Apple announced that the total number of iTunes account (with credit cards attached) has reached 400 million. This was touted as being the largest collection of credit card accounts for any retailer and I have no reason to doubt it. However, looking beyond the bragging rights, there are more interesting patterns to observe about this asset.
What I plotted was the cumulative number of iPods sold (green), the cumulative number of iPhones and iPads (yellow), the combined devices total (red) and the reported number of iTunes accounts (blue).
The first observation is that the combined total iPhones + iPads have overtaken cumulative total iPods. The iPhone started in Mid '07, more than five years after the first iPod shipped. The acceleration in that product line is still evident while the iPod decelerates gracefully.
The second observation is that the total device count has reached 680 million in the last decade. It's a big number but it is still a number that is dwarfed by the overall device market. Apple is still around 10% of the devices market today. It should give an idea of how many devices could still be sold in the next decade.
The third observation is the ratio between the iTunes accounts and the total devices sold. Since iPods, iPhone and iPads have been dependent on iTunes, the number of iTunes accounts gives a rough indication of active users. Combining active users with total devices sold should give a rough estimate of the number of retired devices. In other words, if we assume that account holders typically use one device then by taking the difference between devices sold to date and accounts at that point in time we should know how many devices have been retired.
Dividing that number of retired devices by devices in use should give us the retirement rate and that is shown in the following chart:
Note that as the iPod was slowing and the iPhone was still a small part of the total, the retirement ratio was increasing. As the iPhone accelerated, the ratio began decreasing and is still decreasing.
Projecting the retirement rate should give us a way of more precisely estimating the addressable market for developers, accessories makers, and other ecosystem participants. Currently that means that about 60% of all Apple's devices sold are still in use. We can tune that figure upward in the next few quarters and make better estimates as Apple releases their shipment data.
The iTunes account data is not just a way to calibrate addressable markets but also a valuable method for measuring device longevity. The distance between the red line and the blue happens to be nearly a constant 8 quarters as shown in the following chart (note change to log scale for the vertical axis).
As the chart below shows, the last quarter (first calendar 2012, second fiscal 2012) was robust with 94% earnings growth and 59% net sales growth. Subject to the usual superlatives, the performance was, again, unexpected by many.
Much of that surprise was due to the underestimation of iPhone sales in China during what is a holiday quarter in that nation. Growth this quarter will be more difficult to estimate. The iPhone is still the most important component but the iPad is becoming increasingly decisive in overall performance. In fact, I'm projecting that the iPad will have the equivalent of 73% of the iPhone revenues this quarter.
In this quarter the iPhone is reaching a late stage in its launch cycle but it continues to reach more points of purchase through distribution agreements and it also has a "portfolio" in terms of multiple price points and models available.
The iPad was supply constrained last quarter and may be in balance this quarter. Management has very clearly and repeatedly signaled that the iPad will have a very strong quarter.
So with these clues, here are my estimates for the quarter (with y/y growth in parentheses):
iPhone units: 28.5 million (40%)
Macs: 4.5 million (15%)
iPads: 24 million (160%)
iPods: 6 million (-20%)
Music (incl. app) rev. growth: 35%
Peripherals rev. growth: 20%
Software rev. growth: 15%
Total revenues: $41.9 billion (46%)
GM: 44.8%
EPS: $11.54 (48%)
This earnings value would imply a trailing twelve months’ EPS of about $44.8. At the current price of $571/share the P/E would be 12.7[1]. Cash and equivalents will probably increase to $118 billion.
---
Apple's P/E also dropped to 12.7 around Christmas 2008. I did a search for some headlines to recall that time and came across one that seems appropriate: "Unrest Caused By Bad Economy May Require [domestic] Military Action, Says US Report".
I note the "our" in "our year". This implies fiscal year (that and the fact that he spoke in the past tense before six months had passed in the calendar year.)
Given the public information we have so far, it's now possible to estimate with some confidence the sales history of Apple TV. The following chart is my estimate. It includes all the known data so far with some interpolations to fill in the gaps.
Assuming average revenues per device of $100, we can get an estimate of about $344 million in Apple TV hardware revenues for calendar 2011. This is not a large amount relative to Apple's other lines of business. It is, for example, only 14% of the overall Peripherals revenues and only 5% of the iPod.
However hardware revenues are not the whole story. The business model for the device is in many ways the polar opposite of the business model of the iPhone. Whereas the iPhone employs "break-even" iTunes App Store (and the Music and Video and Book stores) in order to sustain its high hardware margins, the Apple TV business has low hardware margins that sustain content.
The complete picture therefore has to include an assessment of the content attach rates and the agency fees that Apple gets for that content.
Let's assume that each Apple TV is used to generate $10/month in content sales. This is not a lot. It's equivalent to 5 TV shows or one movie purchased or two movie rentals per month. The model I have shows that the installed base of Apple TVs was about 10 million by the end of 2011. That means that the run rate is $1.2 billion in content sales for the Apple TVs in use.
Now Apple does not book all that. They book only about 30% as revenues as their agency fee. That means that Apple TV could be generating revenues at a run rate of $360 million (to Apple.)
If we add that to the $344 million in hardware revenues we get about $704 million for 2011. This is still not a huge business. It is about equal to the revenue from iPad Smart Covers[1]
Looking forward, if Apple TV units sell at double the rate of last year and we increase the footprint accordingly, we could see a revenue rate of $1.2 billion for 2012.
Now this is not a high margin business. The margin on the content may be less than 50%--depending on transaction costs and hosting/traffic fees. The margin on the hardware is also likely to be below 40%. So the business is not wildly profitable. But it probably is profitable. Which means it makes sense to keep it running while waiting for other pieces to fall into place.
As Tim Cook repeated, they are very interested in this space. However, any discussion of the future must include an analysis of the business model and the sustainability in terms of profit that keeps long term development focused on getting the product to be good enough for the right jobs to be done.
What we should think about however is this "polar opposite" business model. Apple is running this as a "hobby" or as an internal experiment. Sales are (relatively) tiny but it generates some profit. Volumes are small but they are growing. It's taking a heck of a long time. It's asymmetric to the prevailing model the company relies upon. It's beneath contempt from all observers. Sounds familiar?
---
Notes:
In 2011 there were about 40.5 million iPads sold. If we assume half of those purchases also resulted in a Smart Cover purchase and if the average revenue per Smart Cover was $35 then total Smart Cover revenues were $709 million.
Markets are difficult to measure. Mainly because the information is not easy to obtain and that which is obtained is not made public. Collecting, analyzing and filling in the gaps is big business with many firms involved in selling it.
However, with all the analysts and companies selling and promoting their "numbers" it's important to understand the difference between the methods used. There are for instance at least the following measurements:
Units sold to end users. For example NPD or GfK data of retail transactions. Also Gartner's estimates for phone units sold.
Units sold to the channel. For example units recognized on income statements usually reported by companies. Also IDC's estimates for phone units sold.
Units in use. For example comScore and Nielsen survey data.
Units "activated". The measurement Google uses to describe Android performance.
Intent to buy. For example ChangeWave surveys of early adopters.
Utilization rate. For example browser statistics.
Each measurement tells a different story about the market but the best story is told when all data is analyzed in a combined integrated market review.
Before diving into that it's important to understand the difference between the first and second measurements or the difference between shipped and sold.
What does "Sold" mean?
Let’s say that you sell a phone to another party. What constitutes a sale? The sales agreement? That you shipped it? That he wanted it? That you were paid for it?
What if he changes his mind and returns it? Is it still a sale? What if a manager's bonus depends on these sales? What if the company’s share price depends on these sales? Is there a way to rig the accounting?
As it turns out, yes there are; many ways. Unethical and fraudulent practices happen surprisingly often. A classic instance would be: A customer is shipped ten phones, though he only wants one, and he gets paid to ship the other nine back, after the close of the year.
The sales manager records ten times the sales he actually made, making ten times the commission and the company’s stock price rises. To compound the offense, the manager could also tip his friends to short the stock at the end of the year, leaving investors “holding the bag” when the inevitable correction follows.
There have been so many cases of this kind of accounting fraud that the FASB (GAAP), SEC, and IFRS have placed a very stringent definition on “revenue recognition”. This means that although you can sell all you want, the company can only recognize the proceeds and profit in the financial statements according to strict rules.
In the case of hardware (Sales of Goods), the customer must receive it (“delivery has occurred”), and like it enough to not return it (“amount to be refunded”), and be able to pay for it (“collection is probable”). If some are projected to be returned or unpaid, that percent is subtracted from total revenue. In the case of software (Sales of Services), it is generally accounted for over a time period. And because it is customary to send the customer upgrades, the revenue must be spread out over the time the service is provided. (“upgrade rights … 24 to 48 months.”)
It gets complicated when a piece of hardware has upgradeable software. The rules used to stipulate that the hardware, in its entirety, must be accounted for as a service and have subscription accounting. This is how Apple had to report sales during the first few years of the iPhone. It still defers some revenues for its hardware, mainly on account of iCloud, but the vast bulk of hardware revenue (96%) is now accounted upfront, recognized upon the product's acceptance by customers. 4% is for software upgrades and is accounted for over a specific lifetime of the product (24 months in the case of the iPhone).
What does "Shipped" mean?
The discussion so far implies that if a product that is accounted for as "Sold" on an income statement does not mean that it's in the hands of an end user. These "revenue recognized" products are sold to a distributor, typically for a phone that's an operator.
These sales satisfy the requirements for financial reporting as revenues booked. But they are not in the hands of users. Nor are they "activated" and they don't generate page views that are measured by web analytics companies. Most analysts and companies now use the phrase "Shipped" to describe these revenue-recognized units though it's also common to hear "sold".
When a product sells to end users it's sometimes called "sell-through". It's counterpart is "sell-in" which is sales to the channel distributors.
A big gap between sell-in and sell-through might imply large amounts of in-channel inventory. This is product that is sitting either in stores or in warehouses or on trucks in transit. If sales are steady, the inventory is measured in time as in "weeks of inventory". This means that the excess is expected to be sold within a fixed time frame if shipments were to end. The smaller this amount, the better or "tighter" the operations are. Inventory, as Tim Cooks says, is fundamentally evil. It eats capital and erodes profitability.
Sometimes miscalculation of sell-through could result in vast amounts of inventory that has to be returned by distributors. That inventory is either written off or sold at fire sale prices resulting in a "write-down". This happened recently with both the HP TouchPad and with the RIM PlayBook. This special charge against income is a one-time (usually) incident but it can also affect a firm's reputation with channel partners for a long time. This type of failure is very costly.
Therefore what matters most is to keep the difference between Sell-in and Sell-through as small as possible. However, it can't be too small. Sometimes if Sell-through is too fast, you get stock-outs which means that there is more demand than supply and sales opportunities are missed. This has happened many times with iPhones and iPads. This is also an unwanted situation (unless there was too much inventory in the channel during the previous period and thus it was being drained in the current period.)
The chart to the left shows how the phone market looked for various vendors last quarter. I compiled the data based on Gartner's "sales to end users" and IDC's "shipments" data. Two vendors had higher sell-through than sell-in (Nokia and LG) probably because they were draining excess inventory. The others had channel inventory of between 5% and 10% of units shipped.
This ratio is shown below in a chart comparing the largest phone vendors.
Management is often rated for performance on this metric, as they should be, since it's a measure of operational skill. However, there are many factors that affect overall performance.
New product launches, windows of opportunity related to seasonal buying patterns, anticipating macroeconomic slowdowns, even natural disasters and legal challenges can affect this metric.
Understanding the overall market requires an appreciation of this distinction but also an understanding of all the other metrics listed above and what stories they tell.
---
Notes: My thanks to Michael Dediu for input on this discussion.
In the iPhone cost structure analysis I showed how revenues and costs for iPhone are probably allocated. The revenue per iPhone was shown to include $29 for revenue items "above" the price of the phone to the channel. This total includes Apple's own iPhone accessory sales plus revenue from licensing the "Made for iPhone" trademark to third party accessory makers. Apple also receives some revenues from cloud services. But, pertinent to our recent discussions on the Android business model, Apple also receives revenues from Google.
Wouldn't it be nice to know how much? Here's a way we can estimate it.
I've read an estimate that 50% to 60% of ad revenues from Google search initiated via iOS are paid to Apple. This is believable because the TAC for Google overall is about 40% and Apple probably drove a hard bargain to get a premium for its, presumably, premium traffic.
So if we knew the revenue run rate for Android search on a per device basis we could perhaps guess how much of each phone's revenue comes from Google. What we've heard last year in Congressional testimony is that two thirds of its mobile revenues come from iOS devices. This would imply that the run rate for iOS would be 2x the run rate for Android.
Having a model of Android revenues helps at this point. Assuming Google obtains $4.4 from Android (excluding AdMob and App sales) and assuming negligible other mobile revenues from other platforms gives a possible Google revenue per iOS device per year of nearly $9.
Taking the lower bound of the revenue share estimate above means that half of Google's revenue goes to Apple or $4.4/iOS device/year or $9 over the two year life of the device.
That would put revenue from Google at about 1.4% of iPhone revenues (see average revenue per iPhone here). And that revenue comes without any costs and so flows straight to the bottom line. That, in turn, would imply that 3% of Apple's operating margin is provided by Google. Not a bad deal considering that some phone vendors can't get that for their entire product line.
The interesting factors at work here are that this contribution by Google to Apple is higher than the contribution by Android to Google. In yesterday's post, I calculated that in 2011 Android contributed about $590 million to Google's operating margin (5% of total).
If we consider that Google pays Apple $9[1] for every iOS device and since Apple sold 156 million iOS devices in 2011 then Apple received $1.4 billion from Google, all of which went to the bottom line.
$1.4 billion from Google to Apple vs. $600 million from Android to Google. Three percent contribution of Google to iPhone profits vs. 5% contribution of Android to Google's profits.
This sets up all kinds of game theorizing which will undoubtedly entertain and enrich us all.
---
Notes:
Perhaps this $9 value is not valid for all devices. Perhaps iPod touch does not get a lot of traffic and is less valuable. Perhaps iPads get more traffic and are worth more. On average, this may be plausible.
Yesterday I presented the estimated Android income statement vis-à-vis Apple's income statement. In this post I'll compare Android as a part of Google's overall business.
Recall that Google has already been compared in terms of overall revenue, growth and profitability to Apple and Microsoft here. The argument can be made that mobility has not yet had a measurable impact on Google (certainly not noteworthy enough to be reported by management).
The impact on Google of Android can be shown in the following diagram:
I used color coding to identify non-Android (Green) and Android (Brown) segments of the business. Overall, Android could amount to about 3.5% of total Google revenues and about 5% of operating earnings.
It's important to note that this is not all the revenue that Google obtains from mobility. This diagram represents Android only and there are revenues also coming from alternative platforms and operator deals.
iOS contributes between 3 and 5 times more ad revenue to Google than Android.[1] The contribution to earnings is even more difficult to assess. We don't know the terms between Google and Apple for search revenue sharing and placement. One analyst suggests that the cost of sales (TAC) for mobile Safari search could be as high as 60%, far above what Android traffic costs.
The other observation is that Android cost structure is quite small (see third bar from the left above.) My estimate is that Android R&D is only about 3% of total Google R&D. I'm projecting $200 million for 2012. That implies between 700 and 900 headcount. It's interesting to compare that total to the 20,000 or more that came with the Motorola acquisition.
Having these estimates allows one to calculate many ratios and potential valuations. I'll refrain from putting a value on Android using multiples or sales or earnings, but would come out well below what was paid for Motorola's $12.5 billion.
Which again compels one to ask what is the strategy at work here.
---
Notes:
There are various reports of the ratio including congressional testimony and reports to courts. BlackBerry, Docomo and KDDI were listed as significant other sources of ad revenue by Google in 2010.
This is a continuation of the "Android Economics" series of posts. It deals with how revenues and costs are categorized for Android.
The following diagram shows an approximate representation of what Android's "Income Statement"[1] would look like.
I'll discuss the assumptions that are built into the model as I go along. I'll begin at the upper left and move toward the lower right in the discussion.
The first thing to note is that sales from Google's (formerly known as Android Marketplace) Play are not registered as revenues. This is because Google, like Apple, treats itself as an agent. Agency means that the revenues don't "belong" to the agent but get passed on through to the primary beneficiaries. In the case of Play, Google passes 70% to developers (or content owners) and then distributes on average 25% to network operators (or carriers).
I emphasize on average because there are many cases where Play transactions are not handled by or don't pass through operator billing systems. In those cases where operators are involved, it's possible that they capture more than 25%. It's not uncommon for operator billing to capture 45% of a transaction's value. The reason for this is that there is significant collection risk on billing--far more risk than on credit cards. It would also imply that on some transactions Google may be paying out more than it receives.
This means that on average about 5% of Play content sales to be booked as revenues for Android.
This 5% ends up a quite a small amount if overall app sales are small. We don't know the exact amount but anecdotal evidence from developers seems to indicate that they receive far more revenues from ad sales than from direct app income. Hence the size of the Android app sales is overall, modest. My estimate is that in 2011 there were about $330 million in gross app sales through the Android market. (Google estimated its sales to be 76 million for 2010 half way through that year.)
The bulk of revenues are therefore from other sources: Search, AdSense and AdMob. I'm modeling that overall revenues are based on a "revenue per device in use" multiplied by the number of devices in use. Google has publicly stated that they are targeting $10/device/yr. in revenues. This is probably ambitious as the amount was nearly that much in early 2010 but the number of devices bought by emerging market consumers exploded. As they are not actively targeted by Google's primary customers (especially in China), the average revenue per phone is likely to be much lower. I estimated $6.5 on average for 2011.
However, even if we use $6.5 per phone per year, the total revenues are quite strong since there were likely more than 215 million users at year end[2]. That results in a total revenue base of $1.4 billion for 2011. Removing the app revenues results in about $1.38 billion from Search and AdSense and AdMob.
How to allocate revenues to these three businesses is mostly guesswork. I used a split of about one third to AdMob, 10% to AdSense and the rest to Search. If we assume this split then the next step is to consider how to allocate costs to these sources of revenue.
As discussed in the introduction to this series, the primary costs of sales for Search and AdSense are network operators and OEMs or phone vendors. They are the primary "channel" which ensure the flow of search terms to Google. As Google also explains, the channel receives revenue share--so-called traffic acquisition costs (TAC).
I used an overall allocation of 39% for TAC. Crucially, this includes the payments to developers for AdMob traffic. The rule of thumb I used was:
Network operators get 20% of Search
Developers get 50% of AdMob
OEMs get the rest (of the TAC)
The resulting split is shown in the column above with the "Cost of Sales" at the bottom. There are also additional operations costs which are negligible.
After this 39% TAC (revenue sharing), Google needs to pay its operating expenses. This includes R&D, Marketing, Sales and Legal costs for the Android division (including AdMob). You can see the approximate values in the column labeled "Operating Expenses". This operating cost amounts to about 27% of sales, with R&D at 14% and Marketing at 9%. These rather high fixed costs make sense as there is a significant development work underway for Android.
Finally, after these costs are allocated, the remainder is the contribution of the division. This comes to about 34% of revenues which is called the operating margin. Google has to attach depreciation from data centers and other costs as well as taxes before placing this into earnings.
Considering the agency structure, the overall cost structure of Android looks like this:
When playing with the assumptions, it becomes clear that the model is most sensitive to the revenue per device and total devices in use. The profitability is entirely dependent on those figures as variable costs are a percent of sales and fixed costs are limited by talent constraints.
For example, if revenues per device drop to $4.5/yr then the operating margin drops to 38%.
Now we can calculate some of the more interesting figures. For example:
Android OEMs receive $0.76 on average per device per year
Android Operators receive $1.07 on average per device per year (including Play)
Android Developers, as a group, receive $1.94 per device per year (including Play and AdMob)
Google receives a contribution of $2.75 per device per year from Android
Again, these figures are very sensitive to the revenue per device (currently assumed to be $6.5).
Because of the number of devices involved, these cash flows are an important part of the value network of mobile computing. The next step will be to assess how they affect the incentives, alignments and competitive stance of various platforms vying for a seat at the table of the future of information.
--
Notes:
An income statement shows the sources of revenues and the costs associated with those revenues. It also shows the fixed costs (or costs which are independent of revenues so they don't go up or down if revenues change). Finally it shows the operating income which is called contribution if it's a division within a company. This contribution is still subject to taxes and depreciation before it's recorded as earnings.
I'm using Android installed base estimated based on daily activation rates as published by Google. I've discussed these estimates here. I'm using year-end estimates but subtracting retirements based on a two year device life.
Android has had unprecedented growth. Based on activation announcements, it's possible to estimate that thus far, about 370 million Android devices have been activated. The total number of devices in use is a lower figure which depends on replacement rate and retirement rate. This total number of devices in use at year end is estimated in the following chart.
I added the blue line which represents what Google had as an internal estimate in mid-2010.[1] The difference between the two lines shows that Android's growth is far higher than what the company expected. If the company itself did not expect this growth, it's unlikely anybody else did either.
Unexpected, exponential user growth is usually accompanied by a dramatic positive improvement in the finances of a company and a higher return to shareholders. The curious aspect of Android's success is that it has not had an impact on either. The market has not "discounted" the half-billion anticipated Android users into a price for Google shares that reflects this growth. It can only imply that those users are not very valuable.
But why would there be such a disconnect between the number of users and their value?
In order to answer this question we have to come to grips with what I call "Android economics". We need to understand how Google uses Android to make money and whether it is succeeding and if it's not, why not.
In many ways, the Android business model is straight forward. It's an extension of the existing Google business model: Revenue is obtained from Search, AdSense and the applications that enable these two. In the case of Android there is also revenue from app sales (Google Play a.k.a. Android Market) and from AdMob. Of course, all these revenue sources (except for Play) are sold through other mobile channels that include alternative, competing platforms. They are present on iOS, Symbian, BlackBerry and even embedded OS phones ranged directly by carriers. For each of these alternatives, Google pays for placement of their search as the default search in the browser.
To Google, total search revenue from iOS is far higher than it is from Android. That's because iOS users engage more with their devices and there are not yet a large multiple of installed Android users vs. iOS users.
But it would make sense that having your own platform would be more economical because there would be none of these placement fees. In this sense Android is another "channel" for distribution of Search and AdSense. But one which may be a lot cheaper.
However, it turns out that it does not work that way. Android has other costs.
In fact, Android's distribution costs might be higher than other channels. What we have to understand is that all of Google's channel revenues have a "cost". The revenue from a particular distributor of search results that Google generates is offset by the cost to acquire the terms. You can think of it as Google paying for the queries through a revenue sharing agreement. Google does not get search terms directly and depends on distribution. Overall, it pays about 50% of revenues back to distributors. In the case of its own web sites the rate might be lower, perhaps 40%.
Google even has a term for it: Traffic Acquisition Costs or TAC.
This revenue sharing in exchange for search terms extends to Android. Google pays about 40% TAC to Android distributors of those searches. But since Android is owned by Google, who does Google need to pay for traffic? Who is an Android distributor? Who gets the revenue share?
Google does not make a secret of it: network carriers and device vendors (OEMs) receive revenue share. From the latest earnings conference call:
Yes. I mean, again, I'm not going to talk about specific of the TAC on mobile. But as you know, we get people using our devices both organically as well as through our distribution partnerships with carriers and OEMs. And typically, the OEMs and carriers participate in some of the economics that are on the Android marketplace or Google Play and some of them participate in the economics around Google Search just the way we would do syndication on the Web platform, which you do with many partners around the world. We have similar deals on the mobile front.
Arora made another point in the quote above. Not only is there revenue sharing with carriers and OEMs for Search and AdSearch but also for Google Play (app and content sales.)
Device vendors and carriers get a cut. Google's model has always been one of giving a cut of revenue to their upstream distribution. It just might be surprising to hear that device vendors like Samsung and carriers get a piece of Search and apps.
This basic observation leads to a series of questions:
How much is paid out and to whom?
Is that revenue sharing sustaining the ecosystem? Do vendors create Android devices and do carriers push Android to consumers because they get this revenue share or is the amount insignificant vs. device margin? What about tablets? Why haven't Android tablets they taken off as Android phones have? Are the economics to blame?
Is this a competitive advantage vs. other platforms? Does Windows Phone compete with revenue share for Bing? Is Microsoft offering a bigger carrot (as well as a stick?)
How does this economic picture show up in Google's financial and stock price performance? Or, more precisely, why doesn't it?
And, finally, what conditions create a virtuous cycle of growth and what conditions could turn it into a vicious cycle of decline? Is there a lurking factor which would cause Google to benefit greatly from this user base or is there an inherent point of failure in the model?
I'll be answering these questions in a series of posts this week.
--
Notes:
Google's internal documents were leaked as part of the Oracle trial (Exhibit 1061). They can be found by using Google search with the following search term: "OC quarterly review".
I analyze my performance every quarter to see if there is any pattern of error in my analysis. I devised a scoring method analogous to the grade point average system used in most US schools. You can read about the fourth quarter here.
This quarter I made one public release of data here and a semi-public update on the iPhone shipments here.
The resulting scores for both early and late estimates are shown in the table below:
Overall performance improved with the later estimates but not enough to move the letter grade. In fact, the letter grade of B+ is the same as it was for the fourth quarter.
The best performance was in (late) iPhone prediction and the worst performance was in Mac prediction. The Mac error was due to the relatively strong quarter the year before (which grew over 30%) and the lack of new product introductions. I did not think enough about these two conditions.
iPod error was in the direction of underestimation. The iPod grew better than expected through the average price seems to have dropped.
iPad error was quite modest at 3.4%. We found out after earnings that Apple was supply constrained. They indicated that they will sort out the supply/demand balance in the current quarter.
Gross margin also came in well above estimates, reaching a record high. This is difficult to predict as many factors come into play.
Overall the average error was less than 6% across all categories (late error). This means there was little wrong with the process of prediction. The seasonally adjusted growth for the iPhone and iPad remained consistent. Next, I will look at the scores for all the other public forecasts.
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.
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.
---
Notes:
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.
See also Charles Arthur's analysis of comparable growth ramps for mobile phone platforms here.
This figure was cited "to date" in a March statement so actual calendar Q1 may have been less, perhaps 650k.
Nokia currently estimates that Devices & Services net sales in the first quarter 2012 were EUR 4.2 billion, comprised of Mobile Phones net sales of EUR 2.3 billion (71 million units), Smart Devices net sales of EUR 1.7 billion (12 million units),
We don't have the total number of Samsung shipments, however estimates exist. They range between 41 and 44 million smartphones and 44 and 47 million feature phones. The low end of that range would imply Samsung shipped 85 million phones.
Nokia's press release indicates that it shipped 83 million.
This would be the first quarter that Samsung beat Nokia in total phone shipments. It had already overtaken Nokia in sales volume and profitability last year but this is the most cited metric of market performance: being the biggest in volume. Here is the tale of the shipments:
How did this happen?
The answer should become visible when we look at at another set of data. If we split the smartphones from feature phones the charts look like this:
Looking at product mix, Samsung growth is shown to be almost entirely due to smartphones while Nokia's stagnant growth seems to be a failure to have any smartphone traction.
It's even more clear when showing the above mixes of devices as percents of total.
As a percent of total, Nokia has shrunk its smartphone business from a peak of 24% in Q3 2010 to 14% last quarter. In the same time frame Samsung's smartphone share of portfolio has exploded from 10% to nearly 50%.
Note that both companies have seen non-smart device volumes contracting. Samsung's level is approximately the same as it had in late 2007 and Nokia's is lower than at any point in the last six years (perhaps longer).
So the answer to the question of how Samsung beat Nokia is told in the following chart:
Samsung was able to convert its portfolio to smartphones while Nokia failed to do so. This is the sort of transition that can only come about from an explicit strategic intention on the part of management. Market demand can steer you in any number of directions, but a vision of a future should provide the compass for making the big bets.
The bet Nokia made many years ago was that there would be a continuing, substantial business in the "low end". And low end meant feature phones. This strategy was still in evidence last year under the moniker "the next billion" users. The decisions were not driven by whether the products would be hired for different jobs, but that they would hit different price points. In other words, segmentation of customers by their ability to pay for devices rather than categorization of the jobs they hired mobile devices to do.
Perhaps Samsung was no wiser, but they were more pragmatic. Being non-dogmatic meant being flexible. They ran with off-the-shelf technologies and managed a transition to smart devices faster than anyone expected. It may not be a perfect strategy but it beat a bad strategy.
