Microsoft

Microsoft is a stable business. Apple isn't. The following charts compare the two. The two charts on top show revenues, subdivided into product lines. Microsoft is on the left and Apple on the right. Note that the vertical scales are the same (zero to $30 billion/quarter).

The lower two charts show operating income by division/product line. The left is again Microsoft with the line showing the consolidated income (net of losses). The right chart shows the stacked areas of profit from Apple's product lines with the yellow line shooing consolidated income. I copied the blue line from the Microsoft chart for a more direct comparison.

Apple continues for the third quarter to have higher operating income and for the fifth quarter maintaining higher revenues.

The following two charts are also another way to view the two companies. As percent of total, how do the product/divisions stack up? The first is Microsoft revenues as percent of total and the second shows the equivalent for Apple.

This comparison I think is most evocative. The stability of Microsoft is contrasted with the dramatic change that Apple is experiencing in the same time frame.

There is a dramatic shift of focus from traditional computers (Mac) to devices. If profit is an indicator of where resources are being allocated, then there is no clearer visualization of the difference between the two companies' strategies.

The following is a mix of all products/divisions operating income in one dense line chart (thicker lines are Microsoft divisions, thin lines are Apple products).

Finally, the comparison of operating income of iOS devices vs. consolidated operating income from all of Microsoft's businesses.

As iOS shifts into its fifth iteration my guess is that Apple will continue its growth trajectory. As Microsoft continues to adapt or protect its businesses from tablets and mobiles, will they grow? If so, how? Microsoft has shown consistency, but that is becoming less and less desirable.

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:

1. 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.

 

In his recent posts Horace took a look at Apple’s fixed assets and their development over the recent years. He also tested the hypotheses that Apple is making investments into machinery & equipment on which iOS devices are produced by overlaying iOS volumes with preceding changes in property, plant and equipment (PP&E).

The question that has arisen is: Are Apple’s investments in PP&E extraordinary?

To answer, I have compiled the capital expenditures (CapEx) for our previously established peer group [1].

But first we need to clarify what CapEx include and not include. CapEx includes investment into property, plants, equipment, office furniture, larger IT hardware and in some cases patents; CapEx do not include investment into long-term marketable securities or other long-term financial instruments, acquisitions or capitalized R&D. Furthermore, CapEx are gross values and are not net of any sold equipment [2]. CapEx are largely depending on a company’s business model and strategy. For example if you are a manufacturer you need equipment to operate, if you are a software company or a retailer, your business will not be capital intensive.

As the second calendar quarter of 2011 is the latest quarter for which all companies have reported figures, we will take a look at last twelve months’ (LTM) figures from Q2/2011 backwards. The following stacked bar chart shows the combined CapEx of our peer group:

 

The combined capital expenditures of our peer group for the LTM CQ2/2011 have outpaced even pre-crisis levels of investments and, combined, account for $34.7 billion. Samsung, a diversified manufacturer of IT hardware and other equipment, has invested more than $11.6bn with Google ($5.1bn), HP ($4.4bn) and Apple with $3.4bn following in line. While Google’s CapEx mostly account for its infrastructure of server farms and other IT hardware, HP’s CapEx mostly account for IT hardware it leases to its customers [3]. In absolute terms, Apple takes fourth place in CapEx spending for the last twelve months ending in CQ2.

Since the business model and sales magnitude varies largely in our peer group, we can also take a look at a common measure to compare CapEx intensity by dividing CapEx by sales achieved in the same period. For the last twelve months we can depict the following chart:

 

The average of the peer group accounts for 4.4% of CapEx over sales. Samsung’s and Google’s business model are clearly more capital intensive, while Apple’s CapEx ratio of 3.4% is below the peer group average but above some of its peers like Nokia, Dell, LG, HTC or Motorola Mobility. Interestingly, capital intensity of HP, Apple, Sony, Microsoft and Amazon is at a comparable level of around 3.4%.

As noted before, business models and strategies are significantly different among companies in our peer group. However, while Apple’s CapEx intensity is not extraordinary, Apple’s CapEx in absolute terms are among the largest in it this peer group and have grown constantly throughout a five year period.

Is this a good thing and why does it matter?

CapEx by itself does not tell us much. We still do not know in what companies specifically invest as financial regulations do not require detailed CapEx accounts. We know that even if a company is not growing assets they need to be maintained, upgraded and replaced – this spending is also called "Maintenance CapEx". Everything else can be called "Expansion CapEx" associated with new product launches, entry to new business area or geographies or expansion of (manufacturing) capacity.

Therefore, Expansion CapEx is closely linked to expected organic sales growth in the future. So let’s go ahead and link CapEx ratio of the previous years with the sales growth of the following year. The following chart shows the cumulative average growth rate (CAGR) over the last four years versus the average of CapEx/sales ratio of the four last preceding years:

 

We can see that high CapEx efficiency has been achieved by Amazon, Apple and HTC with sales growth rates of 33-47%. RIM reached similar revenue growth but with higher CapEx intensity. Google and Samsung with high CapEx intensity have only reached modest growth rates. Dell, HP, Microsoft and Sony have not grown significantly but have close to average CapEx intensity.

We cannot state that CapEx in absolute terms have been extraordinary for Apple, but we can witness that with below average CapEx/sales ratio Apple outgrew in absolute terms Dell, LG, Microsoft, Nokia and Sony and has grown close to the revenue size of Samsung and HP in the last four years.

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Notes:

1. Excluding Lenovo (not reported) and Acer (extra-ordinary low numbers reported, to be investigated), Motorola Mobility figures only available for the last six quarters
2. Minor differences may occur due to local Generally Accepted Accounting Principles (GAAP)
3. HP assumes ownership of these assets and rents them to the customers who in turn have a smaller balance sheet and can run IT hardware CapEx through the income statement as lease expenses

Windows Phone is in limbo. The company acknowledged that it has performed below expectations. During the last quarter for which we have data (ending June) I have an estimate that Windows Phone sold only 1.4 million units (Gartner's sell-through analysis suggests 1.7 million). That gives Microsoft a 1.3% share of units sold (Gartner 1.6%), a new low.

At the same time, comScore data shows that user erosion in the US and EU5 has slowed and is holding at about 2.2% of all users.

For its part Microsoft has lain low during the last few months. It released version 7.5 (Mango) last month to manufacturers.  It has a number of Windows Phone SKUs in the market or recently announced (27 with version 7 and eleven with version 7.5)

It also sued Android vendors successfully and obtained royalties from the largest Android licensees Samsung and HTC. Patent royalties from Android are probably going to be higher than license revenues from Windows Phone for quite some time.

Something is missing from this analysis. Clearly Microsoft has a plan. It's always had a plan. The plan is not easily perceived because the market Microsoft addresses itself to is not directly to the consumer--we cannot read the message. Microsoft needs to work through partners. Device vendors and operators mainly. In order to persuade them Microsoft deploys its check book.

Put another way, the plan is that Microsoft intends to buy market share. Before we get into exactly how, we need to understand the most important but least discussed contributor to device sales: channel incentives.

Before a phone is sold it needs to get through a mine field of obstacles: it needs to appeal to operator or distributor priorities; it needs to fill a slot in a portfolio of products for the manufacturer and the channel; it needs to acquire shelf space; it needs to appeal to some end users and, unless it has a blindingly strong brand, it needs to offer incentives to the retailer.

This last piece of the puzzle is something of a mystery. Although not a universal practice, in many cases retail staff are paid commissions directly or indirectly by the device vendor. This relationship between the retailer and the vendor is not transparent. A buyer typically does not know what incentives are attached to a given device. Stories of salespeople steering people to and away from certain devices abound.

Microsoft acknowledges this:

Both Samsung and HTC Corp. have committed to increasing marketing budgets for the phones, said Andy Lees, president of Microsoft’s mobile unit, in an interview. While manufacturers will determine how the money is spent, some of it will probably go toward spurring retail staff to tout Windows Phone models, he said.

Microsoft Phones to Get More Marketing, Sales Incentives - Bloomberg.

In another interview:

Q: It seems like one of the challenges is getting the salesperson in the store to push the phone.

A: Absolutely. I think that's a number of things:

One — they get influenced by how good the product is. The reviewers have influence with that and also their own experience.

The second thing is the alignment with the operator. I think we're already pretty aligned and over the life of this release, we'll get even more aligned.

Much more here: Business & Technology | Windows Phone chief Andy Lees sees time ripe for Mango | Seattle Times Newspaper.

What's more, Microsoft and Nokia have a deal whereby at least one billion dollars from Microsoft are earmarked for the promotion of Nokia Windows Phones.

Even prior to the launch of the Nokia relationship, with the original Windows Phone launch exactly a year ago, Microsoft made clear that it had a budget for promoting Windows Phones ($400 million in fact). In the event, the money seems to not have been spent, or spent sparingly because LG made public its disappointment. The coded language can be interpreted as a snub to Microsoft for withholding promised funds.

Perhaps the funding was withdrawn because by the time the launch was scheduled, the Nokia deal was being negotiated. Perhaps Microsoft felt it better to put more effort behind the re-launch of the platform with Nokia on board. A re-launch which has yet to happen but seems to have already had $127 million allocated to it by Nokia alone.

Microsoft is proud of what it has accomplished with Windows Phone because they were able to update the OS in 11 months and took only about two years to completely rebuild Windows Mobile into Windows Phone.

But the dependence on a complex value network means that products do not reach users quickly enough and when they do the marketing message is weak, even when backed by large budgets. The real problem with Microsoft's approach is that it's neither viral like Android (because it has a price and a contract associated with it) nor is it focused and agile like Apple's. It seems to suffer from the worst aspects of modularity (market lag) without benefiting from the control over the ecosystem and end user experience that differentiates it.

Microsoft will muddle through but the 20% share that it says is "conservative" seems anything but.

I began comparing Microsoft and Apple's financial performance with a review of "top line" or revenues by product lines over a four year period.

This post is about the "bottom line" for the same companies and products.

Before I jump in I would like to make sure there is no confusion about the terms. I will be comparing "operating income"[1] as a measure of "bottom line". This is a common way to compare the profitability of companies because it excludes taxes and interest income. These non-operating expenses/income can distort a comparison of performance because they can be the result of investment activity or changes in tax law or where the company is domiciled. One should not make judgements of comparative performance on those non-operational bases.[2]

Another challenge is that some companies report operating income by division while others don't. We can usually compare overall operating income but usually not on a division or product-level. This is the challenge I will try to overcome in this analysis between two very different operating models.

The first chart shows Microsoft's Operating Income by Division as reported by the company.

Each area represents a business division. Note some are showing negative income (losses).I've added a line representing consolidated operating income which is the sum of all areas (including the negatives).

The same line from the chart above is super-imposed on the chart below and is comparable to the orange line that represents the operating income that Apple was able to obtain over the same time frame. Note that both axes are using the same scale.

The Blue and Orange lines are indisputable but the allocation of the areas under the orange line may be open to debate.

As Apple does not report a break-down of each product line or division, getting the areas in the Apple chart is a matter of analysis and estimation. The method I used was to estimate gross margins per product (the overall gross margin is known) and assigning a portion of OPEX (also known) in a ratio equal to the sales level of that product. [3][4]

To make the contrast sharper (though more cluttered), I took all operating incomes from all product lines and divisions of both companies and laid them out as time series line charts in the following chart. I allocated Corporate Level Activity as an expense proportionate to each business unit in a ratio proportional to its sales. This allows comparison of product lines individually.

 

Finally, I combined all the iOS product lines (iPhone, iPad and iPod touch est.) as one line and laid it alongside overall Microsoft Operating Income (consolidated).

The second chart in this post showed that Apple has reached higher operational profitability than Microsoft by the end of last year. This fourth chart shows that iOS products combined are more profitable than Microsoft as a whole.

Microsoft invented the software business and built it to become the world's most valuable business by the year 2000. It's still been growing since and after 35 years it is reaching a profit of $27 billion per year. It did this while maintaining enormous margins and a highly disruptive monopoly business model the likes of which the world had never seen before.

It is scarcely believable then that a device business has been created to overtake it in four years.

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Notes:

1. The operating income is almost the same as EBIT  which is explained here: Earnings before interest and taxes - Wikipedia, the free encyclopedia.
2. On the other hand, one should not use Gross Margins alone. The crucial difference between Gross Margin (Sales Revenue - Cost of Goods Sold or COGS) and Operating Income is that fixed costs are also accounted for. These fixed costs are typically Selling, General and Administrative Expenses and Research and Development Expenses (commonly summarized as Operational Expenses or OPEX) which can be allocated to a particular business or division. For different business models, gross margins can be widely different. In the case of Microsoft for example, software has negligible direct variable costs. A CD or download is of tiny cost compared to the price of the license to use it. As a result software often has 80% gross margins. Hardware on the other hand can have very thin margins in single digits (e.g. PCs). Conversely, Microsoft will have very high fixed costs to pay for developers, product management and sales forces. A hardware vendor may have few engineers and sales could be handled through resellers. Thus Microsoft will have very high OPEX and a PC company will have very low OPEX.
3. So, for example, In Q2 '11 the iPad had an estimated gross margin of $2.06 billion (which assumed 34% margin on published revenues of $6.06bn). As it also was 21% of total revenues that quarter, I assigned 21% of OPEX to the iPad. That means 21% of $2.54bn or $540 million was the operational expense allocated to the iPad. This results in operational income estimate of $1.52bn for the iPad in Q2.
4. To summarize, the assumptions this estimate depends on are gross margin estimates and the allocation of OPEX in proportion to sales. Gross margin analysis has been a matter of iteration and peer review for some time and I'm fairly confident in my estimates. The allocation of OPEX is more arbitrary. Chances are that these expenses vary greatly with each quarter where more work is done nearer to launch of a new product and less in late season. If there are better methods available to allocate expenses by product, I'm open to suggestion.

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.

 

I've been providing analysis of Apple's operating and financial performance for some time. Recently we've begun to look at comparisons of financial performance for comparable companies. Now it's time to dig deeper and do comparisons of operating performance as well.

To start, Microsoft.

Whereas Apple has product lines (iPhone, iPad, iPod, Mac, iTunes, Peripherals and Software), Microsoft has business divisions (Windows & Windows Live, Server and Tools, Online Services, Business (Office), Entertainment and Devices). The charts show revenues for both Apple and Microsoft according to these defined segments.

 

The second chart should be a familiar one:

Note that the horizontal and vertical axes are the same. The period of coverage is from mid-2007 to the end of June 2011 which corresponds to the life of the iPhone. The vertical axis ranges up to $30 billion/quarter in both charts.

When shown this way, the exceptional growth for Apple becomes easier to understand (and perhaps Apple's valuation premium of 15.7 P/E vs. Microsoft's 9.5). Microsoft has been growing these past four years but not nearly at the rate of Apple. Microsoft grew quarterly revenues from the ~$15b range to ~$17b range.

Additional points of interest:

• The Mac business generates more Revenue than Windows
• iOS powered devices generate more revenue than all of Microsoft's products put together
• Apple's revenues grew 413% since Q2 2007 while Microsoft's grew 26%
• The release of Windows 7 had a marked effect on revenues in the launch quarter but the sales did not seem to grow above the previous version's run rate ($4.2b/quarter vs. $4.7b/q on average).

But most importantly, whereas Apple's growth has come from new businesses (iPhone and iPad), Microsoft has organically grown existing businesses. The condemnation of leadership at Microsoft should hinge on the absence of significant top line growth. Note that neither the Online Services nor the Entertainment and Devices divisions had appreciable net growth.

 

On October 4th, Tim Cook will take the stage at Apple’s fall event. With Steve Jobs’ transition to head the Board of Directors of Apple and after serving as CEO for fourteen years, it is time to take a look at his reign.

Looking at his performance vs. peer companies from a capital market performance, I have composed the following two charts:

Market capitalization of selected peer companies by calendar quarter in USD million sorted by most recent market capitalization (1997-2011)

Market capitalization as share of combined market capitalization by calendar quarter sorted by most recent market capitalization (1997-2011)

You will note that I included more companies than in previous analysis. The new additions are:

• Compaq (acquired by HP in 2002)
• Palm (acquired by HP in 2010)
• Amazon (a popular request by readers)

I divided this era into three distinct periods:

Restructuring of Apple 1997-2000

In the beginning of 1997, Apple’s market capitalization was lower than almost all of its peers. In absolute terms the market capitalization moved only slightly upwards towards 1999 and the dent in 2000 is significantly lower compared to the market capitalization increase of other companies, first and foremost Microsoft's. Especially in the early part of this period restructuring and streamlining efforts took precedence. The introduction of iMac in 1998 and the iBook in 1999 set the tone in terms of design, quality and "thinking different" for many years to come.

iTunes era 2001-2006

With a stable core business and healthy profitability, Apple introduced the first iPod in October 2001 complementing the earlier introduced iTunes music player. Two years later, Apple introduced the iTunes Store offering downloadable music for the Mac and Windows operating systems. The venturing into the music and portable music player business and the halo effect for the Mac business is reflected in the market capitalization increasing significantly during the following years surpassing HP and Nokia.

Mobile iOS devices 2007-2011

Market capitalization further increased with the entry into the smart-phone market in 2007. Note that market capitalization of all selected companies combined at that time was as high as in the dot.com era of 2000. But this time Apple accounted for more than 10% of it. From 2008 to 2009 market capitalization of all companies declined severely due to the financial crisis. Rapid recovery followed during 2009 and early 2010. Apple introduced the iPad in March 2010 further fueling its rise to the top, surpassing Microsoft’s capitalization and topping Exxon Mobil as the world's most valuable listed company.

During the time of Steve Jobs as CEO, Apple's market capitalization increased on average by 42% every year--an unprecedented track record. According to his own admission, Steve Jobs became CEO when Apple was 90 days away from bankruptcy. He resigned 14 years later after leading Apple to becoming the most valuable listed company in the world. From a value creation point of view, it's hard to think of a better performance from anyone, ever.

[Updated with Mac OS versions. See footnote 3.]

I'm glad Windows 8 is named the way it is. With Windows 7 Microsoft went to a numbering system which is much more rational than the mixed naming of the past. The number 8 actually corresponds to the actual sequential number of major versions of Windows released to date.

Windows proper actually did not start with what was called "Windows 1.0". Windows actually started in April 1992 when Windows 3.1 was released. It was the first Windows which was an operating environment onto itself, apart from DOS. It was followed by Windows 95 (which we can call "2"), Windows 98 ("3"), Windows 2000 ("4"), Windows XP ("5"), Windows Vista ("6"), Windows 7 and now Windows 8.

Given this nomenclature and the dates of general availability of said versions, we can derive a measure of the frequency of upgrades. For example Windows "2" followed about 41 months after "1" and "3" took 34 months after "2". If we continue this for all the versions, and assume "8" will launch by October next year, we can plot the cycle times of new Windows versions.

To make the story more interesting I added the same data for other OS platforms. OS X, iOS and Android have version numbers which correspond to the sequential order in which they were released. I am assuming that the numbering system (1.0, 2.0, 3.0 etc.) are meaningful and that major releases are given a new integer value.[1]

I also added Windows Mobile which suffered from the same confused numbering that Windows suffered until the current Windows Phone 7. To create a map to integer values I used the following: Pocket PC 2000 is "1", Pocket PC 2002 is "2", WinMo 2003 is "3", WinMo 2003 SE is "4", WinMo 5 is "5", WinMo 6 is "6" and Windows Phone 7 is "7". There is no clarity when and what Windows Phone 8 will be so that is left off the chart.

The chart above does give a clue that Windows is a bit slower (more months between releases) than alternatives. However, the point I want to convey is that this cycle time can be a strategic advantage. A faster upgrade cycle means more rapid adoption of improvements, not to mention more revenues. Rather than a line chart, the better way to visualize it is as a turning circle.

The analogy is from aerial combat where a plane that can "turn inside" an opponent can get into a firing position. The tightness of turning circles also means that a competitor can iterate more quickly and thus move up the trajectory of improvements necessary to remain competitive more rapidly. To that end, I re-plotted the data above with radial axes.

The chart clearly shows how among desktops, OS X has been tighter than Windows[3]. Furthermore, mobile OS's have been, typically, more agile than desktop OS's. The exception being Windows Mobile which had significant architectural and business model challenges. It will be interesting to watch the radius of Android. So far it seems to be tight, but as tablet functionality has been added, the speed of change has slowed slightly.

However, the big contrast is between mobile and desktop. Microsoft tries with Windows 8 to merge the two. But these are different ecosystems. Buyers, OEMs, users, all have different behavioral patterns (jobs-to-be-done) for mobile OS vs. desktop/portables. Will the cycle time for Windows 9 and Windows 10 tighten up? Can Microsoft operate its OS division at this new cycle time?

What is even more bad news is that the most important customers for Microsoft, enterprises, actually upgrade every other version. The Windows "radius" is nominally averaging about 35 months but large account adoption is closer to 60 months.

The contrast is then striking: Consumerized devices with over-the-air updates on a 12 month cycle are five times more agile than a traditional corporate Windows desktop. Another way to look at this is that for every change in a corporate desktop environment, the average user will change their device experience five times. Although Microsoft might find comfort in Enterprises' leisurely pace of change[2], those are the wrong customers to keep happy going forward.

The implications are left as an exercise to the reader, but I would argue that along with the asymmetry in business model around pricing that I highlighted in the last Critical Path podcast, Microsoft has a significant operational asymmetry with devices as a new class of computers.

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Notes:

1. The dates of general availability of various versions of operating systems.
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   Version
   Windows
   OS X
   Windows Mobile
   iOS
   Android
   1
   4/6/92
   3/24/01
   4/19/00
   6/29/07
   10/21/08
   2
   8/24/95
   9/25/01
   10/1/01
   7/11/08
   10/26/09
   3
   6/25/98
   8/24/02
   6/23/03
   6/17/09
   2/22/11
   4
   2/17/00
   10/24/03
   3/24/04
   6/21/10
   5
   10/25/01
   4/29/05
   5/9/05
   10/1/11
   6
   11/30/06
   10/26/07
   2/12/07
   7
   10/22/09
   8/28/09
   11/8/10
   8
   11/1/12
   7/20/11
    
2. While at Nokia's Enterprise Solutions I was witness to this difference between the cycle time of devices and the pace of adoption of Enterprises. The fundamental disconnect was that the sales cycle for a "solution" was longer than the shelf life of a device upon which that solution was predicated. Needless to say, Nokia Enterprise Solutions did not last long. Nor do we see today any significant Enterprise-focused mobile device businesses (RIM itself moved to consumerize its products years ago.)
3. I added Mac OS data to the second chart to also illustrate that no company is immune from spinning out of control. Mac OS clearly went spun out after version 6 with increasing delays leading to its demise and replacement. You can also note that its replacement (OS X) was able to straighten-up and fly right. The lesson may be perhaps that ditching and starting over is a viable option.

After processing more than 1500 data points on the performance of thirteen technology companies, patterns are beginning to emerge. The steps so far:

• Visualizing P/E and Growth as time series centered on a point of crisis.
• Plotting P/E vs. Growth with an eye toward any clustering/correlations for the cohort.
• Detecting and measuring any change in the relationship between P/E and Growth before and after the point of crisis.

The final step is to plot the changes in the relationship between pre- and post-crisis for the set of companies normalized to the same starting point and then classifying them: 

The chart shows how the "average P/Es" changed after 9/30/2008 vs. how the companies performed during those periods. An evocative categorization is suggested for the four quadrants.

One way to read the data would be as a degree of effect of the crisis. For example, in the case of HP, its P/E dropped by about 6.5 while its average growth decreased by 41 basis points giving an average of 0.16 drop in P/E for every basis point reduction in growth. That would be a fairly modest impact. In the case of HTC, the impact would be even less. The effect on P/E was zero even though growth dropped by about 78 basis points. At the same time the impact on Microsoft was severe with the P/E dropping as much as for HP even though its growth only moderated by 5 basis points.

Therefore the "slope" (or angle in vector parlance) of each of the lines in the chart above may be interpreted as the severity of discount in value that the crisis invoked. Those values are shown the following chart:

A strong bar on the right half of the chart implies severe impact, a bar around the middle implies minimal impact and a bar in the left represents an inverse relationship where the market priced in opposition to performance[1]. What should be considered along with this chart is the quality of earnings and consistency of performance (which are shown in the posts linked above.)

Discussion

As noted in a previous article, there are really only six companies which had strong separation between pre- and post-crisis valuations: Apple, HP, RIM, HTC, Microsoft and Google. They are also the companies which had strong P/E drops (except for HTC). As a group they are also the companies with the best growth stories historically. This is perhaps the reason for the drop. Basically, because these were strong companies they "had the most to lose". The market "punished" them more severely than the weaker companies because the weak had already been discounted.

The other observation is that Apple and RIM are not treated particularly differently. The drops in P/E are at about 1 for every basis point drop in growth. This means that the the degree of value lost is about the same as a function of growth loss. Microsoft seems to have been the most affected. We can argue that it is perhaps weaker than the others strategically so this is reflected here, but I doubt it's weaker than RIM. Microsoft is also in contrast with Google which seems to have been given a lot of benefit of the doubt.

Nonetheless, this framework offers some hints on how technology companies have been treated after the crisis. There is no rightness or wrongness about this treatment but it may indicate potential for significant reaction in the opposite direction if and when macroeconomic conditions improve. These vectors are, in a way, proxies for volatility or "beta" in terms of correlation to the overall market. The greater the beta, the more amplification to market movement; the greater the slope value

As always, Apple is the canary in the coal mine as far as sentiment is concerned. What should be watched is the pricing reaction as Apple moves from a net reduction in growth to a net increase in growth. How will P/E react? The argument on this site so far has been that growth is exceptionally strong for Apple and it's not being reflected in the price. However, in this analysis we've stretched the time frame and did a longer retrospective. On this new time scale growth is not yet at the levels Apple enjoyed in the heady days of 2005/6. Perhaps this growth will return and when it does we'll get to see which way Apple's vector moves.

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Notes:

1. An inverse relationship with value can happen for various logical reasons, for example that a company has volatile performance which is depending on anomalous events.

The latest survey from ComScore breaks down the installed base of specific mobile platforms in the US. Tracing the data over time shows the following charts:

In the last month Android gained about 2.9 million users, iPhone 1.3 million, Blackberry lost 530k users and Windows held on with a gain of 132k. Other platforms had a net loss of 95k users.

In the last 12 months, Android gained 25 million users in the US. iPhone gained 9.5 million while Blackberry lost 3.2 million and Microsoft lost 1.6 million. Other platforms had a net loss of 1.2 million.

The total net gain of smartphones was about 29 million new users.

RIM switched from being a consistent net gainer of users to a consistent net loser of users in October 2010. Windows Phone is showing signs of holding the line on user base erosion but share remains below 5% (now at 4.7% vs. 4.6% last month). To put the mountain-sized hurdle in perspective, Android now has 7 times more users in the US while iPhone has about 5 times more. To become the largest mobile platform in the US, as some analysts are predicting, Microsoft has a 12:1 disadvantage that looks to continue to grow.

Those are some pretty tough odds.