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The Network Effect's Impact on Software Platforms

The network effect is the single most important determinant of the success of a software platform. It was the primary driver of the Windows operating system's monopoly. No software platform has ever succeeded and endured without a self-reinforcing network effect driving value creation and increasing participation and profitability.

Defining the Network Effect

The network effect is a virtuous cycle ("a complex chain of events that reinforces itself through a feedback loop") of value creation as more users participate. On a software platform, this occurs when developers and service providers create software and services to run on the platform. The added software and services increase the value of the platform and attract new users. New users buy more software and services and thus a virtuous cycle of ever-increasing platform value is created - the network effect.

Powering the Network Effect

This virtual cycle of value creation does not occur unless the primary platform stakeholders engage in ongoing commercial activity with each other. Developers and service providers must find it profitable to supply an increasing quantity and quality of software and services to run on the platform. They will only do this when the platform users are active purchasers of the offerings.

Simply put, developers and service providers must prosper financially to add value to the platform. As platform users buy software and services, developers and service providers are incentivised to create more offerings. The engine of this process is the platform users actively purchasing the offerings being provided.

New users will choose the platform that has the best software and services. So, as more and more users join the platform, the financial opportunity for the developers and service providers grows as the number of potential customers increases. Again, the consumers attracted to the platform must be "paying customers," with the desire and the means to engage in ongoing platform commerce.

Platform Dominance

The software platform with the richest offerings of software and services becomes dominant. The increase in the platform's value rises much faster than the cost of providing the value, accelerating the positive feedback loop. The process continues building more and more momentum until the platform's value proposition becomes so compelling to prospective customers, an inflection point is reached. The dominant platform continues to inexorably strengthen while the competition starts to actively weaken.

Investment Thesis

Apple's (AAPL) position in the Post-PC mobile industry will continue to become more and more dominant as their platform and ecosystem accelerates in popularity. The majority of new customers joining Apple's ecosystem will continue to power the engine of the network effect through their desire and ability to engage in ongoing platform commerce.

The most important takeaway is that Apple will continue the capture the majority of the Post-PC mobile industry's profits. This makes Apple the investment opportunity of this generation.

Mistaking Android Market Share for Platform Value

Market share is mistakenly being used by Wall Street as a proxy for platform value and dominance. According to comScore, as of November 2012, Android is ahead in market share at 52.6% versus Apple at 34.3%. However, Apple generated 71% of the entire mobile industry's operating profits, according to Canaccord. In any other industry, the analysis would end right here, as investors and analysts would never seriously contend that market share is more important than profit share.

Let's examine Android's high market share: 1) Google (GOOG) subsidizes Android for the OEM manufacturers; 2) OEMs subsidize Android sales made by the carriers, and 3) Carriers provide "spiffs" to incentivise salespeople to sell Android devices. Android market share is further enhanced because Android is replacing, at no cost to the consumer, a substantially inferior product - feature phones.

Market share "success" under these conditions will prove to be a fleeting phenomenon, as no meaningful platform advantage exists. The reason the Android platform does not have a self-sustaining network effect is because it lacks a meaningful financial opportunity for developers and service providers. The type of consumer that purchases Android is looking for free deals and has little interest in making ongoing purchases. In fact, Android's overriding appeal is to consumers with an aversion to spending money. In contrast, Apple's platform is designed to attract those consumers who enjoy buying things, especially nice things. This is why Apple's customers are so valuable to Apple's developers and service providers, whereas Android presents developers with little profit opportunity.

The basis of competition within the Android marketplace will continue to make the platform unattractive to developers. Android phones are manufactured by OEM hardware manufacturers and sold through the telephone carriers. The majority of Android phones currently being sold run old Android versions - two or three versions back. The software on these phones will probably never be updated. They cannot run the newest Android applications. The only conclusion that can be reasonably drawn is that these phones are being purchased by consumers for use primarily as advanced feature phones, not as a mobile computing platform.

This problem is not easy to solve. Carriers and manufacturers are incentivised to maximize their profit margins and are not motivated to provide the consistent application platform needed by developers. Carriers profit by marketing all Android phones as "smartphones" (meaning mobile computing platforms). Manufacturers make "smartphones" that have some smart features, but are not real mobile computing platforms. This is extremely profitable by allowing them to avoid the significant additional cost of the expensive internal hardware required by a real smartphone.

The fragmentation of Android software versions and the multitude of different device hardware, allows us to conclude: 1) the vast majority of Android phones sold are not mobile computing platforms in the classical sense, and 2) taken as a whole, the Android "market" is so fragmented in both software and device hardware, that it stifles developers and service providers. They are unable to adequately profit writing Android software, regardless of Android's high market share.

Because most Android phones sold are not used for "mobile computing," it is a mistake to view market share as an accurate measure of platform value. The correct measurement of platform value is the consumption of apps, services, media, and overall usage, as well as the profitability of the platform's developers and service providers.

Flurry Analytics estimates that cross-platform developers generate more than four times as much revenue from iOS as they generate from Android.

Google's Business Model

Google's primary business is selling advertising. They view their web services as distribution channels for their advertisements. Android is an extension of this model. Google's primary motivation for incurring the cost of creating and subsidizing Android is to ensure their services always have access to market. All of Google's platforms and services are viewed by management as the cost of distributing their product - advertising. This business model sets up an inherent conflict between Google and third-party developers and service providers who might otherwise create value-enhancing software and service offerings for the Android platform.

As a thought experiment, let's imagine a situation where developers and providers begin creating "killer" Android applications. They would immediately be in direct competition with Google for user attention and engagement. The more successful their apps became, the more Google would be forced to protect its distribution channel. Google is not likely to tolerate, let alone encourage, competing applications designed to divert user attention and engagement away from Google's advertising. Especially on their own platform, which was expensive to build and continues to demand significant ongoing subsidies.

This is a very real conflict of interest. Third-party developers' apps and services must compete with Google, on Google's distribution channel. These competing products cost Google advertising revenue. This conflict suppresses any meaningful network effect by constraining the platform to serving Google's interests, rather than third-party developers, service providers, and customers.

Another issue for all Android platform stakeholders stems from what is often cited as an advantage. The "open" approach touted by Google, exposes Android to frequent malware attacks. Malware is endemic because it is extremely difficulty to make an "open" software operating system robustly secure. The Android ecosystem's security vulnerabilities will be a major deterrent to enterprise adoption. There are simply too many security risks with Android.

Apple's Business Model

Apple has always been a software and platform company using a fully integrated software/hardware business model to deliver the best customer experience possible.

The key to understanding Apple's strategic business model is that Apple has always been a software and software platform company first. Apple uses state-of-the-art hardware to maximize the customer's experience and to capture the maximum profit from product sales, but the "secret sauce" is the software.

Great software creates intense demand for a software platform, which in turn sells premium hardware. Apple's extraordinary "hardware" margins are a direct result of the incremental demand created by Apple's software. The demand for their software, integrated into premium hardware, drives Apple's extraordinary profitability.

Apple's primary strategic goal is to become the dominant mobile computing platform. They are accomplishing this by providing the most opportunity to the platform's stakeholders. Developers, service providers, and content providers always go with the platform that makes them the most money. Customers always go with the platform that has the greatest quantity and quality of software, service, and content offerings.

Apple knows this and operates their business to accomplish this objective. For example, they do not seek market share for the sake of market share. They intentionally attract those consumers who become ongoing paying customers, creating the maximum profit opportunity for developers and service providers.

Apple's integration of Twitter, Facebook (FB), and other partners directly into the iOS operating system is a reflection of Apple's strategy to maximize the platform's value to current and future users. Contrary to popular belief, Mapplegate increased the value of Apple's Platform because it resulted in a much improved version of Google Maps becoming available to Apple's platform customers.

Apple learned platform dynamics directly at the hands of Microsoft (MSFT) in the mid-1990s. When introducing the iPad, Steve Jobs said, "We are going to win this one." Jobs was directly referring to the platform war lost to Microsoft. His declaration, and prediction, was that Apple will do whatever it takes to become the dominant mobile computing platform in all ways that matter.

The extraordinary talents of Tim Cook and Jony Ive have added a significant dimension to Apple's business model. Through years of enormous investment in time, talent, and money, Apple has created a virtually insurmountable manufacturing moat. Apple's cutting-edge design and manufacturing prowess has become a game-changing competitive advantage.

These major advantages in design and manufacturing greatly benefit Apple. Yet, the power of the software platform dynamics we have been discussing will ultimately be Apple's most important and sustainable competitive advantage.

As the Post-PC industry matures, the hardware required to perform a certain functionality, or a specific set of "jobs to be done," will become "good enough." In other words, over time any device's current functionality will no longer require state-of-the-art hardware. This tends to diminish the hardware's ability to drive future sales, as "knock offs" proliferate. Thus, over time hardware will tend to become a less dominant component of the consumer's buying decision. Of course, even as this trend emerges, it will be a very long time before consumers fall out of love with Apple's hardware.

The consumer's focus will shift to which platform and ecosystem they want to join for current and future purchases. Selecting the right platform/ecosystem will become the most important driver of purchasing decisions. This is exactly what happened in the mid-1990s when anyone purchasing a personal computer rarely, if ever, questioned whether they would be joining the Windows ecosystem. Other alternatives, such as Macs, were usually not considered, even if they were superior products.

Consumers are rapidly shifting away from seeing each device purchase in isolation. They are beginning to focus on the platform and ecosystem - present and future interoperability, quantity and quality of software and services, ease of use, quality of experience and enjoyment, convenience of learning and obtaining assistance, ease of maintenance, etc. They are beginning to consider all the benefits offered by a fully unified, state-of-the-art mobile computing platform and ecosystem.

In Summary

According to analytics firm Chitika, iOS devices (iPhone, iPad) generate far more web traffic than Android devices. Usage is a far better measurement of platform value than market share because usage is a good proxy for engagement. Engagement is the key to platform value.

The commercial interaction of a platform's customers making ongoing purchases creates the financial incentive for developers and service providers to produce increasing quantities of high quality software and service offerings. This process creates a virtuous cycle of value creation, causing the software platform to increase in value for all current and future users. As more paying customers join, the increase in platform value accelerates. The process continues until the platform's value proposition becomes so compelling to prospective customers that platform and ecosystem dominance becomes all but inevitable.

Excerpt from Apple's recent press release:

[CUPERTINO, California―January 7, 2013] Apple today announced that customers have downloaded over 40 billion apps, with nearly 20 billion in 2012 alone. The App Store has over 500 million active accounts and had a record-breaking December with over two billion downloads during the month. Apple's incredible developer community has created over 775,000 apps for iPhone, iPad and iPod touch users worldwide, and developers have been paid over seven billion dollars by Apple.

Source: The Network Effect: Why Apple's iOS Will Win The Platform War Over Google's Android

Additional disclosure: Frequent owner of GOOG since 2004 IPO. Currently no position.