revenue

Data is useful only when put in perspective. Yesterday's post on the Android Income Statement showed how sales and revenues are captured and how costs are paid for that revenue. The data was shown for the entire calendar year 2011 and the maximum value in the vertical axis was $1.5 billion.

Google has also reported that their revenue "run rate" is now in excess of $2.5 billion so there is significant growth, as would be expected from an exponentially increasing user base.

However, it's important to place this growth in perspective, both in absolute and in relative terms.

Below is a diagram showing Apple's revenues for the first calendar quarters of 2010, 2011 and 2012. Each product group (iPhone, Mac, iPad and iPod) is shown separately with estimated gross margins (GM). Operational costs, taxes and net income are also shown.

Consistent with previous versions of this data are the color schemes where white areas represent costs of goods sold.

I also placed a scaled version of the Android Income statement next to the first quarter 2011 revenue bar for Apple. The scale is maintained where $1 billion is represented by the double-ended arrow line.[1]

It might be hard to see the Android section of the chart so I expanded it below at 400% the original:

It is still difficult to resolve the data at this resolution but the picture should become clear nevertheless. Keep in mind that the iPhone data is for one quarter while the Android data is for one year. Comparing revenue "run rates", on a yearly basis Android is 2.5% of iPhone or 1.6% of iOS.

As various members of the Android ecosystem are rewarded from the 40% revenue share of Android, it would be important to consider the scales involved in these illustrations when considering the influence Google exerts. It could be argued that Google's spreading of wealth from search creates strong incentives for participation in its ecosystem.

However, there is little wealth created. 40% of a little is a lot less.

---

Note:

1. The scaling of the image in both X and Y dimensions can be deceptive. I provide the following view where only the vertical dimension (value) is reduced for Android

1. :

 

 

This is a continuation of the "Android Economics" series of posts. It deals with how revenues and costs are categorized for Android.

The following diagram shows an approximate representation of what Android's "Income Statement"[1] would look like.

 

I'll discuss the assumptions that are built into the model as I go along. I'll begin at the upper left and move toward the lower right in the discussion.

The first thing to note is that sales from Google's (formerly known as Android Marketplace) Play are not registered as revenues. This is because Google, like Apple, treats itself as an agent. Agency means that the revenues don't "belong" to the agent but get passed on through to the primary beneficiaries. In the case of Play, Google passes 70% to developers (or content owners) and then distributes on average 25% to network operators (or carriers).

I emphasize on average because there are many cases where Play transactions are not handled by or don't pass through operator billing systems. In those cases where operators are involved, it's possible that they capture more than 25%. It's not uncommon for operator billing to capture 45% of a transaction's value. The reason for this is that there is significant collection risk on billing--far more risk than on credit cards. It would also imply that on some transactions Google may be paying out more than it receives.

This means that on average about 5% of Play content sales to be booked as revenues for Android.

This 5% ends up a quite a small amount if overall app sales are small. We don't know the exact amount but anecdotal evidence from developers seems to indicate that they receive far more revenues from ad sales than from direct app income. Hence the size of the Android app sales is overall, modest. My estimate is that in 2011 there were about $330 million in gross app sales through the Android market. (Google estimated its sales to be 76 million for 2010 half way through that year.)

The bulk of revenues are therefore from other sources: Search, AdSense and AdMob. I'm modeling that overall revenues are based on a "revenue per device in use" multiplied by the number of devices in use. Google has publicly stated that they are targeting $10/device/yr. in revenues. This is probably ambitious as the amount was nearly that much in early 2010 but the number of devices bought by emerging market consumers exploded. As they are not actively targeted by Google's primary customers (especially in China), the average revenue per phone is likely to be much lower. I estimated $6.5 on average for 2011.

However, even if we use $6.5 per phone per year, the total revenues are quite strong since there were likely more than 215 million users at year end[2]. That results in a total revenue base of $1.4 billion for 2011. Removing the app revenues results in about $1.38 billion from Search and AdSense and AdMob.

How to allocate revenues to these three businesses is mostly guesswork. I used a split of about one third to AdMob, 10% to AdSense and the rest to Search. If we assume this split then the next step is to consider how to allocate costs to these sources of revenue.

As discussed in the introduction to this series, the primary costs of sales for Search and AdSense are network operators and OEMs or phone vendors. They are the primary "channel" which ensure the flow of search terms to Google. As Google also explains, the channel receives revenue share--so-called traffic acquisition costs (TAC).

I used an overall allocation of 39% for TAC. Crucially, this includes the payments to developers for AdMob traffic. The rule of thumb I used was:

• Network operators get 20% of Search
• Developers get 50% of AdMob
• OEMs get the rest (of the TAC)

The resulting split is shown in the column above with the "Cost of Sales" at the bottom. There are also additional operations costs which are negligible.

After this 39% TAC (revenue sharing), Google needs to pay its operating expenses. This includes R&D, Marketing, Sales and Legal costs for the Android division (including AdMob). You can see the approximate values in the column labeled "Operating Expenses". This operating cost amounts to about 27% of sales, with R&D at 14% and Marketing at 9%. These rather high fixed costs make sense as there is a significant development work underway for Android.

Finally, after these costs are allocated, the remainder is the contribution of the division. This comes to about 34% of revenues which is called the operating margin. Google has to attach depreciation from data centers and other costs as well as taxes before placing this into earnings.

Considering the agency structure, the overall cost structure of Android looks like this:

When playing with the assumptions, it becomes clear that the model is most sensitive to the revenue per device and total devices in use. The profitability is entirely dependent on those figures as variable costs are a percent of sales and fixed costs are limited by talent constraints.

For example, if revenues per device drop to $4.5/yr then the operating margin drops to 38%.

Now we can calculate some of the more interesting figures. For example:

• Android OEMs receive $0.76 on average per device per year
• Android Operators receive $1.07 on average per device per year (including Play)
• Android Developers, as a group, receive $1.94 per device per year (including Play and AdMob)
• Google receives a contribution of $2.75 per device per year from Android

Again, these figures are very sensitive to the revenue per device (currently assumed to be $6.5).

Because of the number of devices involved, these cash flows are an important part of the value network of mobile computing. The next step will be to assess how they affect the incentives, alignments and competitive stance of various platforms vying for a seat at the table of the future of information.

--

Notes:

1. An income statement shows the sources of revenues and the costs associated with those revenues. It also shows the fixed costs (or costs which are independent of revenues so they don't go up or down if revenues change). Finally it shows the operating income which is called contribution if it's a division within a company. This contribution is still subject to taxes and depreciation before it's recorded as earnings.
2. I'm using Android installed base estimated based on daily activation rates as published by Google. I've discussed these estimates here. I'm using year-end estimates but subtracting retirements based on a two year device life.

 

Android has had unprecedented growth. Based on activation announcements, it's possible to estimate that thus far, about 370 million Android devices have been activated. The total number of devices in use is a lower figure which depends on replacement rate and retirement rate. This total number of devices in use at year end is estimated in the following chart.

I added the blue line which represents what Google had as an internal estimate in mid-2010.[1] The difference between the two lines shows that Android's growth is far higher than what the company expected.  If the company itself did not expect this growth, it's unlikely anybody else did either.

Unexpected, exponential user growth is usually accompanied by a dramatic positive improvement in the finances of a company and a higher return to shareholders. The curious aspect of Android's success is that it has not had an impact on either. The market has not "discounted" the half-billion anticipated Android users into a price for Google shares that reflects this growth. It can only imply that those users are not very valuable.

But why would there be such a disconnect between the number of users and their value?

In order to answer this question we have to come to grips with what I call "Android economics". We need to understand how Google uses Android to make money and whether it is succeeding and if it's not, why not.

In many ways, the Android business model is straight forward. It's an extension of the existing Google business model: Revenue is obtained from Search, AdSense and the applications that enable these two.  In the case of Android there is also revenue from app sales (Google Play a.k.a. Android Market) and from AdMob. Of course, all these revenue sources (except for Play) are sold through other mobile channels that include alternative, competing platforms. They are present on iOS, Symbian, BlackBerry and even embedded OS phones ranged directly by carriers. For each of these alternatives, Google pays for placement of their search as the default search in the browser.

To Google, total search revenue from iOS is far higher than it is from Android. That's because iOS users engage more with their devices and there are not yet a large multiple of installed Android users vs. iOS users.

But it would make sense that having your own platform would be more economical because there would be none of these placement fees. In this sense Android is another "channel" for distribution of Search and AdSense. But one which may be a lot cheaper.

However, it turns out that it does not work that way. Android has other costs.

In fact, Android's distribution costs might be higher than other channels. What we have to understand is that all of Google's channel revenues have a "cost". The revenue from a particular distributor of search results that Google generates is offset by the cost to acquire the terms. You can think of it as Google paying for the queries through a revenue sharing agreement. Google does not get search terms directly and depends on distribution. Overall, it pays about 50% of revenues back to distributors. In the case of its own web sites the rate might be lower, perhaps 40%.

Google even has a term for it: Traffic Acquisition Costs or TAC.

This revenue sharing in exchange for search terms extends to Android. Google pays about 40% TAC to Android distributors of those searches. But since Android is owned by Google, who does Google need to pay for traffic? Who is an Android distributor? Who gets the revenue share?

Google does not make a secret of it: network carriers and device vendors (OEMs) receive revenue share. From the latest earnings conference call:

Yes. I mean, again, I'm not going to talk about specific of the TAC on mobile. But as you know, we get people using our devices both organically as well as through our distribution partnerships with carriers and OEMs. And typically, the OEMs and carriers participate in some of the economics that are on the Android marketplace or Google Play and some of them participate in the economics around Google Search just the way we would do syndication on the Web platform, which you do with many partners around the world. We have similar deals on the mobile front.

- Nikesh Arora, senior vice president and chief business officer at Google Google Management Discusses Q1 2012 Results - Earnings Call Transcript - Seeking Alpha

Arora made another point in the quote above. Not only is there revenue sharing with carriers and OEMs for Search and AdSearch but also for Google Play (app and content sales.)

Device vendors and carriers get a cut. Google's model has always been one of giving a cut of revenue to their upstream distribution. It just might be surprising to hear that device vendors like Samsung and carriers get a piece of Search and apps.

This basic observation leads to a series of questions:

• How much is paid out and to whom?
• Is that revenue sharing sustaining the ecosystem? Do vendors create Android devices and do carriers push Android to consumers because they get this revenue share or is the amount insignificant vs. device margin? What about tablets? Why haven't Android tablets they taken off as Android phones have? Are the economics to blame?
• Is this a competitive advantage vs. other platforms? Does Windows Phone compete with revenue share for Bing? Is Microsoft offering a bigger carrot (as well as a stick?)
• How does this economic picture show up in Google's financial and stock price performance? Or, more precisely, why doesn't it?
• And, finally, what conditions create a virtuous cycle of growth and what conditions could turn it into a vicious cycle of decline? Is there a lurking factor which would cause Google to benefit greatly from this user base or is there an inherent point of failure in the model?

I'll be answering these questions in a series of posts this week.

--

Notes:

1. Google's internal documents were leaked as part of the Oracle trial (Exhibit 1061). They can be found by using Google search with the following search term: "OC quarterly review".

“Within five years after discount retailing pioneer Korvette’s opened its first store in 1957, over a dozen copycat discounters had emerged. In contrast, the giant discount furniture retailer IKEA has never been copied. The company has been slowly rolling its stores out across the world for [close to 50] years; and yet nobody has copied IKEA.

Why would this be? It’s not trade secrets or patents. Any competitor can walk through its stores, reverse engineer its products and copy its catalog. It can’t be that there is no money to be made: its owner Ingvar Kamprad is the third richest person in the world. And yet nobody has copied IKEA.

Our sense is that the other furniture retailers have followed the positioning paradigm and defined their business in terms of product and customer categories, which are readily copied. Levitz Furniture, for example, sells low-cost furniture to low income people. Ethan Allen sells colonial furniture to wealthy people.

IKEA, in contrast, has organized its business around a job to be done: “I need to furnish my apartment (or this room) today.”  When this realization occurs to people anywhere in the developed world, the word IKEA pops into their minds. IKEA is organized and integrated in a completely different way than any other furniture retailer in order to do this job as well as possible.”

Integrating Around the Job to Be Done (Clayton Christensen, Harvard Business School; Scott Anthony, Innosight LLC, Scott Cook, Intuit; Taddy Hall, Advertising Research Council).

IKEA is the world's leading furnishing retailer and an amazing success story. As Christensen points out the success is all the more perplexing because it seems perfectly defensible. Nobody has tried to duplicate or undermine IKEA.

Positioned around a clear job-to-be-done it integrated design, manufacturing and distribution (including warehousing) as well as "big box" retailing as an experience.

This may sound familiar.

Apple's entry into retail depended on a clear job-to-be-done, design, carefully selected merchandise and retailing as an experience. Similar to IKEA, Apple also became a dominant player in its segment and even achieved seventeen times better performance than the average US retailer in terms of sales per square foot.

At first glance they seem to be similar businesses in terms of strategy or "architecture" but how do the actual businesses stack up? Can we find data to support any claim of similarity.

Let’s first have a look at the geographic focus of both companies. The graphic below shows that Apple’s retail operations are focused on North America with 74% of its 365 stores in the USA and Canada. By contrast, and maybe as much based on its origin, 73% of IKEA's 325 stores are located in Europe[2].

Unlike Apple however, IKEA has grown much more slowly. IKEA’s first store was opened in 1958 and had 6,700 sqm (72,110 sqf). The first two Apple stores opened in May 2001. Since then the number of Apple stores grew significantly faster (CAGR: 46%) and surpassed the number of IKEA stores in 2010.

The other difference is in sales growth. In 1954 IKEA’s revenue amounted to approximately $1 million but has grown steadily (note in chart below that first five bars represent decades). In contrast, Apple has grown more rapidly and is also more profitable in terms of margin.

Part of the difference in growth is that Apple was able to subsidize its entry: Apple’s retail operations were loss making for the first three years while IKEA had to rely on financing from its own cash flows.

Eventually, Apple retail became self sufficient and is now more profitable than IKEA. The following charts provides an overview of the economics of Apple’s retail operations and IKEA side-by-side:

While Apple’s revenue per store is still growing, IKEA’s business seems more mature and stable. This makes sense because furniture prices are stable and the number of products (SKUs) depends on available area per store which cannot grow. Apple on the other hand is limited only by traffic issues. Its products take little space and can even be stored off-site.

Speaking of traffic, with 655 million visitors in 2011, IKEA had more than twice as many visitors in its stores compared to Apple. However, each visitor spent about $27, while Apple’s store visitors purchased for almost twice as much.

The same story applies in employee productivity. IKEA has three times the number of retail employees, but Apple’s revenue per employee are 1.5x bigger than IKEA’s.

The largest difference is in the efficiency of real estate. In terms of total sales area IKEA’s operations have more than 30 times the sales floor of Apple.

As much as these numbers tell a story, they don't help us understand the cause of success. The two companies have completely different operations and their metrics seem at odds to one another. What works for one could never be applied to the other.

The fact is that there is no magic economic formula for disruptive retail. For example, by measure of sales per square foot, IKEA would not even make the top 20 list of US retailers.

However, there is one major thing they have in common: a clear formula for positioning your retail operations. Both operations are positioned around a job-to-be-done that has a high priority in people’s life. As mentioned in the opening quote, In IKEA’s case it is “I need to furnish my apartment (or this room) today” and in Apple's case Tim Cook said it best:

“Our retail stores provide the best buying experience and the best customer service anywhere. And while that’s important for a buyer of a Macintosh, in some ways it’s even more important for a buyer of an iPad or an iPhone or another post-PC device because these devices are new to many people. There needs to be a place to discover them, to learn about them before they are purchased, and learn how to get the most out of them after they’re purchased.” Tim Cook, March 2012

Apple offers a place where people can discover and get answers about technology without the pressure of making a purchase. The job is to simplify that which is complex for a price premium.

IKEA offers a place where people can get exactly what they need exactly when they need it. The only downside is that "some assembly is required". In a way, their job is to introduce some complexity in exchange for convenience and a discount.

In the end, they both get the job done and are amply rewarded for it.

---

Notes:

1. Including 13 in Russia.
2. The acquisition of UK-based furniture retailer Habitat in 1992 is the only exception.

During the first quarter this year HTC, RIM and Nokia all surprised investors with bad news. The effect is evident in the share price of these companies which, in the case of RIM and Nokia is around book value, and in the case of HTC, neared 12 month lows and a 70% drop from peak.

These "misses" in earnings and expectations are on top of the already woeful news from Sony Ericsson and Motorola, which have not had profits for years and LG, which has been borderline since late 2009.

In combination, this seems to imply a dearth of profits in an industry that is, by all measures, booming. Units are up 7% with smartphones up 47%. Revenues are up 20% and overall profits are up 52%. This are exceptionally strong numbers. Few industries can measure growth in double digits.

So if the industry is booming but the majority of participants in the industry are loss making (and surprisingly so) then what is going on? There are two answers: new market disruption and low end disruption.

The new market disruption is the migration of a large number of demanding customers away from phones-as-voice-products to phones-as-computing-products. The low-end disruption is the migration of a large number of less demanding customers from branded phones to unbranded, commodity phones.

The New Market Disruption

The new market disruption is evidenced by the shift of fortunes to Apple and Samsung and away from every other device maker. Here is the profit picture:

Of the vendors tracked (public companies who report mobile phone divisional performance), Apple obtained 73% of operating profits, Samsung 26% and HTC 1% [1][2].

The "share of profit" picture is potentially misleading because it could imply that the profits available are a constant. They're not. The absolute profits picture below shows how the industry actually expanded available profits by quite a lot. Two years ago the vendors generated profits of $5.3 billion in the first quarter  and last quarter they generated $14.4 billion.

Seen this way, the story isn't so much that Apple "took the profits from the incumbents". Rather, it's that Apple created a vast new pool of profits. And one need not look far to find out where they came from: operators. These profits were mostly carrier premiums for the iPhone 4S.

Before shedding tears for operators, consider that although this does amount to a current transfer of profits from carriers, the decision is a popular one. Hundreds of operators have made it. It's unlikely that they all colluded to be robbed. Indeed, they willingly hand over these premiums because the iPhone ensures a competitive advantage or preserves their customer base from churning. The calculations that go into a decision to range the iPhone are compelling enough that 250 operators made the decision (though, crucially, there are still 250 who have not).

Following this value proposition to its logical conclusion would suggest that the industry is rewarding those who can supply computers-as-phones which preserve the cash flows of what is essentially a trillion dollar data services business. Vendors which cannot offer this solution saw their businesses implode. At least on the high end.

The low end disruption

Simultaneous with this shift of the high end to smartphones-as-app-and-service-platforms came an explosion of growth in unbranded phones. As Apple led and most brands followed the new market, the old market of voice-oriented phones was abandoned to new entrants offering cheap "good enough" phones. Nokia tried to preserve its volumes and margins there but it's becoming increasingly difficult.

The following chart shows how the "Other" vendors have come to make up about 44% of the market.

Note that although this "feature phone" segment is not growing, it is still a large market (250 million units a quarter). The entrants in this market are numerous (perhaps in the thousands) and they are offering white label and unlicensed knock-off products. They are also offering unregulated (i.e. without IMEI numbers) products which are technically illegal and sold mainly in underdeveloped countries which have no incentives to enforce regulations.

This is a consequence of feature phones reaching the point of being "good enough". The feature set and quality are adequate for voice, text, games and even media playback and are priced at $30 or less.

This commoditization of the low end is pressuring what would normally be the fallback cushion under an underperforming smartphone business. The crisis for the incumbents comes from not only being unable to shift to the new market as fast as needed but also from not having cash flows from a low end that was thought to be sustaining.

This combination of two disruptions is why we see an explosively large and growing market failing to reward all but two of the participants.[3]

---

Notes:

1. You can download, view and interact with a motion chart for the industry data here. All data is sourced from company filings except for some estimates where data is missing.
2. Operating profits are sales minus cost of sales minus operational expenses attributed to the business. When not available, opex is estimated as a percent of total in proportion to sales. Note that operational income excludes taxes, depreciation and other capitalized costs.
3. We cannot say that the thousands of low end entrants are unprofitable. They are probably enough profits to sustain them and even to attract more entrants, but we have to also recognize that there are likely to be very low margins.

Sony Ericsson is no more. The company remains but the brand is gone. Now the phones it makes will be sold under the Sony name. Unfortunately, that means we no longer get reports from the company on its volumes, profitability and sales. The units will be part of "Other" from now on.

That vendor's data disappears as did HTC's and Samsung's earlier reporting. Bit by bit, vendors are withdrawing information. RIM stopped reporting its average selling prices some time ago, Motorola may disappear completely and they already stopped reporting tablet sales.

This makes the picture of the market fuzzier each quarter. We have to rely more and more on analysts who publish estimates. I try to pick from the available data the best assumptions but the errors are undoubtedly increasing. Here are the charts showing unit volumes in terms of absolute, share and ranking.

As I wrote previously, Samsung has overtaken Nokia which lost the top spot in unit shipment ranking, a spot it held for 14 years.

Of all the participants, only three brands enjoyed growth this last quarter: Apple, Samsung and ZTE. ZTE, like Apple, is noteworthy for its late entry. The others are in a mess: Motorola -4%, Nokia -24%, RIM -26%, HTC -29%, LG -44% in terms of unit growth y/y. This, while the market managed a modest gain.

It still find it fascinating that such a large market, selling 400 million units every quarter can exhibit such rapid change in participant ranking.

This is a transcript of a voice interview conducted April 19th 2012.

The interview is available as an audio file here.

--

Jim Zellmer: I thought we'd start by describing your education from the beginning, Horace.

Horace Dediu: OK, that's good, yeah. I like to say I'm the product of the public school systems. I went to public schools in three different countries, and probably maybe a dozen different schools altogether because we moved a lot, moved over 30 times.

My family emigrated, and we were what you might call political refugees for a while. We were stateless. We didn't have passports. We were officially not citizens of any country. So, for a period of about four or five years, that was the case. I started having regular schooling in Romania, and then moved to Italy and was enrolled in a school, actually, in the city of Verona, which is where "Romeo and Juliet" was originally set.

I was saying...my background. I spent a year in school in Italy, and I went to school in the north of Italy, in Torino. The thing was that I didn't know Italian, so I actually had to learn. But that's a lot easier for children. I was about nine, I think. And so, I learned Italian, was able to have a good school year. But then we moved.

In the summer, we moved again, and we emigrated to the United States. It took about a year to get the paperwork for that--because that was our ultimate goal was to be in the US. I was enrolled in the public schools. First, in Cleveland, where we found someone to help us. I actually went to, I guess, elementary school in the city of Cleveland, where we lived.

And then, later on, for middle school... What happened in Cleveland around that time was that busing started, desegregation. It would have meant, for me, more than one-hour journey across the whole city, from the west end to the east end of Cleveland, and my parents would have none of that. So, we moved to a suburb, immediately adjacent, which is called Lakewood. I went to middle school and high school in Lakewood, Ohio, for three years in high school.

And then, we actually moved yet again, to Boston. My father got a job in the booming tech sector at the time, which was in the early '80s. I ended up in a suburb of Boston called Medford. We didn't know much. Again, we were flying pretty blind here. We weren't familiar with neighborhoods or what were good schools or anything like that--"good schools." Mostly it was a question of, "Can we find affordable housing?"

Medford turned out to be a pretty lucky choice. In one hand, at the time, it was a blue-collar town. It was one of the near suburbs. So the closer to the city, it tends to be the older the immigrant generations are. It was settled mostly by Italian Americans. And so, a lot of the children I met in school were of some ethnic background.

Again, in the Midwest, that was a bit more rare. So East Coast, for me, was a little bit more vibrant in the sense that there were more interesting ethnic backgrounds and people from different histories and so on.

I enjoyed it, but I only had one year at Medford High School. It was actually more enjoyable, that year, I would say, than my years in Ohio. I have friends that I retained from that one year, and I don't have friends I stay in touch with from Ohio.

But it has changed. The city since has become much more, I would say, a lot of those families moved yet again, probably to a further suburb, and has changed character. I think it's more Hispanic now, the city overall. Nothing wrong with that, it just probably would feel different to anyone there now.

I was, again, in Medford. My choice, my next question, was where to go to college. I had been doing OK in school. And that was an interesting puzzle to solve as a kid, because you don't quite know how to fit in, the usual problems. Fortunately, having moved around so much, I had a pretty thick skin, and having had an accent or a strange background just made you a little bit tougher. And so, I was pretty immune to some of the high-school politics.

I focused on studies, and my parents are both educators. My father has a PhD in mathematics, and my mother had a Master's in mathematics and she taught. Actually, her job was as a teacher. They both got certified as teachers in the United States. My father had taught, also, university in Romania, but he ended up teaching high school and other two-year colleges in the US. It's very hard to go into academia from another country.

In any case, the fact that I had such devoted, academically inclined parents helped in focusing me on academics. That also, I think, was my nature. As far as college, my concern, we always had financial concerns, right?

Jim Zellmer: Right.

Horace: So, for me, I wasn't interested in the social aspect of college. For us, really, the decision was, "Can we keep expenses down?" I was accepted at Tufts University and also at Brandeis, which were local. That was important to me, that it would be near to my home and I could actually commute to these places.

Tufts was slightly better. It was a little bit closer. It was actually in Medford. So, I almost went to the college that was nearest to me. It had a very good program, also, in both engineering and computer science.

The odd thing is now, in college for me, was that - it's almost accidental - but, they had an option for you to take two degrees. The dual degree program was meant for people to study liberal arts and engineering. The idea would be you'd be a well-rounded individual.

The weird thing is that when I went there, which is 1985 to 1989, the School of Liberal Arts included the mathematics department and included the computer science department, which is a spinoff of the math department. So, computer science was a Liberal Arts degree; whereas, engineering was like electrical, mechanical, and so on, the traditional subjects.

I enrolled in the dual degree program with the intention of obtaining a computer science degree from the Liberal Arts School and a computer engineering degree from the School of Engineering. That meant that I would essentially take about 30 percent more courses. I think it was 50 credits versus the standard 30, or so. So, I was going for incrementally more material, but I would end up with two bachelor's degrees.

That's what I did. I actually also did it in an accelerated fashion. I ended up doing that in three and a half years, rather than what they expected it to take, five years.

Jim Zellmer: Wow.

Horace: That involved a lot of summer school. I was actually going through taking some of the requirement courses in the summer. So, I was basically a student 365 days a year and I managed to get the two degrees.

In the third year, there was one of these internship opportunities for research in a lab, GTE Laboratories.

Jim Zellmer: I'm sure.

Horace: GTE Labs was, again, local, which was important to me. They actually put us up in the dorms. So, the only time I spent living in a dorm was during the summer of my internship because it was paid for by the employer.

That was a great time. I loved it. I absolutely adored it. Those years right at... In my third year, which actually was my, I guess, my second year as I was a junior a bit early, I was going through this internship and I was studying, I was going working in the research lab. Then I ended up doing my senior year, my last year, I kept going back there. Somehow they kept me around as a part time employee because the project I had been on turned out to be useful.

It was in the library. I was actually working on indexing, which turned into search, which turned into Google later on, but we didn't know what it was then. We called it information retrieval. The algorithms, so we now do search intuitively when it actually became a commercial product, but it was something we did as research back then.

It was great because I was getting the experience I wanted desperately, loved it, and then I was still in school and I managed to get my degree. I was even earning money while I was doing this. It worked out very well, but it was a very tough period.

I graduated with not the highest scores, but I think I was magna cum laude, or something like that, which is not summa cum laude, but it's pretty good. It's like 3.8 GPA, or something like that. That's it. I don't know if that's what you wanted to hear. Then, of course, I did grad school.

Two years, while I was still employed. I took a full time job at the labs, then essentially I did two years. In '92, I got my Master's in computer engineering. Then I spent about a year or two figuring out what to do next. I went to New York to have a bit of experience. Oh yeah, I remember. I applied to Harvard because I wanted to go to business school. The reason I wanted to go to business school was I didn't understand business.

Jim Zellmer: [laughs] How did that play out? MBA's are often criticized.

Horace: Yeah, I'll tell you how it played out. Well, first thing is this. I'm sitting with my friends. We're all engineers, hackers, if you will. We're like, "We don't understand. We don't understand how we get funded."

Here we are sitting in these nice offices, but how does this company, who's basically a boring utility, how are they going to fund us to do cool stuff? We just compared notes and nobody knew. I realized none of us knew how business worked.

I said, "Well, I better learn about this." To me, I had been so focused in engineering that all this business stuff, the only thing I knew was because I would read the "Wall Street Journal." I didn't have either friends, acquaintances, families. All my friends were nerds. All my family were educators. I knew nobody, literally not one person, who could tell me how the stock market worked.

I would pick up the Wall Street Journal, read it cover to cover, and I wouldn't understand what the heck they were talking about. It sounded very abstract to me. It sounded like I need to learn something that there was something missing in my education.

I felt that the only way to get that training was to go to business school. And so, I applied. I was rejected, and the assumption was, in my mind, that I was too technical, too focused in a very, very narrow niche. Back then, there were headhunters that were trying to headhunt people. So, one headhunter got a hold of me and they said they had an opportunity in New York. I said, "Oh, New York. I know they do business in New York. So I better learn more from going to New York."

And so, I took a job with Chase Manhattan, at the time. It's called something else now, but it was Chase Manhattan. The job was also in IT, but at least it was IT, more pragmatic--corporate technology they call it. But I was there trying to understand more about business. I would still read the "Wall Street Journal" every day, still wouldn't understand it.

I reapplied to business school. I told them what I did. I said, "Look, I took this job because I wanted to learn business." I think I somehow convinced them the second time because I was so mad to do these things.

Jim Zellmer: Persistent.

Horace: Persistent. Somehow, I got accepted. I'll never know how they made that mistake.

Jim Zellmer: [laughs] Yes, of course.

Horace: But, anyway, once I went there, I was like, "OK, teach me." Now, the problem was that you start to learn with the case method, and you realize pretty quickly that there is no real curriculum. This is actually a lot of examples you're being given. It's not even empirical. It's like, "Let's throw a lot of examples and see if something makes sense in a pattern somewhere."

Jim Zellmer: This was Harvard?

Horace: Yeah. So, Harvard Business School. It was the only school I applied to, because I felt I didn't know how to qualify quality in terms of business. It was just a brand name. If you know nothing about phones, you just buy the iPhone because you know it's the best, right? So that was me, very naive. And throughout the school, it wasn't as rigorous.

In many ways, it was easy, because in engineering, engineering is very hard. You have to take test and you have to get answers right. And then in business school, it seemed like you just had to talk and you had to be articulate and you had to somehow be sufficiently smart-sounding to succeed.

Jim Zellmer: The theater, aesthetics.

Horace: Yeah. They drilled that into you. They said, "This is what we're teaching you is how to basically be a leader," and that leadership meant being proactive, not being passive. It meant getting in, if you will, on the discussion. I got that. I got it. It made sense to me because, yeah, in the meeting, if you sit there and say nothing, probably no one pays attention to you. You won't go anywhere in life.

So that was one of lessons. The other ones were about vocabulary. What we're not learning here, however, is that there's axioms. There's no specific rules of business. In fact, if you were to put rules down, there'd be many which would contradict each other. One of the classics is that money now is better than money later. But you need spend money now in order to have money later.

Jim Zellmer: [laughs]

Horace: So these two things are contradictory. There were no rules in business that made any sense as if you were proving a theorem or something like that. I decided all right, let's just go with the flow. I met nice people. I learned more from a lot of people.

The best thing that happened to me is that I had Clay Christensen as a professor. He was the nicest guy. The way he taught, it just resonated with me. He hadn't yet published "The Innovator's Dilemma." He was only teaching us operations, which is a first year course.

It's the only technical course in the sense that you do some process diagrams and you do some analysis. Finance is another analytical course, but the math is pretty straightforward. It's not very conceptual, in a way. Accounting is not either. It's interpretation.

But the professor, Christensen, he had a way of speaking to me that made sense as an engineer. It wasn't just me, there were a lot of people in the class who just felt that this guy was getting to the heart of a lot of the questions that we had. I took him as much as I could. I also had the option to take him in the second year. But, unfortunately, there was change in the dean and I think he had to change courses that he was teaching in the second year.

In any case, we had a good two years there. My question was, what do I do after I graduate? This was 1996. The Internet, at the time, was just emerging. Netscape existed as of 1994 or 1995. There were no Internet business models per se. Certainly, there was a technology industry. But it was pretty much boring and either IBM or commodity PCs and you had a bunch of software companies like Microsoft and Adobe.

It was already getting a little bit tired as an industry. As an MBA, it wasn't really that exciting. Everybody was doing either consulting or investment banking. Those were the typical ways of getting out of school. I had, of course, done something different. I did a startup. And nobody...

In fact when I told people I wanted to do a startup everybody said "You came to the wrong school. No one goes to Harvard to learn how to do a startup. There are specific schools that  train you for entrepreneurship." Like for example, Simmons or something. I forgot the names now. Maybe that's a women's college. I don't remember the names.

But the point is guys were saying "No, when you come out of here, you are either going to become a CEO of a Fortune 500 company or you're going to be a consultant for life or you're going to be in finance, managing other people's money or in private equity." I was like "Oh man. All right, well, whatever."

Jim Zellmer: [laughs]

Horace: I went and did this startup. I did a startup with no VC money. It was done with a partner in California who had raised money from the government using SBIR grants.

We're talking the Department of Defense, and we were doing algorithms research. I went back to my university and recruited an engineer who I worked with in a basement office right off of Massachusetts Avenue. That was in '96. We built a system. We ended up licensing it to Adobe. It was a plugin to Acrobat. We didn't benefit much from it financially. Other people made a lot of money but not us.

But we did learn a lot. So I'm thinking: In business school, I didn't really learn how business works, but I have this degree which gives me credibility. Now, I'm going to do my own business...

Jim Zellmer: It's a ticket horse, yes.

Horace: Yeah, but I did my own business. I threw away the ticket.  It didn't help me at all. What I was realizing, for example ... I didn't know how to do sales. I thought when you're doing your own business, you actually need to know how to do sales, and they don't teach you that at business school. I actually went and took a sales course, like they do in a daylong seminar.

I'm saying there are so many pieces that are missing. I didn't know how VCs, how to handle VCs and how to do pitches and do all these things. And none of that was taught, so I thought, OK, what I'm going to do? I'm going to do on-the-job training. I'm going to figure this out. And [learn from] networking with people in technology.

Eventually, I decided from the learning we had in the first startup to do another one, to do e-books! That was 1999. I'm trying to do an e-book startup in 1999. [So] I get on a standards body. I'm doing something with folks and I'm actually in a standards group that includes people from Microsoft, from Adobe, from a bunch of other startups, and from Nokia.

Actually that's where I met someone from Nokia, who...

At the time--it was 1999--I realized at that moment, with or without Nokia, I said, all computers are going to be handheld devices. This is so obvious. I can't express how obvious it is. I was interested, because Nokia had pretty much at the time the best mobile devices.

Jim Zellmer: Yeah, they were the player, no doubt.

Horace: I was asking myself, look, everybody in the U.S. doesn't get mobile. It's obvious that either it's Japan or Europe. And so, the question in my mind was, do I stay with the technology industry and try to figure out how this mobile computing will play out, or do I go to somebody who really knows mobile and expect that they will actually figure out how to become a computing company?

I chose the latter, partly because they also offered me a job and the dot-com bubble burst, and I wasn't ever going to get funding for my e-book business, which was called Handheld Media by the way. It was a great idea, great business idea, that we would actually help publishers convert books. Because at the time, the publishing workflow didn't include exporting tools. You either went to print or PDF, and we had this tool that would reformat a PDF book into a publishable format, like what e-pub is now.

Jim Zellmer: E-pub, right.

Horace: At the time, it was called OEBF, Open E-Book Format. It was using HTML, a variant. I actually had a workflow I could execute on my own and I could basically produce e-books. I did a couple of dozen, mostly as trials. I remember them even now, actually going through and manually extracting hundreds of pages, fairly quickly though.

But, anyway, that all came crashing down because although e-books were still interesting, there was no more funding in the docket. I had the opportunity to work with Nokia because they were actually very interested in launching something, not necessarily in e-books, but in media distribution. They wanted to sell music. They wanted to sell video. They wanted all those things in 2000. I came to them. Now, I'm playing my ticket, my bus ticket.

[The job] was something about how to do business strategy. They hired me. I had this technical background as well. One year I spent based in Boston. But then I was fairly quickly moved to Finland because that's really where you need to be to have any career opportunities. I was young. I was not married. Finland has its charms.

[I met] another American ex-pat who had moved there before I did and he extolled its virtues. I was pretty sold on that. Even though you pay more taxes, you get less wages, everything I did was economically the wrong thing to do.

Jim Zellmer: [laughs] That's a learning, though, too. You've learned a lot. Looking back on all that, Horace, what might have been better or more effective? When you think about your kids today...?

Horace: I don't know. I'm probably having too long of a chat on this, I mean fooling around this. But yeah, I'm very conscious of education, as I said. I realized pretty much after a year after leaving ... When I started Asymco, it's very weird. Again, you never know when you start down a journey where you're going to end up.

It was purely going to be app development because apps were just starting out. Apps were really almost invisible or there was no development going on in Europe. So my idea was why don't I bring iPhone apps into the land of Nokia, because here it's a green field site.

Jim Zellmer: Yes.

Horace: But it was a tough sell. I got one customer, but it was very, very tough. I wanted to bring apps to small and medium companies. I was going to essentially do apps as marketing material, like apps that are essentially a branding thing.

I was naïve also about the Finnish business culture because I think Finnish businesses are extremely conservative and that wasn't playing out. But the fortunate thing was that I began to blog because I had blogged while I was inside Nokia. I told that story about how I started doing it because I realized I wanted a bigger audience.

Then when I left, people kept saying "Why don't you do that while you're on the outside, just for fun?" I took that year to figure things out. I  went back to writing my blog. Then, literally, everything was happening in 20 minutes. It was like a fire hose. I had to learn everything. I kept asking: OK, how do I do this?

So, I am learning every single thing, because I had done it inside Nokia where it was movable type. It was a completely different system. I didn't have to set up anything. It was very simple. It was done for me.

But on the outside, I am having to do it all myself. I started using actually iWeb, which at that time had a blogging tool. So, I opened an account on MobileMe. I was just putting everything through the desktop tools. They were right under my nose. Then I realized the limitations of that, and I moved to the next thing. I was like, "Oh! Seems like WordPress is something people use. Let's go to that." So, I went to WordPress.

Then I realized, "Oh! Hang on! If they are hosting me, they are going to put ads in my stuff, and I don't know what they put there. So, I better host myself...how do you do that? " I need to find a hosting provider. How do you do that?"

So, every technology, every bit of knowledge I had to have, I obtained strictly on my own. I say that every single character written in Asymco and every single mouse click that made it possible was performed by me.

I had no technical support at all. It helps maybe to have a computer science background, but years had passed. So, I was able to... Here the key to the whole thing is that, every step, I am learning, and it keeps me motivated. I am like, "Oh! I understand how this works."

I had some friends, who were more technical, and I would ask them, and they would say, "Oh! You are wasting your time. You can't get any traffic. This won't work." I would ask: "Tell me about Twitter", and they would say, "Oh! You're better off on Facebook." I was like, "Oh! Man!" Every single thing that I was given as advice turned out to be...

Jim Zellmer: Wrong?

Horace: Yes, doing the opposite would actually be the right thing. And so, I started learn about stats, the numbers game of blogging. So, how does that work? What does it mean to have good traffic?

I didn't expect to get advertising revenue, but I was thinking: what does it mean to be successful? So, I would go to John Gruber's site. John puts up his own rates, and I am like, "Oh wow! Look at the numbers." He actually tells you how much he charges per week, and then he says he is fully booked. So, you know what his income is. And so, from that, I was like wow! That's my goal I said to myself.

If I can get the traffic that Gruber gets, then I can charge these rates. I was trying to figure out how much traffic he was getting. He was getting like four million page views a month. I said, "I don't know if that's a lot or not." It certainly is a lot to get money, but you know, how do I get from zero to four million? So, what happened is that also when I was starting out, I reached out to John by email, directly by email.

Some time before I mailed him and said, "I used to work at Nokia and there's a couple of things you're writing about that I wanted to amplify or I wanted to give you some background." He has great stuff, and he actually used my material in one or two blog posts. I wasn't blogging at that moment.

But once I started blogging I mentioned to him, I said "Remember me? I sent you that info, and now I have my own blog." He didn't say anything. But then I wrote, I think the first piece that I wrote that was provocative. It was why someone at Microsoft had been fired or something like that. He linked to me. Then I saw. Then my eyes were open, because then my traffic... from zero to 12,000 a day.

Jim Zellmer: Yeah.

Horace: 12,000 views, for me, was like infinity. My server crashed and all that. I went back [to him] and I said "Thanks for the traffic. Now what do I do because I need money to be able to get this traffic managed." He said "No, you don't need money." You need to turn on caching." I was like "Oh."

Jim Zellmer: [laughs]

Horace: That solved the problem. But then I was asking him "So where do I go from here? Should I think about putting ads on my site? Is that the right thing," because I was so naïve. And he said "No, no, no."

He gave me one piece of advice. This is the only piece of advice I ever got from and from anybody that was useful. He said "Don't put ads. Just do what you do. Your value is in the future. Just keep doing what you're doing." That's all he said, one line.

I said "OK. If he says that, I believe it. That makes sense. Let's do it." I kept getting better at what I was doing, basically writing as well as I could, getting the feedback from comments and learning every step of the way.

This is still going on. One year on, I learned what Twitter really meant. I didn't know Twitter. The first thing I learned at Asymconf was what a hash tag is good for. [I mean] I knew what they were. But I did not use them. I never used a hash tag before Asymconf because I don't use Twitter that way. I don't use it to look up stuff. I mostly use it as a way to get my word out and get feedback, just like a mini micro blog.

But then I didn't understand the potential of a hash tag. It dawned on me when people were writing about Asymco and using a hash tag and if I searched on that I could find out everything that everybody said about it, a great idea.

But that I learned again just a few days ago. So many things I learned, thousands and thousands of details. So many things that the tables are now turned. Now people expect me to teach them about blogging.

Jim Zellmer: Yeah. [laughs]

Horace: For example, how to get traffic. A lot of people are sending me emails with paragraphs and paragraphs of effusive, "Oh you are so great. Thank you so much. Can you help me with this?" I'm like "Well, you don't need to say any of those thank you things, just tell me what you need."

A 15 year old sent me a request for an online interview. He made it easy. Five questions. So sure, I'll answer five questions. I treat everybody equally. Whether it's the Wall Street Journal or a 15 year old. I give them equal attention. I learn as much from both. The kids will teach you more, actually.

Jim Zellmer: Given all of that, if you were entering college today, what would you study?

Horace: I would still study engineering, absolutely. I am at heart an engineer. My son, I hope he does the same things I do. When I was a kid  I loved building things.

I loved building Lego, although I didn't have money for a lot of them. I loved building model kits, the little plastic model kits, planes, and so on. That's not fashionable anymore, and mostly, it's old men who do it nowadays.

Jim Zellmer: [laughs]

Horace: [But] I'm trying to teach my kid. I actually bought a whole bunch of kits and began to model again so he could see me do it so he would get a passion for it.

I think building things with your hands, learning how things work, being passionate about numbers and about technology and things that are tangible is the only way to really create if your mind works that way. I'm not saying it's for everyone. To me, that's the heart and soul of progress.

By the way, I didn't mention this, but my parents also infused in me a love for the arts, and not "modern music". Being Romanians and of a certain age, they weren't ever part of the Rock and Roll, if you will, generation, although they knew of the Beatles.

So, they listened to classical music. Throughout my life I was exposed. I was taken to the theatre, opera, ballet. I used to sit in these performances since I was five years old. I maybe didn't get it. I wasn't talented. I tried to play the violin. I wasn't good at it, but I understood, after repetition, I understood the value of that.

When I went to that liberal arts college and got my degree, even though it was in computer science, I had a lot of requirements. I had to take English poetry. I had to take Japanese art. I had to take a lot of courses that were basic requirements. At the time, they were a burden, but in retrospect, they actually taught me a great deal. I'm very proud of having that background.

I'm not saying to not have an arts education, but absolutely, if you have the skills and can execute or can perform as an engineering student, do that and do the other things. Do the other things which develop the other half of your brain.

Jim Zellmer: Where did you learn to write, Horace? You write very well. Especially given that English is not your first language, you're able to be succinct and you have a wide ranging command of the language. So, where did you learn that?

Horace: Reading, partly. OK, so I have to give a lot of credit, and I did once on Twitter, give a credit to my English high school teacher. I said if you like the writing I have on Asymco, you should thank her.

Actually I wrote to her. She had seen my work in "The Boston Globe." It had been syndicated from that or something.

Jim Zellmer: [laughs] Wow.

Horace: She wrote me an email saying me an email saying, "I'm so proud to see your work and I sent it to your calculus teacher, as well."

They were both retired. The calculus teacher had seen my work in the financial section, actually. He sent her a note saying, "Check out the. . ." They read the paper. These are from that generation, right?

Jim Zellmer: Yes.

Horace: I've never seen my work in print. I've seen it online, but there it was. I thanked her. What I said is this: What she taught me was to write plainly and write clearly. This was Medford High School, a working class neighborhood, nothing special about it.

The teachers I had in English in Ohio didn't instill in me the same passion. The same books were read. Right? The same classics.

Jim Zellmer: Classics, yeah.

Horace: Twain and Conrad and all those classics, but the teacher in Medford, when I would write an essay, and also, I think, there was positive feedback because I was perhaps a little bit better than average in her class. Better than I was in Ohio. There I was about average, maybe.

I had good grades, but I didn't feel like I was great at it. I was nervous because a lot of the tests were vocabulary, or a lot of the tests were not essays.

This teacher instilled in me the passion for writing good essays. She kept telling me how great my essays were.  I was writing somehow, and I loved reading the books. That's the other thing, the other kids would cheat. They would read the Cliff Notes.

Jim Zellmer: Yes.

Horace: They would copy from each other or do all these things. I was like, "No, no. I want to go home and I really want to read this book. These are really nice books." So, a lot of reading, a lot of passion for reading and I think practicing with essays. Practicing, also, in the writing of work online.

Now, again, when I look back at my early stuff, I cringe. It took me a while to find my voice. I didn't know what a voice was. I figured that out quickly. Then I had this challenge of working in the rigor of data. I realized the way to make my stuff stand out is to avoid opinion, to avoid hyperbole, to avoid all these things which bloggers seem to do.

So, anyway, it took some time. I think there's both a lot of ability, like, Einstein said, "It's 20 percent ability, 80 percent perseverance or perspiration." It's just practice. The other thing is it's like an athlete, right? An athlete gets good because they practice every day.

When I set out I said, "This is so much fun. I want to keep to it. I want to write a story every day. I want to write a blog post every day. I pretty much stuck to that. I was even writing on weekends, but I stopped because time, family. But, I write every day. I think of it as mental athleticism. You've got to go running every day if you want to be an athlete. You've got to write every day if you want to be a writer.

I heard, later on, that Jerry Seinfeld said he wrote every day. That was his key to success. He always tried to write jokes every day. That, to me, is what I learned. You bite your tongue sometimes, you learn how to deal with comments. Through comments, you see exactly how people make mistakes. They make mistakes by getting ahead of their thoughts, or they are too impulsive.

You get this great sense of what makes it good and I thought myself being able to write things. I write email in a good way, crisp in the email. You get a sense for it. For example, if somebody sends me ad copy, like a sponsor, and they send me a copy, I sometimes cringe when I look at it.

Jim Zellmer: I noticed that!

Horace: I can't help myself, I edit their copy, and even though they probably don't want me to, there is no time to go back and do feedback. But it's something you learn as a skill.

Some other people have asked me, "How can I teach my son to write well?" To me, it's not about being able to do more, it's actually being able to cut stuff out, and just go straight to thought. Maybe it takes practice.

Jim Zellmer: Now that you are a parent in Finland, your children are in Finland, so what choices do you have for your kids'?

Horace: We are very conscious of that. So, I like [Finland]. Well, I came for one reason, because, it was a wonderful place to play. But I stayed because it's a wonderful place for families.

What Finland's known for, among other things, is that it has the best scoring students on tests ...So, their educational system is considered absolutely in the top, literally top of the world.

There's a lot of mystery about why that is, and you can't really put your finger on it. A lot of educators from Finland have been on world tours trying to explain what they do, and everybody comes away scratching their heads.

I think this actually goes back to Christiansen theory, because when you study it people want to see a formula or an algorithm, but in fact, what is happening is, is something about whether the system is integrated or modular.

Whether the system is centralized or decentralized. So, it's not a question of process. It's like when he approaches health care, he comes  at it from these two different angles. He says, "It's not about being public or private. It's being modular or integrated."

The assumption in other countries is always that everything is modular, and it cannot be anything else. So, in a sense, you need to question down at the deeper roots of causality.

So, my son, just to give you some perspective. He is now in pre-school.

He is six now or he is in grade zero, as they call it here, and he is going to a French school, meaning that they speak French in class.

Jim Zellmer: An immersion school. Yes.

Horace: There are several language schools like this. We're going to the French one partly because his mother went to a French school, his uncle went to a French school and they have loyalty to it, but also because I'd personally like for him to learn a romance language because I knew one. I still know Romanian. I had learned Italian, and I took French in school myself.

The thing is that it doesn't cost any more to go to that school than any other school. All education is free. Not everybody can get into any school, but it isn't about money. The other thing is that it's a small nation.

There's only about five million people, so all the decision-making can be centralized. There is no local school boards. There's no organization down to the smaller units that you might imagine. It's very simple and it's top down.

If you were to try to do a top down approach for a country as big as the United States it wouldn't work. You can't really transplant this system. People are very wary of centralization and control and the decision-making at the top that is incompetent. I completely understand that.

However, this being a small nation, it works and it's central. There's a question of optimum size. I mean, in some sense five million might be the right, maybe 8, even 10 million maybe works. I don't know  beyond that.

There's also the question of how different the people are in terms of homogeneity. Although Finns are fairly homogeneous, there are minority groups as well and there's been plenty of immigrants. I'm not an expert on any of this, but I'm just pointing out some minor details.

I really like the school system. We actually had a parent teacher meeting this morning. They're very relaxed. Children seem to be much more relaxed. This is one thing that came across from the educators meeting and discussing around the world.

There's no pressure. Even though they're performing exceptionally well, there doesn't seem to be that pressure on testing, on measurement, on all these things that supposedly correlate with performance. In many ways, it's asymmetric, or doesn't make sense to people who are steeped in education theory.

I don't know if that's advisable, though. The problem, again, is that it may only work in this context. It may only work in the Nordic country, but we're very happy with the way it works. It's the same thing, by the way, with healthcare. Healthcare here is also centralized. It is a public resource.

Jim Zellmer: Yeah. What's your sense of the teachers you've encountered? One of the things "The Economist" reported a couple years ago was that Finland requires master's degrees from teachers. Contrasting that with what you experienced in America and Verona and Romania, do you have a sense of differences in the teacher capabilities, or no?

Horace: Because here mostly all degrees are considered Master's, it's essentially, I think, five years of school, of education. There's so many differences I can't even begin.

My wife, for example, she has a master's degree. A bachelor's degree would be more equivalent to like a two year college in perception.

Jim Zellmer: OK.

Horace: So, if you have a technical degree...a lot of people drop out. They get out because it is somewhat  long and tedious and it is also not conducted in the American's style of valuing... It's so hard to explain. I actually would like him to go to university in the U.S., but I'd like him to go to every other school in Europe, or in Finland, more specifically.

I think the U.S. higher education system is better. It's better because it actually doesn't teach you according to a cookbook. It's actually much more open. In a way, that's the opposite in the lower grades.

Jim Zellmer: Yes.

Horace: The lower grades are open and the students are given a lot more freedom, and the teachers are given a lot more freedom. So, it's the opposite.

You'll see this, also, in Japan. Japan's educational system is a bit of a joke because they drill so hard in order to get good scores and get into a good university, but once they get into the university, they do nothing.

The entry is your ticket. After that there's hardly any effort. I've heard from others that the way university programs here are, many students will stay in for 6, even 10 years. It takes a long time because they'll drop in and out. They'll take a couple of courses. They'll do something else.

It isn't rigorous in the sense of, "Hey, the clock is running. This burns a lot of money. You've got to get a job to pay off loans." Because you've got that pressure on you in American universities, I think people actually are faster. It's more efficient. It tends to also draw more talent into it. The professors are more ambitious.

So, there's something I like about the U.S. higher education system, although if you listen to Clay, he'll say that it's also being disrupted, and he's probably right, especially the bigger names are going to be pressured from online education.

Jim Zellmer: Given your steep experience in technology and engineering, what is the role or is there a role for technology in education? Certainly in America and other countries we have all these people who say "Gee, our kids don't have iPads, they're just falling behind," among other things. So what is your perspective on that, Horace?

Horace: Well, technology is useless without the software. Hardware is useless without software. Computers are useless without a job to be done.

Jim Zellmer: Yes.

Horace:  I believe technology will help, but we have to make sure that we solve the job problem with technology, rather than saying that technology itself is this answer. I think the iPad has potential because it enables the content to come through again. What you might learn by using it is focused on the content itself.

In other words, a computer was always hard to use. Most of the time you spent using it was actually learning how to use it. So you have to fight through it to get to the actual content and material was supposed to teach you something. Even the way that it used to be, that there was a computer room or a computer lab and you would go and sit in front of these computers and there were all these things considered.

In other words, it got in the way. I think that what the content needs to do is be more pervasive. You need to give the platform to someone who can build something on top of it, someone who can actually create new content, new material, new ways of teaching.

The real innovations that I've seen have been the Khan Academy or even Ted Talks or something along the lines of video content that is packaged in small pieces that people can take and learn at the rate that they're comfortable with. That makes a lot of sense to me. I don't know how that can be worked to the K-12 system because that is so regimented. But I think kids having iPads seems to be potentially a breakthrough opportunity there for how to really teach.

It's all going to come down to the materials. Is this a platform that teachers can build stuff on? The only thing I have to criticize the system for is that it's still not possible for laymen to create material for it. We need more and better tools that sit on top of the tools we have. So abstract from the hardware so you can create great e-books, you can create... experiments and so on.

Jim Zellmer: Right. Well, that's great. I appreciate your time today, Horace. Perhaps we can continue this again one day on education, which certainly continues to change. Again, good luck with the French school, with your son.

For Apple 2012 started with almost the same growth as 2011 started. Q1 2011 saw earnings growth of 92% and Q1 2012 saw growth of 94%. As the following revenue growth table shows, the pattern for the last twelve months has been very consistent:

Here are some notes:

• The iPad is growing at a faster rate than the iPhone and has achieved in two years what the iPhone took four.
• The iPhone grew units at nearly 90% and revenues at 85%. This is slightly below the quarterly average over the last two years of 99%
• The Mac showed significant weakness though the previous year's Q1 had exceptionally high growth of 32%. The Mac still grew faster than the market and therefore gained share
• The iPod is declining consistently. Units showed a lesser decline than revenues as the average price dropped from $164 to $157.
• The iTunes store continues to grow very rapidly, reaching a new record level above $2.1 billion revenues
• Peripherals were weak with 11% growth but that may have something to do with lowered Mac sales
• Software had good quarter though not exceptional
• The top line grew at nearly 60% which is not exceptional but the bottom line grew at 94% which is above average

Overall, the company had a very good quarter and showed consistency, which, incidentally, implies predictability. The following graph shows the top and bottom lines in historical context with color coding matching the table above.

 

The following charts show Google and Microsoft revenues and operating income:

Both companies showed healthy growth. Revenues: Microsoft 6%, Google 24%. Operating Income: Microsoft 12%, Google 48%. Google had a particularly weak margin Q1 2011 so its income growth appears very strong.

The surprise in Microsoft's performance was the 4.8% increase in Windows revenue at a time when PC sales were expected to be declining or flat. Final PC numbers are not yet out so we'll have to check back on this figure to see whether Microsoft has been able to get higher pricing for Windows or whether the market did expand. (Average revenues per PC sold have been quite steady for years). Overall, Microsoft's business shows consistency. Of course, that should not be cause for comfort. Nokia had remarkable consistency until it jumped from a burning platform and RIM grew more rapidly until its platform imploded.

As Google still obtains 96% of its income from advertising, it's quite remarkable that it is now at 61% of Microsoft's revenues. Google is also growing more rapidly than Microsoft so the possibility exists that the top ad service will overtake the top software company in revenue, establishing a new benchmark for how software can be monetized.

The curious thing about both of these companies' financial performance is that mobility does not appear to have had any impact on either top or bottom lines[1].  There is no business division or income statement line that can be attached to mobile revenues. Microsoft placed Windows Phone under Entertainment and Devices but that division is dominated by Xbox and accessories. Google bundles everything under Advertising and has never broken out mobile, much less Android-derived income.

The surge in valuation for mobile-focused startups seems to leave investors in both these companies unaffected. The damnation for both companies lies in mobility being non-core businesses whose strategies center on reaction and defense.

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Notes:

1. Google does not answer specific questions about the impact of mobile on their business but they do acknowledge that there are traffic acquisition costs (TAC) associated with OEMs and Carriers who deploy Android. This means that there are costs of mobile sales (i.e. Search) but not to any measure of specific value.

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

From Nokia's Q1 2012 financial interim report

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

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

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

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

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

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

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

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

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

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

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

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Notes:

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

 

Nokia reported Q1 results following very closely the warning issued last week.

There were few surprises. There is much more detail in terms of regional performance which might be a better indicator of how the smartphone strategy is playing out. I plotted the data in three charts.

Regional Sales Value

A year ago Europe and China were nearly equally valuable as regions to Nokia (€2.1 billion and €1.9 billion, respectively). Even though sales fell across all regions, China fell so much that it has become the fourth in value and nearly the same value as Latin America (€577 million for China vs. €542 million for Latin America). This is a significant reversal for a very important market. The drop in value is a staggering 70%. Is there some clue as to what caused this?

Regional Unit Volumes

The data on volumes shows that Europe's drop is consistent (35% drop in value coupled with 32% drop in units). This implies an erosion in pricing but not a very large drop. However, in China the volumes fell less rapidly than sales (70% drop in value and 62% drop in volume). The pricing story was significantly worse. This story repeats in Middle East, Africa and Asia Pacific where volumes held but value dropped. This implies significant change in pricing in those regions. That's borne out by the chart below:

Regional Selling Prices

Prices in Europe dropped by about 4% but in China they dropped by 21% (from €80 to €63). In APAC the drop in price was 25% and in Middle East and Africa it was 30%. In the Americas prices increased with North America up by one third and Latin America by about 6%.

This uplift in NA is primarily due to the Lumia launch as channel was being filled. However, note that North American volumes were extremely small: only 600,000 units sold (inclusive all models).

As the Lumia line was not available in many markets, and as only 2 million were sold, it's hard to see its impact. The only clear effect was on North America prices and that overall smart devices ASP held the line (down only 2% y/y and up 2% sequentially). The €220 average price for Lumia was well above the €143 for all smart devices sold. Nevertheless, smart device volumes were down 50% to about 12 million units--nearly the same as RIM's pitiful results.

What these data points add up to is that Nokia cut pricing aggressively while losing volumes. The price cuts were "forced" by conditions and probably were designed to slow the drop in demand. Emerging markets, once Nokia's core growth area, showed dramatic value contraction due to price pressure. Nokia's brand value, which normally allows for price premiums regardless of functional value, is clearly evaporating in its last bastions.