Re-thinking Apple's "Thermonuclear War" Against Android

by Mark W. Hibben
8/11/13

No Effective Bans

Incensed by what he deemed to be blatant theft of Apple's innovations, Jobs told his biographer, Walter Isaacson, "I'm going to destroy Android, because it's a stolen product. I'm willing to go thermonuclear war on this." Far from destroying Android, the years since this declaration have seen Google's Android become the top mobile operating system for smart phones and tablets, both in market share and in the size of its user base.

IDC's most recent data on smartphone and tablet market share make it clear that Apple's contentious approach has not in any way arrested Android's growth. In Q2, 187.4 million Android OS smartphones were shipped, versus, 31.2 million for iOS. Android's smart phone OS market share increased from 69% a year ago to 79%, while Apple's share decreased from 16.6% to 13.2%.

In tablets, Apple's market share decline has been even more dramatic, going from a 60.3% share last year to 32.5% this year, while Android went from 38% to 62.6%. Even as the overall tablet market grew year over year by 59.6%, Apple's unit shipments declined by 14% to 14.6 million units.

If Apple's legal maneuvers were intended to curtail or at least slow down the growth of Android, then they have been an abject failure so far. Even when recent court decisions have gone in Apple's favor, they have not resulted in any effective ban of Android products.

Apple's most important legal victory came last year when it won a $1 billion patent infringement suit against Samsung in Federal court. However, the judge later reduced the judgement to $550 million and refused to ban the import of Samsung products. Both Apple and Samsung are appealing the case.

The latest turn of events may or may not result in a ban. On Friday 8/9, Apple won a favorable ruling by the U.S. International Trade Commission that Samsung had infringed two of the six patents Apple claimed were infringed. The ITC's ruling banned Samsung from importing products that infringe the Apple patents, but Samsung has potential work arounds, such as software changes to get around the patents in question, and only older devices may be impacted.

And things haven't always gone Apple's way. Apple suffered a setback when the ITC ruled that Apple had violated Samsung patents and banned import of older model iPhones and iPads. The ban was vetoed at the last minute by President Obama. In March 2012, the ITC dimissed an Apple complaint against Google's Motorola unit charging infringement of three patents. This was overturned by the U.S. Court of Appeals on Wednesday 8/7, but the case now bounces back to the ITC for further consideration.

Never Much of a Chance

With so many cases and decisions being handed down, it's easy to miss the larger trend. Apple's legal war against Android never really had much of a chance of success, and here's why:

1) Android, at the level of its fundamental operating system architecture, is in no way a rip-off of iOS. Android was developed by Android Inc. which was founded by Andy Rubin and others in 2003. By the time Google bought Android in 2005, it was known that Android was working on a smart phone OS, well before the iPhone debut in 2007. Android is based on Linux, and uses a homegrown Java Virtual Machine (Dalvik) to run apps written in Java.

I've written about the Android app architecture in the past, explaining that my dislike for it was what drove me to become an iOS developer. But even as an iOS developer, I can acknowledge that Android is a unique product distinct from iOS.

Apple's software design and physical design patents couldn't really get at the heart of Android, because it's so different from iOS. The lack of fundamental overlap between the two operating systems means that Apple's patent attacks could only nibble at the edges of Android rather than deliver a mortal blow.

2) Even when Apple proves infringement of a patent by a competitor's device or group of devices, the Federal Government will be reluctant to grant an import ban. This was demonstrated in Apple's patent victory last August when Apple's requested ban on some Samsung products was refused.

This goes back to the ambivalence towards monopoly currently built into the legal system that I have referred to in past articles on Apple's anti-trust woes. The patent system was mandated by the Constitution and intended to promote and reward innovation by granting monopoly status to the inventor for a limited period of time.

Since that time, legal and social attitudes towards monopoly have evolved, so that it's frowned upon even when not illegal. In the role of encouraging competition, the U.S. government will prefer to use royalty payments and penalties rather than an outright ban on those who do infringe a patent.

3) Any success Apple might have in the U.S. or elsewhere will still leave huge emerging markets unaffected. Currently I'm unaware of any Apple patent litigation in India, and only one case in China in which a Chinese company is suing Apple for infringement.

4) Apple is not the only company capable of innovation and willing to enforce its patents in court. The "thermonuclear war" commenced with Apple suing HTC in March 2010. HTC countersued and the dispute was eventually settled in November 2012 with a cross licensing agreement between the two companies and an undisclosed payment by HTC to Apple.

Staying Ahead of the Competition

I don't advocate that Apple drop its patent litigation. Apple should defend its intellectual property vigorously, but investors should not expect this to solve Apple's Android competition problem. It probably won't.

The best way for Apple to mitigate the effect of "copycat" products is by accelerating its pace of innovation. With $130 billion in cash, Apple can easily afford to do this. Then copycat products can only feature outdated tech that just makes them less desirable, even at a discount.

Apple management have realized that the pace with which Apple innovated in the past is not the pace that will keep it competitive in the future. Apple has begun to increase its R&D spending as a percent of revenue, as I pointed out in my article on their second quarter earnings. Ramping up an R&D effort of the magnitude (roughly double the 2012 level) that Apple needs takes time. Researchers have to be hired, new facilities found or built, and a mound of research proposals have to be sifted through for the ones most likely to yield successful new products.

 

Time Warner and the Virtue of Focus

by Mark W. Hibben
8/8/13

Final Deconstruction

Once a poster child for the empty promise of synergy between Internet, print and video media, Time Warner has rediscovered the old-fashioned virtue of focus, focusing on what it does best, video and film content creation. This earnings season, it easily bested its media congomerate rivals, 21st Century Fox, Comcast, and Disney, in operating income growth.

The lesson of focus, while fully learned, has yet to be fully realized. Time Warner is still looking to spin off its Time publishing arm, and word is that won't happen until next year. The final deconstruction of AOL Time Warner won't come a moment too soon, as the publishing division revenues continue to decline.

As I noted in my previous post on Jeff Bezos' purchase of the Washington Post, spinning off print publications (even though they always have substantial Internet presence) has become the thing to do. News Corporation separated its print publishing business in the wake of scandals at the British News of the World at the end of June, with the publishing business retaining the New Corporation name and the rest of the business rechristened as 21st Century Fox.

Rupert Murdoch, the founder of News Corp continued as CEO of Fox, by far the larger entity. Fox retained the cable and broadcast television programming business, home of Fox News and Fox Television, as well as the Twentieth Century Fox Studio. Content is king in the digital multiscreen world, as long as it's video content.

Along with some form of video content production and distribution, most of the big media players are involved to a greater or lesser extent in physical distribution networks. Fox owns an interest in BSkyB and a couple of other European direct broadcast satellite operations.

Comcast is a very large cable company, with a TV Network (NBC) and movie studio (Universal) grafted onto it. Comcast completed the acquisition of NBCUniversal in March. The ABC television network represents Disney's involvement in physical distribution. The media company exception when it comes to physical distribution is Time Warner, which has numerous Cable "networks" such as CNN, but no physical cable or television networks. In the table below , I summarize the financial contributions of the major categories of operating units for these media giants.

The Cable & Television Networks category combines cable networks such as HBO or CNN, which are really just packages of programming distributed to physical cable operators, with broadcast television programming and distribution. Since the legacy TV networks such as NBC and ABC traditionally combined program creation, distribution and broadcast network operation into a single company, the Media companies continue to report results corresponding to the legacy organizations. This makes it impossible to separate content creation and sales distribution from the physical distribution process for the broadcast TV units.

Studio Film and Video production involves traditional theatrical film production as well as TV show production in the case of Time Warner for third party broadcast TV networks.

Synergy or Ballast?

Is there synergy between the the physical distribution networks and the video (defined broadly to include film) content creation business? For broadcast television and to a lesser extent cable, there probably still is. The broadcast TV industry as it grew in the 1950's turned to developing its own content because of the special needs of the medium. The TV industry needed content that could be frequently interrupted with commercials, fit into relatively short 1/2 hour and 1 hour blocks, and which didn't demand too much visually of a medium with serious limits in display size and resolution.

Even now, broadcast networks produce much of their own content, and in the new distribution medium of the Internet, self-produced content is seen as something of an advantage, as in the case of Netflix. For the most part, however, combining content creation with physical delivery mainly provides financial ballast for the content creation side of the business.

This is especially true of film production, which is notoriously expensive and risky. Warner's video content business has had a good year, with hits such as Man of Steel and HBO's Game of Thrones, and this is reflected in the greater than 30% increases in operating income in its cable network and film production businesses. Meanwhile, Disney has struggled with flops such as the Lone Ranger, reflected in Disney's greater than 35% operating income decline for its film unit.

So infrastructure operations should be a good thing, you would think, since they provide more consistent revenue. Here, the problem is that the media companies are mostly invested in the wrong infrastructure. Satellite and broadcast TV both suffer from bandwidth restriction and a lack of two way communication. All media delivery is moving to the Internet, and all media will be inherently interactive. With truly high speed Internet, the kind you can only get with fiber optics, there's no need for any other form of Internet connection for fixed location, home or business, service.

Satellite and broadcast TV are living on borrowed time, the time required to build out a fiber optic system in the U.S. This is especially true since the government and mobile telecom operators covet the TV and satellite spectrum for mobile communications. In the fiber optic future, wireless communication will be reserved almost exclusively for mobile applications.

Even Comcast, which has a mixed fiber optic, coaxial cable delivery system, will be burdened with the death throws of a traditional TV broadcaster, and this will come at a time when it needs cash to finance the upgrade of its cable broadcast networks to fiber based interactive Internet.

The virtue of Time Warner's focus on content creation is that it safely insulates itself from the disruptive transition that is taking place in physical content delivery. In the fiber optic future, content is still king.

 

What Bezos Brings to the Washington Post

by Mark W. Hibben
8/6/13

Not Philanthropy

On its face, the purchase of the Washington Post newspaper by Amazon CEO Jeff Bezos appears to be a philanthropic good deed. For a mere 1% of his estimated net worth of $25 billion, Bezos takes a money loser of the hands of the Washington Post Company and frees it of the pressure to be profitable by taking it private. Bezos could have found a less worthy charity to support than an institution such as the Post.

But I don't write about charities, and in fact I don't think charity is what Bezos has in mind at all. Bezos is one of the few tech company CEOs who is an engineer by training, having graduated from Princeton with a degree in electrical engineering and computer science. He sees in the Post's predicament an opportunity, as he describes in his letter to the Post's employees:

"There is no map, and charting a path ahead will not be easy. We will need to invent, which means we will need to experiment."

Spoken like a true engineer. How will Bezos engineer a turnaround in this bastion of print journalism? The obstacles are daunting to say the least.

Lately, local newspapers have been passed around like unwanted orphans between prospective foster parents. No one really wants them, but they feel sorry for them. Just last week, the New York Times announced that it was selling the Boston Globe for a mere $70 million after having paid $1.1 billion for it in 1993.

The sale of the Post is just the latest example of a family owned newspaper being sold off. The Graham family controls the Washington Post Company (WPC) and Donald Graham, who is friends with Bezos, is CEO. The Grahams will continue to control the Washington Post Company, which will be renamed.

Even though the newspaper has been losing money, WPC overall is profitable. WPC had revenue of $959 million and operating income of $23 million in Q1 of this year. Besides newspaper publishing, the company has cable television and broadcast television operations, and the for-profit Kaplan University, its largest revenue source at $527 million in Q1. The newspaper has been the big money-loser, with a $34 million operating loss on revenue of $127 million in Q1.

Not surprisingly, investor reaction to the sale has been very positive, with the stock jumping over 4% the day following the announcement. Unburdening WPC of the newspaper's losses frees up considerable cash flow which could be put to better uses. The perception that this will unlock some additional value in WPC is probably justified, although the current valuation of the stock may not be. WPC shares are already up over 62% for the year, pushing the current P/E to 32. Although Don Graham shopped the newspaper in great secrecy, there has probably been a long standing perception that it would be put up for sale.

Faring Poorly in the Digital Age

Why have traditional print publishing companies such as the Post fared so poorly in the age of digital content. I'm not sure of the answer, although I am sure that understanding the answer will be key to any turnaround of the Post.

I don't think the answer is as simple as "failing to adapt to the new technology". The Post appears to have done all the right things. The Post has a modern, well designed news web site with a respectable ranking of 103 of all internet sites in the U.S., according to alexa.com. That puts it behind cnn.com at 16 and nbcnews.com at 50, but ahead of mashable.com at 177 and wired.com at 421. Ofcourse, there is also a Kindle digital version of the paper,as well as iPad and Android apps. It doesn't appear that the Post has missed the digital content boat.

While the Internet presents a broader competitive landscape, it also provides a way to reduce production and delivery costs of the paper's content, as well as reach a much wider audience. So what's wrong with this picture? More importantly, what is there for Bezos the engineer to fix?

Towards a More Dynamic Washington Post

An important clue to the answer lies in Bezos' background as a software engineer and in the amazon.com website. Amazon.com is what's called a dynamic web site. When you buy something on Amazon and are shown a page summarizing your purchase, that page was dynamically created by the web server just for you, with no human intervention.

Another important use for dynamic web sites is allowing users to create and display their own unique content in a web page which they can then share with others. Facebook and a host of similar social networking sites are good examples of this.

Yet another example of dynamic web page technology is Netflix, which presents a customized page (after you log in) showing what you've recently watched, as well as suggestions for other videos based on your viewing history. The page content you see is all driven by a data base on the web server that stores information about your viewing history.

Bezos the engineer, as an expert in dynamic web sites, sees an opportunity to "experiment" with the Washington Post. Is it likely that he wants to experiment with a new form of printing press? No. He wants to apply what he knows about creating dynamic web sites.

The various newspapers, including the Post, all make use of dynamic web site technology to build and maintain their sites, but their focus is mostly on moving content from the reporters to the site in a way that minimizes labor, via a content management system (CMS). Thus, when a reporter writes an article on his computer, the CMS moves it into the paper's site, creating a web page for it, replete with the appropriate title, navigation links, and advertising.

What the Post and most other news sites don't do is provide much in the way of user customization. You can log into the site and off to the side will be a box with a list of article suggestions, but other than this, the page you see is what everyone else sees. If you wanted to create your own page with just the articles you're interested in reading, there's no way to do that. The Post's tablet apps aren't much better.

Another important clue is in Bezos' own words, once again from his letter to Post employees:

"Our touchstone will be readers, understanding what they care about – government, local leaders, restaurant openings, scout troops, businesses, charities, governors, sports – and working backwards from there."

 

Apple's iPad Loses Market Share to Android

by Mark W. Hibben
8/5/13

Android is the Dominant Tablet OS

IDC's tablet market share data for the second quarter released today (8/5) confirmed that Apple has lost its dominance of the tablet market, going from a 60% market share in 2012 Q2 to a 32.5% share in Q2 2013. Google's Android has gone in the opposite direction, moving from a 38% market share last year to a 62.6% share in the current quarter.

The overall tablet market cooled off slightly. For the first time in over a year, the worldwide tablet market didn't post sequential growth with an 8.3% decline from Q1 to 45 million tablets shipped.

Tablet OS 2013 Q2 Unit Shipments (millions) 2013 Q3 Market Share 2012 Q2 Unit Shipments (millions) 2012 Q2 Market Share Year-over-Year Growth

1. Android

28.2

62.6%

10.7

38.0%

162.9%

2. iOS

14.6

32.5%

17.0

60.3%

-14.1%

3. Windows

1.8

4.0%

0.3

1.0%

527.0%

4. Windows RT

0.2

0.5%

N/A

N/A

N/A

5. BlackBerry OS

0.1

0.3%

0.2

0.7%

-32.8%

Others

0.1

0.2%

N/A

N/A

N/A

Total

45.1

100.0%

28.3

100.0%

59.6%


Apple has been the number one manufacturer of thin and light tablets since it created the category with the iPad and has been a principal driver of growth in the market until this quarter. Apple is still the number one manufacturer, with Samsung in second place at 8.1 million units shipped in Q2.

However, Google's Android is now the dominant tablet OS. In the span of a year, Android has gone from being second place to iOS to having a commanding lead, even though no single Android tablet maker can match Apple in unit shipments.

Competing Economic Models

This underscores the advantage of Google's Android business model. Google's Android ecosystem is like a market economy in miniature, with numerous Android device makers competing among themselves for market share, with little regulation from Google. The advantages of the Android ecosystem are the advantages of the market economy: consumer variety and choice, and an abundance of devices reflected in their relatively low cost.

The disadvantages of the Android ecosystem are likewise the disadvantages of a (more or less) unregulated market economy: fragmentation, uneven quality, and a lack of "consumer protection" for Android users. Android users having problems with either their hardware or software generally can't turn to Google for help, but are stuck with whatever support the device maker provides.

Realizing that this was a disadvantage, Google has been trying to change this, and we saw some signs of this at Google IO this year. Google has started to emphasize consistency of user experience and is trying to promote a uniform set of standards for Android device makers to adhere to in customizing Android. Google has also started marketing Android devices by other manufacturers, such as the Samsung Galaxy S4, with their own version of Android that Google will update directly.

Apple's iOS business model is like a centrally planned economy in miniature. Product decisions are made by a central authority, Apple, and there is no competition within the iOS ecosystem with respect to key products. How well this works really depends on the quality of decision making of the central planners. When good decisions are made, all is well, and the planned economy prospers.

When Jobs was in charge, Apple generally made good decisions. Now that Jobs is gone, many, including myself, are questioning the decisions of Apple's current leadership. But there is a more fundamental problem in the current iOS ecosystem in its very vulnerability to the decisions of Apple's management.

Apple's iPad Lull

Not releasing a new iPad in Q2 appears increasingly to be a strategic blunder, and I have to wonder why a new iPad wasn't released at the expected time. After releasing the 4th gen iPad only about half a year after the 3rd gen, investors and consumers naturally expected Apple to pick up the pace in product releases.

What has been holding up the 5th gen iPad? I believe this has been due to the lack of a next gen processor for it. Apple has introduced a new A-series custom System-on-Chip (SOC) with each succeeding generation of iPad. To be competitive, Apple needs a 4 cpu core SOC, since this has become the standard for high end smartphones as well as tablets.

Apple has yet to build a quad-core SOC and may have run into development problems. Another hint that all is not well in Apple's processor development area is the fact that Bob Mansfield, who had overseen SOC development as Senior Vice President of Technologies, was recently removed from his post.

Who was Mansfield's replacement? There's no indication he was replaced on Apple's Executive Profiles page. This may signal that Apple is moving away from in-house designed SOCs, or may simply reflect that a replacement for Mansfield hasn't been found.

Unleashing Innovation

As an Apple investor, I continue to be concerned about Apple's market share declines in it's flagship products, the iPhone and iPad. Apple's iOS tablet market share stood at 60.3% a year ago and has shrunk to 32.5%, according to IDC.

I often hear from young Apple fans who profess no concern about this. As someone who was around when Apple was nearly put out of business as the Mac OS ecosystem collapsed in the mid-90's, I'm not so sanguine. At some point, and it's difficult to say when that is, Apple's market share decline will threaten the health of the iOS ecosystem and Apple itself.

But I continue to be optimistic about Apple's Fall product introductions, as well as its long term future. Apple appears to be accelerating R&D spending. This is critical in order to roll out new products faster, which Apple needs to do in order to retain or gain market share. Apple's $130 billion in cash has the potential to unleash an unprecedented wave of innovation in consumer electronics, if Apple's leadership would only commit to using the cash for this purpose.

 

Apple's Ebook Intransigence

by Mark W. Hibben
8/5/13

Playing to the Fan Base

In my previous writings on Apple's ebook trial, I warned that losing the trial could lead to a much wider ranging investigation into Apple's iTunes business. On Friday (8/2), the U.S. Department of Justice proposed just such an investigation as part of its "remedies" for Apple's anticompetitive ebook practices. This investigation will take the form of an external anti-trust monitor to be installed at Apple who will conduct wide ranging surveillance for a period of ten years of Apple's digital content businesses, music, video, apps as well as books.

Why did the DOJ take this approach rather than simply opening its own new investigation of Apple? That's easy. This way, the ever budget-conscious U.S. government will get Apple to foot the bill.

Rather than realistically thinking through Apple's legal position and its consequences, the Apple sympathetic portion of the tech media has exhibited all the classic symptoms of denial. For instance, the Mac Daily News take on the DOJ proposals:

"There is no evidence that Apple conspired to fix ebook pricing and the U.S. DOJ is plainly inept."

As I've pointed out in the past, the mounds of evidence the Government assembled for the case are there for all to review on the DOJ's web page. I doubt that anyone at Mac Daily News has done so.

Apple friendly journalists such as Philip Elmer-Dewitt have sometimes gone to great lengths to paint Apple as the aggrieved party. In their eyes, Amazon was the wicked monopolist engaged in "predatory" e-book pricing before Apple came to the rescue of the book publishers. One of his recent posts on the DOJ's proposed remedies contains an outright misstatement of the government's proposals. He writes:

"Among other things, the DOJ is demanding that Apple let Amazon and Barnes & Noble sell their e-books on Apple's online store for two years without paying the 30% commission Apple has charged pretty much every other content provider since it launched the iTunes Music Store in 2003."

In fact, the government's proposal is much less onerous. Quoting from the Proposed Final Judgement:

". . . Apple shall allow any E-book Retailer to provide a hyperlink to its website ore-bookstore in or through its E-book App without . . . compensating Apple for any sales of E-books that follow consumers’ use of such hyperlink. . . "

As the DOJ makes clear in an accompanying memorandum, the purpose of the provision is to undo a step that Apple took in 2011 forbidding ebook apps such as the Amazon Kindle from providing links to on-line ebook stores. Apple is not being required to sell books through the iBookstore at a loss, nor is it being required to sell ebooks from competing retailers such as Amazon on its own iBookstore.

What Apple is being required to do, among other things, is abrogate the "agency model" contracts that guaranteed Apple a 30% commission on every ebook. These contracts were found to be instruments of illegal price fixing, so naturally, the government isn't willing to let them stand. What exactly will replace them remains to be seen.

Apple's agency model replaced the wholesale distribution model for ebooks throughout the ebook industry once the iBookstore was established. In the agency model, the bookseller takes a fixed percentage commission (Apple's was 30%) for each book sold, while the publisher determines the retail price of the ebook. In the wholesale distribution model, the retailer paid a wholesale price to the publisher, but was free to charge any retail price, even taking a loss.

Taking a loss on ebooks was precisely what Amazon was doing in many cases prior to the advent of the iPad and the iBookstore. Among the many ironies of this case, publishers actually made more money under the wholesale model, while Amazon lost money. When Apple and the publishers colluded (according to the DOJ) to impose the Apple agency model on retailers such as Amazon, publishers made less money per ebook, and Amazon made more, since it was no longer allowed to take a loss on its ebooks. The publishers were willing to do this because they feared the impact of Amazon's discounted ebooks on their physical book business.

Was Amazon's "predatory" pricing anti-competitive under the Sherman Antitrust Act (SAA)? No. Businesses are free to take losses on products, and loss-leaders occupy a time-honored position in retailing. The Federal government's power to regulate interstate commerce, granted by the Constitution, does not extend to mandating that businesses be profitable.

The Path Forward

As an Apple investor, iOS developer, and admitted fan, I would really like to see Apple put this behind it. Unfortunately, the best way to do that at this stage is for Apple to admit it screwed up. The continuing denial of any wrongdoing by Apple's leadership is only making matters worse. The DOJ specifically cited the "intransigence" of Apple's executives in justifying the need for the external compliance monitor:

"Appointment of an external monitor is appropriate here because Apple’s executives refuse to accept responsibility for their wrongdoing: they have consistently held to the view that their conduct was appropriate, and that they intend to do nothing differently in the future."

The DOJ memorandum also confirmed my misgivings that Apple's "business as usual" defense of the agency contracts would blow up in its face:

"The evidence at trial established that Apple aided the Publisher Defendants in forcing Amazon, its rival, to increase the prices at which it could sell content. . . And Mr. Cue testified at trial that he takes the same approach in each of the digital content markets where he negotiates distribution deals."

The External Monitor's (EM) power to review Apple's business practices in any digital content area is quite sweeping. The EM may review any document, interview any employee in furtherance of the EM's mandate to ensure Apple's future compliance with SAA. Apple lawyers called this "a draconian and punitive intrusion". Yes. It's supposed to be.

When I first wrote about the case, I was concerned about the effect of an adverse ruling on Apple's already depressed share price. Fortunately, that hasn't happened, but in part this is due to the denial phenomenon I describe above. Now that investors are starting to realize how this could adversely affect Apple's larger digital content business, I expect some negative blow back, with share prices settling back into the $400-425 range I predicted in my Q2 Apple earnings preview.

Hopefully, not for long. After all, Microsoft had to endure similar external monitoring as part of the Final Judgement in U.S. v. Microsoft.