PC

The iPad is still only slightly more than a year and a half old. Forecasting unit volumes has proven very difficult. But more than that it's proven very difficult to appreciate the impact on the market it's disrupting, PCs.

For some people this is obvious, but what if you don't live and breathe disruptive theory? What if you don't watch every data source like a hawk for hints of change? What if you are not even a technologist. How would you form an opinion on the effect of the iPad on PCs?

There are many industries and sectors about which I know nothing. If you asked me to analyze a market like industrial lubricants, I'd probably start by reading the consensus opinion put forward by the leading market analyst, an expert in that particular sector. That would form the baseline.

In the PC sector, that opinion is formed by Gartner (and IDC and Forrester perhaps). Gartner will get a lot of citations and its stats and opinion forms the baseline view. It may not be right, but we can expect it to be the "consensus". This is because Gartner surveys a lot of data and interacts with a lot of insiders in the industry. They collect and weigh these inputs and put out what is likely to balance them all.

If Gartner says that the iPad is a "media tablet" that is not a PC they may be wrong. But they are also repeating what the PC industry is saying. So I value Gartner as a reflection of the consensus. If there is a significant gap between Gartner and what I conclude to be reality then there is an interesting opportunity as well as evidence of incumbent ignorance.

Let's then look back on how Gartner has been reporting the iPad's rise and the PC's decline.[1]

Q2 2010

"The consumer PC market registered double-digit shipment growth, but consumer mobile shipment growth slowed. This was due in part to slower growth of mini-notebooks," Ms. Kitagawa said. "Surging popularity of Apple's iPad temporarily cannibalized mini-notebooks, as well as consumer notebook sales to some degree. It is not certain at this stage if the cannibalization will continue with the current price point of media tablets."

Q3 2010

"Media tablet hype around devices such as the iPad has also affected consumer notebook growth by delaying some PC purchases, especially in the U.S. consumer market. Media tablets don't replace primary PCs, but they affect PC purchases in many ways," Ms. Kitagawa said. "At this stage, hype around media tablets has led consumers and the channels to take a 'wait and see' approach to buying a new device."

Q4 2010

“U.S. holiday sales were not fantastic for most PC vendors, but the professional market did show healthy growth during the quarter,” Ms. Kitagawa said. “Media tablets undoubtedly intensified the competition in the consumer market. These devices do not replace primary PCs, but they are viewed as good enough devices for these who want to have a second and third connected device for content consumption usage. Mini-notebook shipments were hit the most by the success of media tablets.”

Q1 2011

"Weak demand for consumer PCs was the biggest inhibitor of growth," said Mikako Kitagawa, principal analyst at Gartner. "Low prices for consumer PCs, which had long stimulated growth, no longer attracted buyers. Instead, consumers turned their attention to media tablets and other consumer electronics. With the launch of the iPad 2 in February, more consumers either switched to buying an alternative device, or simply held back from buying PCs. We're investigating whether this trend is likely to have a long-term effect on the PC market."

Q2 2011

Overall shipments of media tablets took place late this quarter and volumes remained low, minimizing any impact of the media tablets for PC substitutions in the second quarter of 2011

Q3 2011

"The main contributor to the weak consumer PC market in the U.S. was intensified competition for consumers' money," Kitagawa said "Media tablets and smartphones took center stage in the U.S. retail sector, and the expectation is for continuing demand for these devices throughout the holiday season."

I've added emphasis for the key words describing the impact of the iPad (referred to as "media tablets").

Note how the message changed over time. At first the effect was thought to be temporary (presumably due to "hype"). Three months later the "hype" was leading to "hesitation" in the channel. Three more months and there was "a hit" on Mini-notebooks but only for those needing a second or third device for "consumption". In the fourth report it seems that "consumers" (vs. business users) are really interested in this. The fifth report suggests that the effect is "minimal". The latest report suggests that this is a "localized effect".

An external observer (or paying customer) reading this must conclude that five quarters in, these media tablets are having some effect but most probably a transient one. By keeping tablets separate from PC's Gartner is implicitly stating that the two products do not compete. If they have an effect it's on the discretionary spending by consumers. Similar to the effect game consoles or consumer electronics may be having on PCs.

However, if tablets were added to notebook totals the chart for 2011 would look like this:[2]

 

Notes:

1. The quotes are from periodic reports (every quarter) from the same analyst at the same firm using a consistent set of measurements about the market. In order to ensure the same context, I've selected the comments from press releases published using the same template.
2. Source: Digitimes Research, compiled by Digitimes, October 2011

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.

 

[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.

In a rare reflective moment Steve Jobs, after the launch of the iPad, mentioned Apple's DNA. He said:

"Technology alone is not enough. It's technology married with the liberal arts, married with the humanities, that yields the results that makes our hearts sing.

Nowhere is that more true than in these post-PC devices...that need to be even easier to use than a PC, that need to be even more intuitive than a PC; and where the software and the hardware and the applications need to intertwine in an even more seamless way than they do on a PC.

We think we are on the right track with this. We think we have the right architecture not just in silicon but in the organization to build these kinds of products."

Steve Jobs' legacy in product development has been clearly established and celebrated. What remains now is to determine his legacy in company development. If indeed Apple has the "right architecture in the organization" to serially build disruptive products. The collection of evidence begins today.

If Apple has indeed become Jobsian then it will have been a grand achievement. John Gruber is already convinced. He points out

Jobs’s greatest creation isn’t any Apple product. It is Apple itself.

If indeed he has built Apple sufficiently well to last then he has built an admirable process and not just a product. But this would not be a unique achievement. There have been other companies which preserved their founders' cultural imprints, at least for significant periods beyond their departure. Consider that Disney, Ford and even HP and IBM remained successful for many years after the departure of their founders operating much the same way. They were infused with an indelible culture and preserved it for some time.

But a leader should aspire to do more. A leader should claim to have left a legacy not just on their company but on all companies.

Is it not more worthy to have changed civilization than the fortunes of a few?

I believe that Steve Jobs has actually sought just that. He put it as "making a ding in the universe." This can be interpreted as developing products that "change everything". But if the thing that Steve Jobs should be most proud of is the creation of Apple Inc. then how exactly could an Apple Inc. benefit the world?

This is where Jobs' quote above strikes me as valuable. The lesson the world should take from Apple is that a company needs to become multi-dimensional. It needs to mix the core business with the disruptive innovation. It needs to combine the intellectual with the artistic. It needs to maintain within it the rational and the lunatic.

Apple's violent success should serve as a powerful beacon that others should follow. Rather than copying its products other companies should copy Apple's processes--its way of thinking. They should copy how Apple harbors the creative process and the technology processes under the same roof.

If they do heed this call then we should look forward to the the post-Jobs era as that time when large companies gained the ability to intertwine multiple core competencies. A time when humanism balanced corporatism. A time when we came to reconcile the rational and spiritual.

--

This post has be re-published in The Harvard Business Review Blog as: Steve Jobs's Ultimate Lesson for Companies - Horace Dediu - Harvard Business Review

Horace and Ryan discuss HP’s departure from the PC business, the end of the TouchPad, buying your way into innovation and what it takes to compete and survive in the Post PC era.

via The Critical Path #5: HP's Innovation Antibodies - 5by5.

This is a good one.

HP's sudden departure from a business model that has sustained the company since inception is symptomatic of the passing of an era. Yesterday HP announced that it would exit the PC and tablet computer business, focusing on higher-margin "strategic priorities of cloud, solutions and software with an emphasis on enterprise, commercial and government markets." In other words, HP is fleeing upmarket, away from a core that it will abandon to device makers.

HP management conceded that the disruptive impact of the iPad forced their hand but that hand was already quite weak from a decade of over-serving the market. The last decade offered plenty of opportunities for incumbent PC companies to adjust to the realities of mobility. However only one computer maker made the transition.

Why is that?

Consider how HP and Apple faced the changes in the PC market almost exactly a decade ago.

• On September 3, 2001, HP announced that they would acquire Compaq.
• On October 23, 2001, Apple announced the iPod.

The rest, as they say, is history.

But what would any reasonable person have done? The PC industry was no longer young but still thriving, why not consolidate? Consolidation is a natural and well-reasoned practice for maturing industries. You get rid of over-capacity, you consolidate overhead, "leverage synergies" and boost margins.

And it's not like they were ignoring innovation. Compaq had a growing line of PDAs, so there were plenty of diversification opportunities. Microsoft was offering Pocket PC and the Phone edition was on the roadmap. HP was clearly watching mobility carefully.

Contrast that with Apple's predicament. Which aspiring manager would want to deal with the disaster that was Apple at the time? Apple was struggling with a declining Mac business and had just re-booted it with OS X but it seemed a quixotic effort. Moving to music players seemed desperate (and late). Margins were low, commodity vendors were lining up, record labels offered resistance, they did not have any IP or any DRM and nothing but Mac users as target audience.

As it turns out, the path of sustaining and the path of disruption diverged that moment in time a decade ago. Companies like HTC, Apple and RIM were embryonic in their device businesses vs. Goliaths like Microsoft, HP and Dell. But they grew, at first slowly, but at all times profitably.

By the time their success was worth noticing, in 2004, HP and Dell decided to dabble in devices. But all their efforts were half-hearted. They did not crave profits but growth and share. HP's PDAs and phones never received management attention. How do I know? Because they relied on off-the-shelf components for everything including software. It indicated that the value to be offered was in "leveraging" (there's that word again) their brand and distribution. The value of HP was not to build something great--something that required blood, sweat and tears.

The result was a set of mediocre experiences while the (now incumbent) Apple was iterating rapidly into new directions. By the time the future was self-evident, it was too late to build foundations. HP did the right thing to acquire Palm, but they did it far too late. In 2010 the game was over.

How cruel.

But that's the nature of unforeseeable growth: you cannot foresee what will happen and plans never work out. Data and planning don't help. The lesson is that you need to plan for that which cannot be planned. When you are at your peak you must assume failure is imminent and when you are at the trough you must assume success is inevitable.

All failures of strategy are rooted in the assumption that outcomes are predictable.

This is why I expect Apple is now working on shaping the post-iPhone world.

--

Update: This article has also been published in the Harvard Business Review blog: HP's Decade-Long Departure - Horace Dediu - Harvard Business Review

When Apple changed its name from Apple Computer to Apple Inc. they signaled that their business has moved on. We can say it's to devices or to mobile computing or to the Post-PC era. To understand that this is not a shift driven only by wishful thinking we can plot the change in volumes for the platform-based devices Apple sells.

The stack of products is shown in an increasing level of mobility. At the bottom is the non-portable desktop Mac, above are Mac portables (laptops) followed by the iPad, iPhone and iPod touch. The mobile computers Apple sells are explosively more popular (and important).

To gauge importance consider the following chart which shows the unit values above multiplied by the average price they are able to obtain for a picture of the sales mix.

(I also added Peripherals, Music and Software sales as well as iPod (non-touch) for a complete split of revenues).

Mobile computers are now well above half the revenue base for Apple. Finally, if we consider the contribution to profitability of each product line, we can see how iOS-enabled products (as a proxy for mobile computing) have become the vast bulk of profit creation for Apple.

By this metric, we can see that mobile computing (as opposed to portable or immobile computing) is driving 80% of Apple's profitability. This 80/20 mix of mobile/non-mobile should put aside any doubts that Apple has moved on to be a business oriented around mobility rather than traditional computing.

This cannot be said for many of Apple's contemporaries. Microsoft derives negligible revenues from mobility. Neither does Intel, nor Dell or HP and even Google's revenue lines don't make mention of mobile income.

In fact, the only companies which do have mobile revenues as 80% of their income are those dedicated to telecom markets. Namely, Nokia, Motorola, Sony Ericsson, RIM et. al. But, as we shall see in the quarterly mobile market overview, few of Apple's mobile-focused competitors are doing well.

So Apple is a unique company that has made the transition from one industry to another and, in so doing, captured the bulk of the profits. In passing, I should also mention that the traditional Mac business is still doing well and, by some measures, is capturing the bulk of the PC hardware profits.

So the key to much of assessing Apple's value and opportunity should be based on this new market (mobile computing) rather than the traditional competitive landscape of PCs and operating systems. The company has moved on, now we wait to see how long before analysis of the company follows.

In a new ad for the iPad Apple once again makes the case that the tablet is a good substitute for a PC in a number of use cases (and permits some new ones.)

We'll never stop sharing our memories. Or getting lost in a good book. We'll always cook dinner and cheer for our favorite team. We'll still go to meetings, make home movies, and learn new things. But how we do all this will never be the same.

This belief that the iPad "cannibalizes" the PC is a powerful concept. The growth of the PC has certainly been affected. But has the Mac's growth also been affected?

Tim Cook seems to think so. In the earnings call he said:

In terms of cannibalization, we do believe that some customers chose to purchase an iPad instead of the new Mac during the quarter, but we also believe that even more customers chose to purchase an iPad over Windows PC. And as I've said before, there's a lot more of the Windows PC business to cannibalize than the Mac.

If we look at the behavior of Mac vs. iPad, the following chart may be useful:

First off, we can observe that since introduction, iPad has always sold more units than the Mac. Now it's selling more than twice as many units and the revenue from those units is higher than those of the Mac. The other line to look at is the growth (y/y). During the time that the iPad has been shipping, the Mac growth has been declining.

Yes, it's still growing at five times the rate of the PC market (and 7.5 times the rate of Windows only PCs), but the iPad phenomenon is indeed affecting the Mac.

With the launch of Lion, Apple is clearly showing that there is dramatic improvement potential in traditional personal computing. But increasingly the improvements are "borrowed" from touch interfaces. Clearly, as the ad implies, computing will never be the same again.

Steve Ballmer stated and Andy Lees confirmed that Microsoft views iPad and other tablets as "just PCs". From a market measurement point of view Canalys agrees. IDC and Gartner don't, calling the new devices "media tablets."

Before deciding whether tablets belong with PCs in market metrics, it would be interesting to look at what the data shows. When seen as a combined market, the focus should be on platforms. The following chart shows the four main PC+tablet platform volumes since late 2008 [1].

The second chart shows the same data as share of total market:

This comparison allows for some fresh observations:

1. Excluding iPads, Apple is very close to being 5th largest global PC vendor. Global share likely to be above 5%. Including iPads, Apple would be 2nd.
2. Platform year-on-year growth was Windows: +1.3%, OS X: +26%, iOS: +170%. Android growth cannot yet be measured since Android tablets have not been on the market for more than 1 year.
3. In Q2 2011 one million more Windows PCs were sold than in Q2 2010. In same time, 903k more OS X PCs and 5.5 million more iPads.
4. Excluding tablets, nearly 50% of the global PC growth was due to the Mac. Including iPad, Apple was responsible for ~70% of the growth in the PC market in Q2.

The picture that emerges is that while Windows continues to be dominant with 84% of units sold in the last quarter, the growth belongs to tablets which captured about 90% of it. If Windows remains marginal on tablets, the "PC market" will likely tip away from Microsoft in two years (depending on how quickly Apple can build iPads.)

Microsoft is making the commitment to move Windows to a tablet form factor but they are doing it while retaining the user interaction model of a desktop. This may or may not work but they are also conceding that a separate experience is also necessary. By rejecting the notion that a mobile OS alone can do the job, they are essentially building a "hybrid" tablet/laptop/desktop product which may be challenging to use but preserve their presence in the form factor.

Whether Microsoft succeeds or not will depend on whether the new form factor is disruptive in more than user experience. In other words whether this is just a "new PC" or a "post-PC". The argument comes down to business model changes. For example the new model comes with different cycle time of product development (deep, integrated, yearly changes), different ecosystem (apps), different cost structures (high R&D in hardware), vast scale (device economics, components, ramps), and potentially new distribution (operators in the channel mix.)

Summed up, the real challenge for Microsoft is whether they can keep their business model (selling OS licenses to hardware vendors) as PCs become more device-like. Not only is iOS setting the benchmark for performance but Android is potentially ready to take share if the market turns slightly more modular. Microsoft's differentiation looks to be primarily its legacy of PC software.

It may also seem that much remains to be discovered in this market but I think the main bets have already been made. The PC market as we know it is in the end game.

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Notes:

1. I used Gartner data for overall world-wide PC market and merged it with Mac and iPad data from Apple. Android data is estimated.

Windows Phone Marketplace has reached 25,000 apps. That's an impressive figure given that so few devices have actually been sold. Compared with Android which is activating half a million devices per day, Windows Phone seems like a rounding error. According to Gartner, 3.6 million smartphones using a Microsoft mobile OS were sold in the first quarter of 2011, of which 1.6 million were Windows Phone 7. That implies a daily activation rate of 17,500 per day or one WP device for every 28 Android devices.

And yet the number of apps on Windows Phone is more than 10% of the number of Android apps and Android Apps are about half of iPhone apps. As far as Windows Phone is concerned, apps are being added faster than users. Why is this?

If we take the point of view that mobile platforms behave like the computing platforms of years gone by (i.e. Windows vs. Mac) then this is inexplicable. Developers should not be bothering with a distant third. This would be like betting on the Amiga in the era of Windows.

But we're not in the PC era any more. That era had very high software development costs. It had very difficult software distribution channels (retail box sales typically) and very few categories of software with high price points. It was also dominated by institutional buyers which did not give quarter to small vendors. It was also a time when there were orders of magnitude fewer users and even fewer buyers.

The post-PC era is characterized by an explosion of ideas and application of new talent to software. It's an era of immediate gratification and painless, one click distribution. App production is a cottage industry not something entrusted to only a few experts or those who can raise venture capital. It allows the small to distribute widely and get a shot at stardom. It has been (thankfully) avoided by enterprise buyers. The result is an explosion of apps: well over half a million new apps have been built in three years on three platforms that did not exist three years ago.

So the very reasons which are driving developers to spread their bets across all and any new platforms should indicate the potential for new platforms and the sustainability of small platforms. The thesis that one dominant platform wins the mobile "war" is naive. The post-PC era will be a multi-platform era. Developers already understand this. Platform vendors know this. It's time to unlearn the lessons of the PC era.