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Apple Formula 1

by Mark W. Hibben

Apple “Firing on all Cylinders” Again, According to Jobs

Apple once again had a blow-out quarter, as Tim Cook, COO, and Peter Oppenheimer, CFO related at the analysts’ conference call on 4/20/2011.  Although there were sequential revenue and earnings declines from Apple’s Q1 2011, which includes the normally strong holiday buying season (2010), it was still the best Q2 ever for Apple, with year-over-year revenue growth of almost 83%.  Firing on all cylinders?  Apple is like a Formula 1 race car, while the other tech companies are mere Fords or Chevys.  Now that Apple has demonstrated that it can sustain the earnings that seemed mere flukes a quarter or two ago, the tone of the analysts has gone from moderately positive to reverential.  So many of their questions were prefaced with the phrase “help us understand. . .”

Q 2 2011
Actual % Change Q2 2010 % Change Q1 2011 Apple Guidance at Q1 '11 Blogger Consensus Apple 2.0 The Street, Thomson Financial
Revenue ($B) 24.67 82.7% -7.7% 22 25.34 23.34
Earnings ($B) 5.99 95.1% -0.2%      
EPS ($/share) 6.4 92.2% -0.5% 4.9 6.33 5.36
Gross Margin (%) 41.4 -0.7% 7.5%      
Mac Unit Sales (M) 3.76 27.9% -9.0%      
iPhone Unit Sales (M) 18.65 113.1% 14.8%      
iPad Unit Sales (M) 4.69 NA -36.0%      
iPod Unit Sales (M) 9.02 -17.2% -53.6%      

Mystified Analysts

Clearly, analysts still don’t comprehend Apple’s Formula for success, so that their prognostications consistently fall short of reality.  My readers who have been following me since the iPad Saga days will not be so mystified.  In a very real sense, Apple is only doing what they have always done so well, provide beautifully integrated software and hardware personal computing solutions.  The fundamental difference is the competitive arena.  In the desktop marketplace, especially as it existed in the late 80’s and early 90’s, Apple’s highly integrated Macs succumbed to the onslaught of the commodity PCs partly because Apple’s hardware/software integration approach failed to be compelling to consumers.   Many consumers wanted more choice in hardware, software and combinations thereof than Apple provided.  In the mobile computing marketplace, Apple’s highly integrated approach is much more compelling.  Consumers don’t really want to be able to customize their smart phone hardware or operating systems, and variety in software is all in Apple’s favor, at least for the time being.  Equally important, Apple mobile devices can compete on price in a way that the early desktop Macs never could.  The early Macs were made in the US and were beautifully made at that, but they were also very expensive.  Having off-shored production of all Apple computing devices and having achieved very high production volumes, Apple can compete with commoditized smart phones and tablets on price.  Is victory in the War for Mobile Internet Supremacy (WMIS) thereby assured?  Not quite.  Not yet.

War of Paradigms

When Nokia CEO Stephen Elop announced the strategic alliance with Microsoft for Win 7 Nokia Phones, he called the WMIS a “war of ecosystems”, but it can also be called a war of paradigms.  The Google Android consortium closely follows the Windows PC paradigm that once so thoroughly defeated the Apple Mac paradigm.  Android has the additional cost advantage that Windows didn’t have in that it’s supported by advertising revenue and is therefore “free” to the consumer.  Android may not provide as high a quality of user experience as iOS, but then, neither did Windows, and Windows won anyway.  Windows eventually dominated by sheer numbers, and Android seems to be winning on the basis of numbers as well. In the most recent quarter, Apple shipped about 27.9 million iOS devices while in the same period about 31.5 million Android devices were shipped, according to Google. 

As the chart shows, the worldwide population of iOS devices is still considerably larger than Android, mainly due to Apple’s two year head start, but Android appears to be slowly catching up. 

During the conference call, one analyst even drew the analogy between the Android vs. iOS and PC vs. Mac.  This elicited a number of statements from Tim Cook.  First, Cook pointed out that iOS “outreaches” Android worldwide by 59%, which is actually slightly less than the population difference I estimate.   I estimate that the worldwide population of iOS devices stands at 185 million vs. 113 million for Android, or 64% greater.  Cook also pointed out that Apple continues to make inroads in the corporate world with 88% of the Fortune 500 testing or deploying iPhone, and here Apple’s major competitor is not Android but RIM.  Finally, Cook reiterated that Apple’s approach is “integrated” rather than “fragmented” as is Android, a characterization that goes back to the early PC vs. Mac days.  Cook insists that consumers “don’t want to be systems integrators” for their phones, but if he thinks that this is what owning an Android device amounts to, then he’s ignoring the 350,000 people who activate Android devices every day. 

As was the case in the PC vs. Mac wars, I suspect that quality of user experience may not be as decisive as Apple executives hope and that variety and choice in hardware and software (including OS) are also important to the consumer.  But in the end, it will really come down to price.  Consumers pretty consistently vote their pocketbooks and are usually willing to accept some minor inconvenience on behalf of saving money.  Here, the differences in manufacturing approach between the Google and Apple paradigms may be crucial

Competing Economic Systems

The group of Android device manufacturers amount to a sort of freewheeling market economy of smartphones and tablets.  No central authority tells the manufacturers what to make or how much product to make.  The manufacturers come up with their own designs, manufacture and sell them to consumers in competition with each other and with the world of mobile devices in general.  The price that the manufacturers set is determined by the marketplace.  It may seem that this market economy of Android devices is chaotic and inefficient, but we know that market economies in general usually produce a rational allocation of resources and rational outcomes in terms of consumer preference for one product over another. 

In contrast, Apple and its business partners look very much like a planned economy in miniature. Decision making regarding products is centralized and monolithic.  There may be competition between different companies to be a supplier for a particular component, but the planning requirements for Apple’s products tends to work against competitive outsourcing.  Apple will sign a long term contract with a particular (probably a single) manufacturer for the iPhone or iPad, then that manufacturer will sign long term contracts with component suppliers in turn.  Generally, everyone will prefer to keep working with whomever they already know and trust.  Even though Apple is no longer the manufacturer of its products, that doesn’t mean that Apple can just get their manufacturing partners under contract and leave it at that.  Such manufacturing contracts require very close and careful supervision and monitoring by the Prime, in this case, Apple.  This is because manufacturers can be extremely clever in cutting costs while still meeting the letter of their contracts.  The net result is often a product that doesn’t really meet the needs or intentions of the Prime.  To forestall this, Primes develop large internal bureaucracies for purposes of contract and “supply chain” management, and Apple is no exception. 

To be sure, the Apple economy is remarkably efficient, as centrally planned economies go.  This may be due in large part to the competitive pressure exerted by the larger market economy in which Apple operates.  Nevertheless, the Apple economy is exhibiting some of the characteristics of planned economies, namely shortages.   In the most recent quarter, iPad deliveries fell to 4.7 M from 7.3 M for Q1 2011. 

As Tim Cook admitted in the conference call, Apple simply failed to anticipate the extent of demand for the iPad 2.  A common failing of planned economies, and this isn’t the first time it’s happened.  There was a similar shortage at the introduction of the iPhone 4 last year.  It may also be that Cook was being a little disingenuous about the iPad 2 shortage.  Apple may have chosen to release the iPad 2 early, knowing that they had inadequate inventory built up at the retail level, simply to counter the recently released Motorola Xoom.    

The recent earthquake and tsunami in Japan have put especial pressure on Apple’s supply chain management.  Apparently they’ve been able to keep the Apple manufacturing economy going without interruption for the present and the near term (through Q3), but Cook admitted a couple of times to risks in the Fourth Quarter (which will end September 30).  Cook insisted that there weren’t any unknown or unsolvable problems, and the analysts appeared satisfied, but here’s how I read the situation.  When the quake struck, Apple’s manufacturers had enough parts inventory to last through the end of June (end of Apple’s Q3), but after that, if the Japanese parts suppliers aren’t back on line, or substitute suppliers found, things get dicey.  As Cook stated, Apple employees are working “around the clock” to assist suppliers (yes, this is all part of “supply chain management”) to alleviate any shortages.  It remains to be seen how successful they will be. 

The reader should not construe this depiction of the “Apple economy” as criticism per se.  I’m really just trying to show how very different the Apple and Android paradigms are.  Certainly, if Apple and its manufacturing partners were a single (very large) company, no one would fault Apple for centralized decision making and coordination.  As long as Apple makes good decisions about products, as they have done, the Apple economy thrives.  However, the Apple economy is also more vulnerable to the consequences of poor product decisions, by virtue of the lack of diversity of its products.  For instance, Apple only has one basic model of iPhone (with minor variations).  If a future model happened to flop, Apple revenues would surely suffer.  In contrast, if an Android manufacturer has a flop in a particular Android device, the effect on the Android economy is relatively minor.

Decisions and Diversity

Apple’s vulnerability to its own decision making is the thing that bothers me the most about the Apple Formula.  Especially since that decision making seems to come down to one exceptional man, Steve Jobs, known to be in frail health.  Unfortunately, it does appear that Tim Cook is the heir apparent to Jobs, and while he has been thoroughly inculcated in Apple orthodoxy, he doesn’t have the vision to see beyond the next quarterly report.  Well, visionaries are hard to come by, so Apple and its investors will have to make do with Cook for the foreseeable future.  Under the circumstances, the best way for Apple to protect itself would be to diversify its product line.  This would be a good use for some of the US$ 65.7 B in cash Apple is currently sitting on.  Yes, the cash pile grew again, by about US$ 6 B this quarter.  According to the 10Q, US$ 23 B is in corporate securities, which could give Apple major stakes in many suppliers and partners, so the Apple economy may amount to a more integrated single company than appears at first glance.  But Apple still has plenty of cash to throw around, and product diversification should be a top priority.  Hopefully, this is a decision Cook will be able to take some time soon. 

  • 1.
    Apple Formula
  • 2.
    Paradigm War
  • 3.
    Catching Apple
  • 4.
    Systems Compete
  • 5.
    Strained Suppliers
  • 6.
    Decisions Diversity
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