Apple's Huge Ecosystem Blunder

| About: Apple Inc. (AAPL)

In response to my article about "Apple's Loser Strategy" quite a few readers criticized me for supposedly "failing to understand" that the value of the iPhone is "not in the hardware" (where many competitors have arguably equaled the iPhone in quality), but in the "software" and Apple's unique "ecosystem."

In this article, I will show that it is the supporters of Apple's (NASDAQ:AAPL) ultra-premium pricing strategy that evidently do not understand the true value of Apple's software and ecosystem. If they did actually understand the value of Apple's ecosystem, they would be making the exact opposite arguments in terms of the trade-off between margins and market share.

Software ecosystems derive their value from volume and market share, first and foremost. In the long-run, sustainably high profit margins are merely a by-product of mass adoption of the ecosystem.

The Global Mobile Ecosystem War

First of all, let's get one thing straight: Apple is not the only mobile device company that is in the business of creating sticky software-based "ecosystems." Apple's competitors such as Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT) and BlackBerry (NASDAQ:BBRY) are quickly catching up in that regard. Whether it be new versions of iTunes, games, app stores or the integration of various productivity tools, Apple's ecosystem is quickly and continuously becoming less unique as competitors build out their own ecosystems.

But this is really the key point, so pay attention: If the value of Apple's mobile products is really all about the value of its "ecosystem," then Apple should be doing everything it can to increase market share rather than to over-protect ultimately unsustainable profit margins.

Ecosystems only have value if enough people are participating in them. Failure to recognize this was the fatal error of Apple's Mac strategy in the 1980s and 1990s and it was the secret of Microsoft's success during this period. The success of a software ecosystem ultimately depends first and foremost on the number of people that adopt it. Sustainable profit margins are a direct by-product of market share, not premium quality per se.

Microsoft figured out that it was far more important to get people all around the world hooked to their very sticky Windows and Office "ecosystems" than it was to maximize a fleeting image as a premium product. Thus, they allowed and even encouraged cheap computers to run their software. Furthermore, Microsoft never vigorously fought software piracy in emerging markets as much as it could have because it was creating Microsoft ecosystem addicts out of people that could not afford their full-priced software today, but that would be able to afford it tomorrow. Microsoft's strategy worked; Apple's failed.

So, if it is really true that Apple is primarily in the software "ecosystem" business today (as opposed to the hardware business), then it should be adopting a Microsoft-type strategy of market-share gain and mass adoption, rather than a "Louis Vuitton" strategy.

Apple Is Fighting Old Wars and Losing Again

Right now, Apple is clearly losing the world-wide "ecosystem" war to Google's Android. Indeed, Apple is currently in the process of simply surrendering the majority of the world's territory without even a fight. And with its recent decision to offer its 5C phone in China at over $700, Apple is committing a colossal error, relegating its company to serve a relatively small global niche.

Apple made a similar mistake in the 1980s and 1990s, and the company almost went bankrupt as a result. The previously dominant Mac quickly lost market share to inferior but quickly improving Windows-based products until Mac ultimately became a marginal high-priced player in the market. The value of Mac's previously vaunted ecosystem collapsed in part because software developers stopped making software for the platform (due to relatively low volumes) and in part because consumers did not want or need an expensive computer with an ecosystem that was not compatible with the now-dominant Windows ecosystem.

Some Apple supporters seem to think Apple's comeback was somehow a vindication of its old Mac strategy originally laid out by Steve Jobs. That is a total misreading of history. The real lesson of Apple's comeback is this: When it comes to software ecosystems, if you lose the battle for market share, you lose the war, and you might as well get your company to make some other kind of product. That in fact, was what Apple was ultimately forced to do in order to survive: Go out and make totally different products, because their Mac strategy was a total failure.

Incredibly, Apple seems not to have learned its lesson and is now stubbornly re-applying the failed Mac strategy to its newer line of products. And the result will be much the same if they persist: Market-share loss, relegation as a niche player and eventual dramatic margin erosion.

Physical Dimensions of Experiential Products

Some people think that Apple can continue to grow a $500 billion market cap by being a niche luxury provider of consumer electronics. It can't.

First, we must understand that Apple's value cannot be sustained by the physical aesthetics of its products, such as with a Louis Vuitton purse. Unlike a Louis Vuitton handbag, Apple consumer electronics products must ultimately succeed or fail based on the differentiated functionality they provide to their users.

Second, Apple cannot sustain a $500 billion market cap and its consequent status as the largest company in the S&P 500 (NYSEARCA:SPY) by producing luxury hardware. A $500 billion market cap depends on a massive volume of sales. This necessarily entails mass production. Almost by definition, luxury hardware cannot be mass-produced. In a mass-produced product, the quality of craftsmanship and materials cannot provide the primary basis for a sustainable competitive advantage because it is simply too easy to imitate mass-produced hardware.

Luxury hardware such as a Rolex watch can sustain their "luxury" designation in part via real physical differences created by differentiated costly inputs and artisan labor (craftsmanship). By its very nature, the artisanal (as opposed to mass-produced) creation and supply of Rolex watches is made scarce by physical (material and human) limitations and costs.

By contrast, the differentiation of Apple's consumer electronics products must ultimately depend on differentiated functionality, and most of this functionality is a matter of a software "ecosystem."

Software ecosystems cannot be sustained as luxury goods for two reasons: First, the experiential value of any software ecosystem has no real physical supply constraint. Second, software-based experiences are relatively easily commoditized and delivered to consumers at near zero marginal cost.

Let us take an example. A business plan based on selling Rolex watches to middle class people in India is unlikely to succeed because the parts and specialized craftsmanship required to produce Rolex watches costs more than average middle class people in India can afford. With Rolex watches, high prices are largely a function of physical limitations.

Take another type of premium experiential product: Upscale resort vacations. Experiences such as those provided by luxury vacation resorts cannot be replicated or distributed cheaply because there is a very costly physical dimension involved with hotel construction, beach front property, swarms of service-providing employees, etc.

Because there are economies of scale with software production and distribution, once adoption of the software reaches a certain critical mass, a producer can profitably (i.e. high ROIC) sell even the most sophisticated software "ecosystem" in the world at a very low price to consumers. In other words, the marginal cost of producing and distributing an additional unit of a massively adopted premium-quality software product, particularly through the internet, is close to zero.

As a result, even poor people in Africa can afford to access the experience of the best software-based ecosystem, even if they don't actually own a computer or any other electronic device (they go to internet cafes). In particular, you don't need to own an iPhone to download music, play video games or purchase and use various types of apps. You can do all of that with cheap and/or rented hardware. Indeed, at the rate Android is going, there is virtually nothing that can be experienced on an expensive iPhone that people around the world cannot experience on cheap mobile phones within the Android ecosystem.

In this sense, software ecosystems are mass democracies by nature; not exclusive clubs. And companies that try to turn software ecosystems into exclusive clubs will fail.

Not only can any formerly "exclusive" ecosystem be copied, the lesson of history is that an overall superior ecosystem will eventually emerge from a massively adopted platform since software developers will make the most and the best apps for the ecosystem with the most market share because that is where they can obtain the greatest number of potential clients for their software. This was the dynamic that determined the outcome of the PC ecosystem war (which was lost by Apple) and it is currently being replicated on an even larger scale with mobile ecosystems.

People need to remember that the features of any software ecosystem can be relatively easily copied. And because the same experience provided by any software feature can be fairly easily replicated, it becomes commoditized over time. Therefore, the premium value of the code that supports the ecosystem is only temporary. The more enduring value is created by mass adoption of the ecosystem. Therefore, the real key to creating enduring value with an ecosystem is to achieve as much mass adoption as possible.


I have written this article primarily to address the erroneous view that Apple can succeed as a luxury goods provider, and in particular, that it can succeed as a provider of an exclusive luxury-priced "ecosystem."

The first thing to note is that Apple does not create value only with its software-based ecosystem. It does not just create value with its hardware either. People that make this an either/or debate really do not understand Apple. Apple creates enduring profitability by combining value from a variety of sources in order to meet a variety of consumer needs in an integrated and relatively unique way.

Having said that, AAPL analysts are correct to emphasize the central importance of "ecosystem" in the company's value proposition. A sticky ecosystem, massively adopted, is the only sustainable source of abnormal profit margins for the products of a company such as Apple. Both innovative hardware and software can provide an initial edge, but they can relatively easily be copied. By contrast, addiction to a sticky ecosystem that has been massively adopted is a difficult barrier to entry to crack.

Apple presumably understands that luxury profit margins cannot be sustained on the basis of the physical characteristics of mass-produced hardware. But many AAPL aficionados seem to think that the company can defend luxury margins for its hardware by creating a sticky software ecosystem. It can't. Software ecosystems are democratic by nature; their use cannot be restricted to an elite club. Anybody that tries to create an exclusive software ecosystem will fail because it will be copied and eventually surpassed by an ecosystem that has more massive adoption.

By essentially pricing itself out of the world's largest and fastest growing markets, Apple has committed a massive blunder by dramatically limiting the adoption of its ecosystem. This is a form of self-mutilation that radically limits the value of the Apple's ecosystem and the value of the company as a whole. Worse still, Apple's ultra-premium pricing strategy places it in a precarious position since absolutely every single element of Apple's software "ecosystem" and hardware can be and will ultimately be replicated and commoditized. This means that in the long-run, given its current strategy, Apple will have neither high market share nor high margins.

Some people have misunderstood my argument and believe that I am advocating that Apple produce "cheap" phones. I do not advocate that Apple produce "cheap" phones or that the company have a product line for each and every price point. My argument is that Apple does need to achieve massive adoption of its sticky ecosystem in the world's largest and fastest growing markets. This probably means market share of at least 35% or more in all major markets. To achieve this, Apple needs to create a more extensive portfolio of products at different price points in the mid to upper range that guarantee it a dominant and defensible market share in all global markets rather than its increasingly niche and indefensible market share in developed markets.

Apple can preserve its premium brand image and still offer high quality products that are accessible to the upper middle classes in countries such as China and India. This is not an either/or proposition.

In fact, I believe that Apple must hook the middle classes in developing countries to the Apple ecosystem in the next two years or the vast majority of the world's customers will essentially be lost to Apple forever. In an increasingly global marketplace, if Apple fails to capture a massive share of the market for mobile devices in emerging markets, iPhones and iPads risk becoming novelty-type has-beens much as occurred with Mac back in the 1990s.

Remember: Software ecosystems are democratic by nature and derive their value from volume and market share, first and foremost. The idea that a software ecosystem can be sustainably priced as a luxury good or that it can sustainably maintain the luxury pricing of hardware is a chimera.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.