007 were 255 million and total units in Q2 2010 were 318 million, or 24% over three years and 6.2% compounded. This means industry-wide sales growth is half the units growth.

The second thing to note is that the Apple+RIM group grew from 3.3% share of cohort to 26.6%.  That means that more than 1 in 4 dollars sent to these 7 companies was spent on Blackberries and iPhones!

Jointly, Apple and RIM took $8.6 billion and Nokia took $8.8 billion.  Compare that with three years ago when Nokia took 40% of the income and RIM + Apple took 3%.

So whereas the entrants increased units share by 6x in this time period, at least in this large subset of the market, they increased revenue share by 8x.

Recent data from admob shows that Android OS share is highly dependent on a single vendor (HTC). (http://metrics.admob.com/wp-content/uploads/2009/11/AdMob-Mobile-Metrics-Oct-09.pdf page 7)

There is an implied message in Android advocacy that once more licensees join in, volumes will be distributed among a broad set of companies benefiting from a healthy rivalry. This broad licensing will be a boon for volumes and for user choice and the platform itself will prosper.

I'm going to argue here that there will be no healthy distribution of volumes or profits in the Android platform.

History shows that volumes for an openly licensed mobile platform concentrate in the hands of a single vendor. To illustrate, I attached a list of all the devices which shipped (to date) with a flavor of Windows Mobile. The list includes 911 different phone models (search on your own on pdadb.net under the pdamaster tab--search criteria are on the last page of the PDF).

The Windows Mobile platform "took off" and had hundreds of concurrent licensees in the middle of this decade. In spite of this wide adoption, one vendor captured 80% of the volumes for all instances of the platforms: HTC. Having started with the iPaq as a PDA and followed by being the first to market with a WinMo device, HTC dominated Windows Mobile volumes even when faced with literally hundreds of competitors. These competitors included all the big names: from PC vendors like HP, Dell and Toshiba, to cellular incumbents like Motorola, Sony Ericsson, Samsung, LG and every ODM and OEM in between. The reason HTC won is mundane: they have the experience and the distribution to make an impact and they iterate rapidly and are intimate with the details of making a tough-to-integrate product work. They basically worked their way up the value chain from a contract design shop to a branded top tier vendor.

But if you exclude HTC, dividing the number of units of WinMo shipping at any given time by the number of licensed products in the market at that time, one gets about 50,000 units/licensee. Think about that: except for HTC, an average licensee could hope to ship 50k units for any phone they engineer and market. And they also need to prepay Microsoft the minimum license fee of $10/unit (approx) for a minimum order of 50k units or half a million dollars.

This is actually a paradox. Put yourself in the shoes of a business manager at one of the potential licensees. Consider the situation where there are 200 competitors in a market all shipping undifferentiated products, and one competitor has 80% share. Would you want to be the 201st? Saying yes implies hoping to split the remaining 20% 200 ways or obtaining, on average, 0.1% share? But this is not a share of all phones, it's a share of that platform, which itself is, at best 10% of all smartphones which make up maybe 20% of all phones. So you are committing a few million dollars to pursue (.2*.1*.001=) .00002 of a market. That target is 3 orders of magnitude less than what Apple obtained in 2 years (without the margins). It never adds up unless you expect your entry to blow out of the 20% ghetto and take on the incumbents.

As it turned out there were dozens upon dozens of business managers who opted to be the 201st (or 301st). Unsurprisingly, the result was that every Windows Mobile business plan failed (except that of HTC). Every decision to join this ecosystem on the device side was a value destroying decision, repeated 900 times.

Why?

I don't have an answer as to why so many are taken in by this. I have a hypothesis that it has to do with excess R&D capacity (e.g. idle engineers) that compels small companies to build product with no hope of market penetration, but I cannot prove it. They may also couple the low barrier to entry to the premise from the platform vendor that a no-name licensee could be the next Dell/Acer/HTC if the platform "takes off".

Regardless of the cause, the proliferation of WinMo SKUs did nothing for the success of the platform overall. For consumer products, it does not matter what jockeying for position happens within the value chain if the end user/developer experience is painful and uncompetitive.

Android will win or lose on the user/developer experience. It will not win or lose on the proliferation of licensees.