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Barbarians at the Gates of Apple

by Mark W. Hibben
11/7/2011

Time to Think Really Different

There’s nothing like a stable, prosperous, and orderly empire to attract hordes of envious “barbarians”.  Often the so-called barbarians aren’t much different from the imperial citizens, except that they’re on the outside looking in.  Apple’s mobile device empire is stable, happy and prosperous, and quite possibly at the zenith of its glory and power.  From inside the walls of Apple’s iOS, the barbarian hordes seem disorganized and uncouth, but what these outsiders (mostly Android) lack in sophistication, they more than make up in brute force and sheer numbers.  And their population is exploding.  As I pointed out in my recent review of Google’s third quarter results, Android devices were activated at the average rate of 600,000 per day in the most recent quarter, whereas Apple shipped iOS devices at an average rate of nearly half that, 319,000 per day.  Apple must change if it is to survive the coming onslaught, and now is the best time to effect such change, while its coffers are overflowing and the siege not yet begun. 

Earnings Scorecard

In last quarter’s review of Apple’s financial report, I offered for the first time an estimate of their fiscal Q4 (which ended in September) financial performance. 

For my first outing, I didn’t do too badly, handily beating the blogger consensus, which was way too bullish.  For once, the analyst consensus didn’t underestimate Apple earnings, but their usual conservatism got them closer than anyone else, as the summary table shows.

Category Fiscal Q4 2011 % Change Q4 2010 % Change Q3 2011 Apple Guidance at Q3 '11 MH (at Q3) MH % Error        (at Q3) Blogger Consensus Apple 2.0 The Street, Thomson Financial
Revenue (US$B) 28.27 39.0% -1.1% 25 30.76 8.81% 33.47 29.45
Earnings (US$B) 6.623 53.7% -9.4%   7.4 11.73%    
EPS (US$/diluted share) 7.05 51.9% -9.5% 5.5     9.07 7.28
Gross Margin (%) 40.3 9.2% -3.4%          
Mac Unit Sales (M) 4.894 26.0% 24.0%   4.1 -16.22%    
iPhone Unit Sales (M) 17.073 21.1% -16.1%   20.4 19.49%    
iPad Unit Sales (M) 11.123 165.6% 20.3%   12 7.88%    
iPod Unit Sales (M) 6.622 -26.8% -12.1%   6.7 1.18%    

 

I’ll take a 9-12 % error on revenue and earnings anytime.  As is usually the case when a company misses the consensus earnings estimate, it was somehow regarded as Apple’s fault.  I will not resort to such excuses for my estimate error.  Where did we all go wrong, bloggers and analysts alike?  Basically, we were all expecting Apple to roll out a new iPhone in the fourth quarter. 

If Apple had done so, and if they had been able to meet demand, there would have been no sequential decline in iPhone sales and revenues, and Apple would have exceeded my revenue and earnings expectations.  In Q4, iPhone unit shipments declined sequentially 16% to 17 M units, while revenue declined sequentially 18% to US$ 10.98 B.  For whatever reason, Apple wasn’t able to build up enough channel inventory in time for Q4, so rather than antagonize customers with short supplies, they simply pushed to release date into their fiscal Q1 2012.  This was a good call regardless of the financial impact.  Why Apple could not deliver the iPhone 4S in Q4 is perhaps the more interesting question, given the relatively modest changes to the phone.  Probably, critical components that are shared with iPad 2, such as the A5, were in short supply.  This may even have been a consequence of the Japanese earthquake and tsunami, which Apple indicated might have an impact in Q4.  Things might have been worse had it not been for the surprising strength of Mac unit sales, the only area where I underestimated unit volume.  As stated in the financial conference call held on 10/18/2011, most of this strength comes from sales of Mac laptops, especially the latest Macbook Air, which finally got the second gen Core i processors they have long needed.  Macs are clearly enjoying a halo effect as a result of the popularity of iOS devices, something Microsoft can only envy as it contemplates stagnant Windows PC sales. 

Apple continues to execute their strategy of expanding in emerging markets, including the Middle East, South America, and China.  Year over year segment growth wasn’t quite as explosive as last quarter, and Japan even showed modest y/y revenue and operating income declines, but Asia Pacific continues to grow robustly.

Segment Fiscal Q4 2011 Revenue US$ B % Change Q4 2010 Revenue Fiscal Q4 2011 Op. Income US$ B % Change Q4 2010 Operating Income
Americas 9.648 34.26% 3.288 55.98%
Europe 7.397 35.53% 3.114 50.65%
Japan 1.111 -20.70% 0.485 -26.63%
Asia-Pacific 6.530 139.02% 2.718 148.45%
Retail 3.584 0.50% 0.679 -25.95%

 

The Retail Segment showed some weakness, however, with flat revenues and declines in operating income.  The income decline is probably the result of preparations to open 40 new stores in 2012, as well as greatly expand many existing stores, as disclosed in the conference call.   We can expect Apple’s retail segment to be quite strong in the coming quarter, which includes the Holiday season. 

Mobile Device Population Update

As I do every quarter, I’ve updated my worldwide iOS and Android population estimates with data provided by Apple and Google.  With Apple this has always been an easier process, since they provide specific shipment numbers for each of their product categories every quarter, as well as providing a cumulative shipment total for iOS devices.

As of the end of the fiscal year, that number stood at “over 250 M” according to Apple, which I assume in my calculations to be 251 M. Factoring in a 10% replacement rate as new models replace old ones, I estimate the current worldwide population of iOS devices (devices in use) to be 235 M versus the current worldwide population of Android devices, estimated to be 173 M. Apple still has a substantial lead in device population, but the really bad news for Apple is the rate at which Android is growing relative to Apple.  As I pointed out in the beginning of the article Google activated an average of over 600 K Android devices per day versus Apple’s average shipment rate of 319 K iOS devices per day over the last quarter, and I project the Android activation rate to approach 700 K/day in the next quarter.  For the final calendar quarter of the year (Apple’s fiscal Q1), I expect Apple to ship an additional 38 M iOS devices for total cumulative iOS shipments of 289 M or an average shipment rate over the quarter of 418 K per day.  Factoring in the 10% replacement rate, I expect the iOS device population to be 271 M.  In the same period, I expect Google to activate an additional 63 M Android devices for a total cumulative Android activation number of 253 M or an average activation rate over the quarter of 692 K per day.  Factoring in the 10% replacement rate, I expect the Android population of be 233 M.

It doesn’t take a math genius to see where this is heading, but why does it matter that one or the other device type becomes predominant in terms of population?  As Stephen Elop put is so succinctly, this is “a war of ecosystems”, and numerous virtuous cycles take hold when one particular ecosystem becomes dominant.  Selling the device is just the beginning of the revenue generating process for both Google and Apple.  Each device type has built in numerous mechanisms that tend to direct the user’s attention and purchases to the marketplaces preferred by the respective companies, such as iTunes, the App Store, etc.  The devices are a means to the end of capturing and holding the commercial attention of the user, as well as a direct source of revenue.  As the ecosystem gets larger, the increased revenue in turn allows the company to both enhance the desirability of the company’s hardware and software offerings as well as reduce unit costs through traditional economies of scale.  Furthermore, both the Android and iOS ecosystems are now so large that they are in competition for scarce resources such as displays, RAM, and flash memory, and being bigger affords some advantage in securing long term supply contracts.  While neither Apple nor Google may be able to get a strangle hold on the other, other competitors such as Microsoft and RIM may find the going much harder. 

I’ve long considered RIM utterly doomed, but Microsoft has a shot at achieving a reasonably secure third place if they can make the Windows 8 strategy work. 

Thinking Different

The best time for a company such as Apple to respond to a challenge such as is posed by Google is when the company is still on top.  That time is now.  Not next year, not even next quarter.  Now.  Unfortunately, generating a sense of urgency in the midst of the enormous success Apple has enjoyed of late can be rather difficult, but it’s likely that Apple management, looking at the same data that we’re looking at, have reached a similar conclusion.  Something must be done.  The question is what.  Unfortunately, it appears that Apple’s answer is to just do more of the same, only faster: open more stores, expand faster in emerging markets, ramp up production, but otherwise not change anything else in what has obviously been a very successful formula.  This kind of inertia is typical of corporate management, which tend to stick with the tried and true until confronted with a financial crisis.  Usually, by the time the crisis hits, it’s already too late, and the management end up grasping at straws.  Thus HP belatedly realized that Windows Mobile wasn’t making it, so they bought Palm.  Later they abandoned their Palm OS based tablet when it became apparent that they couldn’t afford the investment required to compete effectively. 

So the Prime Directive in Apple’s Different Thinking should be: Don’t Wait Until it’s Too Late!  It sounds perfectly obvious, but this is by far the most difficult step that corporate management have to take.  The Second Directive should be: Don’t Assume that Doing Nothing is the Lowest Risk Course of Action!  Even when you can get a corporate management to confront an impending crisis, they almost always end up “racking and stacking” the available options in terms of risk, and deciding that doing nothing (or next to nothing) is the safest option.  It almost never is.  In fact it’s usually the option guaranteed to fail. 

So what do I think Apple should do?  First of all, I don’t think that a wholesale restructuring of Apple’s business is in order.  Above all, Apple should not abandon their highly integrated approach to devices in general, whether Mac or iOS, in which they provide OS, hardware and many apps.  This is a huge advantage in the mobile device space, and they should continue to build on it.  It’s in Apple’s corporate DNA.

Here’s my short list of things Apple should do:

1)  Diversify the iOS device product line.   Apple management get probed about this almost every quarter at their conference call, and the usual response has been to say something like “we just want to build the best phone (or tablet) that we possibly can” as if to offer consumers genuine choice in these product categories is somehow unthinkable.  I’m sure Apple still wants to build the best personal computer they possibly can, but that doesn’t stop Apple from offering Macs in a wide variety of form factors and price points.  For the low cost Mac option, there’s the Mini.  For the high end workstations, there’s the Mac Pro.  For laptops there are the MacBooks and Airs.  Furthermore, Apple management haven’t tried to offer obsolete Mac models as the only lower cost options for Mac, the way they continue to do for iPhone.  Like the Mac, iPhone and iPad should be offered in three different form factors and price ranges starting with “Pro” versions:

iPhone “Pro” featuring a larger 4.5 inch diagonal 1280x720 AMOLED display, HDMI port, dual core A5 1+GHz processor, Facetime HD front camera, larger battery.

iPad “Pro” featuring a 12 inch diagonal 1920x1080 LCD display, HDMI port, quad core 1 GHz processor, Facetime HD camera, larger battery.

For the mid range, Apple can go with updated versions of what they have right now:

iPhone 5 featuring a larger 4 inch diagonal retina display, redesigned impact resistant case, larger battery, Facetime HD camera, dual core A5 processor at 1+ GHz.

iPad 3 featuring a 10.1 inch diagonal higher resolution 1280x960 display, dual core A5 1+ GHz processor, Facetime HD camera.

For the low end, clearly Apple needs to do more than just provide last year’s models:

iPhone “mini” featuring a 3 inch 600x400 pixel display, single core A4 processor, ultra slim design, Facetime standard resolution camera.

iPad “mini” featuring an 8 inch diagonal 1024x768 display, single core A4 processor, ultra slim design, Facetime standard resolution camera. 

The specific features listed above are obviously subject to much variability.  The intention was to give some idea how the product ranges could vary by feature set.  Variety is one of the few areas where the Android ecosystem currently enjoys an advantage over iOS.  If Apple management do nothing else to address the Android challenge, they should at least diversify their iOS product line.  If they haven’t begun already, Apple could start now on these products and have them in production by the Spring of 2012 and on store shelves by the Summer, since they are so derivative of current products. 

2) Put that cash to work.  Apple now has amassed a pile of cash and marketable securities worth over US$ 81 B, which is more than the annual GDP of many small countries, including Libya, Costa Rica, and Bahrain, as of 2010.  I can’t believe that Apple management pat themselves on the back for their thriftiness in sitting on this pile quarter after quarter.  At the latest conference call, analysts once again probed Apple about what they might do with the cash, and for once, Cook evidenced some flexibility regarding a dividend or stock buyback, which apparently were unthinkable under Jobs.  While I would personally welcome such an action, I actually don’t think this is where the emphasis should be. 

Apple should be using this cash to enhance their competitiveness.  Some have talked about Apple buying ARM holdings, but as I’ve pointed out in the past, European and US regulatory approval would be contingent on maintaining ARM’s status as a merchant vendor of processor IP.  Apple would be specifically precluded from denying competitors access to ARM designs, as well as being firewalled from ARM engineers to prevent gaining a competitive advantage through insider knowledge.  Owning ARM would actually disadvantage Apple by making access to ARM technical support more difficult.

Recent reports have indicated that Apple has been investing in greater chip design capability, which I have advocated since early 2010, but from the growth of the cash pile, that investment appears to be very modest.  Apple bought chip design houses PA Semi and Intrinsity in order to build up their hardware IP portfolio as well as acquire needed engineering personnel.  Both companies specialized in high performance low power processors such as Apple needs for tablets and phones.  More recently, Apple lead a consortium that bought the patent portfolio of now-defunct Nortel, beating out Google.  With these three acquisitions, and its continuing hiring in the processor design area, Apple probably has the requisite IP and talent to design their mobile processors from the ground up, rather than merely license ARM designs, but there’s no indication they are doing so.  Apple seem content to stick with ARM, even though doing so means that Apple’s hardware development will tend to be paced by ARM processor development, along with the rest of the industry.  I believe that Apple lacks the necessary leadership in the area of processor development to make a truly Apple unique processor a reality.  Apple needs to buy more processor design experience and leadership capability.  Apple needs to buy nVidia.  For a mere US$ 8.1 B dollars, barely a tenth of Apple’s current cash reserves, Apple could own the premier graphics chip design house, as well as one of the best ARM processor design houses, as well as the maker of the first quad core ARM processor to enter production.  nVidia is a great match for Apple that enhances its hardware/software vertical integration, and which very effectively counters Google’s impending acquisition of Motorola.  With nVidia, Apple could become nearly impregnable in the areas ultra-mobile computing, both for Intel and ARM based systems.  Most importantly, nVidia could provide Apple with the critical mass it needs in IP and engineering talent to achieve unique processor designs that give it a genuine competitive advantage over the rest of the mobile device industry.

3)  Develop a touch-screen enabled version of Mac OS X.  OS X Lion is already touch enabled, but Apple have refrained from taking the final step of offering some of their Macs with touch screens.  This seems to reflect Jobs’ conviction that touch screens are not useful for desktop computers.  Jobs made the point more than once, that users quickly get tired of vertically mounted touch screen devices, which I’m sure is true, as far as it goes.  But why assume such devices must always be vertically mounted?  Microsoft have not.  Since the Microsoft FAM, I’ve been thinking about Microsoft’s Intel tablet strategy, and I’m convinced that this is a potentially important market segment that Apple should not deny itself. 

I believe that people will want tablets equipped with Intel mobile processors that can be used as full powered desktops as well.  I think a touch screen enabled Macbook Air would be a big seller, especially if the keyboard were detachable.  As much as I like Apple’s track pads, I think touch screens would be even more desirable for their laptops.  Offering an Intel based Mac OS tablet/laptop hybrid would effectively counter Microsoft’s Windows 8 strategy. 

How much hope do I have that Apple will take the three steps I’ve outlined above?  Unfortunately, not very much.  Apple management seem to be having difficulty doing anything that deviates from the path established by Steve Jobs.  Item 1) has the best chance of implementation, since it fundamentally applies what Apple have been doing for years with the Mac line to iOS devices, and therefore doesn’t really represent a departure from current Apple practices.  Item 3) is almost as likely as 1), since Apple have been moving in this direction with OS X Lion in any case.  But Apple management still have to get over the Jobs thing, and they may not be able to bring themselves to do so until Windows 8 comes out.  If Windows 8 is at all successful on Intel tablets, it will push Apple into a touch screen enabled OS X.  Item 2) is the long shot.  As logical as it is, it will be hard for Apple to buy what largely amounts to a Windows PC hardware supplier.  In this, Apple management need to swallow their pride and embrace the opportunity.

Projections for Next Quarter

Regardless of what Apple decides to do in 2012, I fully expect Apple to have a great holiday season, so that their fiscal Q1 2012 will set new revenue and earnings records for the quarter.  Apple's Q1 is traditionally their strongest, but this season will be particularly good. See the next panel for a my specific revenue, earnings and unit sales projections.

Category Fiscal Q1 2012 Fiscal Q4 2011 % Change from Fiscal Q4 2011 Fiscal Q1 2011 % Change from Fiscal Q1 2011
Revenue (US$B) 34.50 28.27 22.0% 26.74 29.0%
Earnings (US$B) 7.85 6.62 18.5% 6.00 30.7%
Mac Unit Sales (M) 5.50 4.89 12.4% 4.13 33.0%
iPhone Unit Sales (M) 22.00 17.07 28.9% 16.24 35.5%
iPad Unit Sales (M) 12.00 11.12 7.9% 7.33 63.7%
iPod Unit Sales (M) 16.00 6.62 141.6% 19.45 -17.7%
  • 1.
    At the Gates
  • 2.
    Earnings Scorecard
  • 3.
    Segment Revenues
  • 4.
    Mobile Growth
  • 5.
    Eco- systems
  • 6.
    Thinking Different
  • 7.
    iOS Diversity
  • 8.
    Cash to Work
  • 9.
    Mac OS Touch
  • 10.
    Hope for Change?
  • 11.
    Next Quarter
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