Apple's Free Software Announcement - Much Ado About Nothing

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 |  About: Apple Inc. (AAPL), Includes: MSFT
by: Larry Smith

Last Tuesday at an Apple (NASDAQ:AAPL) new release event, Apple announced they would no longer charge for software upgrades. Craig Federighi who heads up Apple's operating systems stated, "Today we're going to revolutionize pricing" As usual, many analyst thought this move by Apple was the greatest thing since sliced bread. Mark Spoonauer at Laptopmag.com stated "Apple's free operating system is essentially a marketing coup". US Finance Post stated "The free software will help Apple sell more hardware and expand its ecosystem". Emily Coyle from Wall Street Cheat Sheet wrote this "In addition, Microsoft (NASDAQ:MSFT) now faces the new problem of its corporate customers expecting operating system upgrades for free. Businesses are unlikely to stay with the Redmond, Washington-based company if its rival offers free upgrades and it doesn't." The Sydney Morning Herald ran this headline "Apple's free software business model upends everything we know".

To all that hyperbole I say "hooey". In my opinion Apple's free software will not make one bit of difference in Apple or Microsoft going forward.

Software is Not a Moneymaker for Apple

Historically, Apple has never charged much for software. In the past, Apple has charged from $129 (for the original OS X 10.0) to $29 (OS X 10.7 Lion) to $19.99 (OS X 10.8 Mountain Lion). As you can see the price for the OS has been steadily dropping Apple's iWork and iLife software, which Apple will now give a way for free sold for around $50.00, depending on what version you purchased. Since Apple has been charging so little for its software, I don't see how giving it away draws any new buyers in. The cost of software did not keep buyers away from software, nor did it draw buyers in. The cost and functionality of the hardware is what draws people in and keeps people away.

The free software will have little effect on Apple's bottom line. In FY 2012 Apple sold $3.5 billion worth of software, which includes extended warranties and 3rd party software. That $3.5 billion is only 2.2% of Apple's $156 billion in revenue. Apple will still sell some software, extended warranties and 3rd party software so the hit to revenues is likely only about 1%.

Apple's Office Product is Second Class

You will not find any objective observer proclaim that iWorks is a better productivity suite than Microsoft Office. Office is the clear leader in productivity software, with market share in on-premise use of 80% to 95% according to consulting firm Gartner. Even on Macs, Office dominates with 84% of users using Office compared to 16% using iWorks. Office 365, Microsoft's new cloud version of Office, which sells for a yearly fee of $99.00, has already sold 2 million subscriptions doubling from 1 million in May.

Free iWorks, may keep some Apple users who require a minimal word processing/productivity product from buying Office, but for users who require an advanced productivity product or for those who require compatible software for work, Office will still be the choice.

Free Upgrade of Operating System Will Not Entice Buyers

When an individual purchases a new computer, the cost for the computer includes the cost for the operating system. This will still be true for Apple or Microsoft based computers. After purchase, the buyer of an Apple product will get all future updates, including new operating systems for free. A Microsoft customer will get free updates of the computers current operating system, but will have to pay if they want any new operating system that is released. Most new Microsoft operating systems for upgrade retail for about $100.00. In general, Microsoft owners keep the operating system that comes with the computer. Currently, Windows 7 operating system has the leading share of Windows computers, followed by XP, Windows 8 and Vista. Microsoft computer owners use the operating system until they decide it is time for a new computer and then go buy a new computer. They do this for two reasons; because they are familiar with the current operating system and new operating systems often require more advanced hardware. A person buying a $700.00 Windows machine will not turn to a $1,200 Apple computer because she/he may want to upgrade the operating system in the future.

Entry Point Cost Will Still Be the Deciding Factor.

When a person goes out to buy a car, if they are looking at Chevy Malibu's or Toyota Camry's, chances are they will not upgrade to a BMW because the dealer will provide free oil changes. That shopper has a general dollar amount they are willing to spend, if it is $20,000 for a mid-size car, they won't suddenly buy a $40,000 car to get some minimal service for free. That analogy applies to shoppers looking to buy a computer.

Microsoft Windows based computers still make up almost 90% of the desktop and laptop market, Apple is less than 10%. Apple's high cost of entry, limits the number of people who will buy an Apple computer. Entry level prices for Apple computers range from $999 for an 11" MacBook Air to $1,099 for 13" MacBook Air and up to $1,299 for 13" MacBook Pro with retina Display. Windows based laptop computers on Amazon (NASDAQ:AMZN) range in price from $369.00 for a Dell (NASDAQ:DELL) Inspiron with 15.6" display to more fully loaded computers like the HP Envy 17.3" display for $692.78. The buyer of a new computer may believe Apple is the better product, but is it so much better than a Windows computer that he/she will pay twice as much for it. In most cases the answer to that question is no and a free software upgrade won't change that.

The fact is many Americans and residents of foreign countries have limited disposable income. Apple has made the corporate decision that they don't want to make a computer for the common man, they want to make the Cadillac of computers for users to aspire to. I make no judgment on that thinking, I just know it does limit sales.

Tablets

The Apple iPad dwarfs sales of the Microsoft Surface, which Microsoft was late to market with. The iPad is a well-designed product with loads of apps and easy interface. The pricing of the iPad is similar to other tablets which I believe will help it maintain its sales. However, I do not believe free software upgrades will help sales of iPads as most tablets users upgrade fairly quickly. Features like extended battery life, sharper picture, and improved appearance drives sales, not a free upgrade of the software. The tablet space is very competitive with Amazon selling the device cheap hoping to sell content, Apple selling a higher priced device hoping to make money off the device and content, Google is also selling cheaper devices and Microsoft just getting started. In that competitive environment, a free software upgrade is not a game changer.

Corporations

One of the analysts I quoted in the opening paragraph, was, in my opinion, completely off-base with her comment stating "Businesses are unlikely to stay with the Redmond, Washington-based company if its rival offers free upgrades and it does not." Microsoft owns the enterprise and their huge corporate installed base is not going to undo their entire IT infrastructure to install high priced Apple products. Corporate sales are entirely different from retail sales in that the process usually involves open bidding and detailed pricing over the term of the contract. The terms offered by bidders may actually include free upgrades. To think Apple's new free software promotion is going to turn the corporate IT world upside down is pure folly.

Summary

I am not an Apple fan boy or hater. I have both MSFT and AAPL products in my house. I own stock in MSFT, my son owns stock in AAPL. I personally believe there is room in the world for both MSFT and AAPL to prosper. However, I do not believe Apple's free software gambit is a game changer and I do not believe it will add or take away from earnings. Apple is a high end device company and will continue to be a high end device company. Pricing their products at the high end allows Apple to maintain large margins, those margins will not be hurt by the free software. However, that same high margin keeps some potential customers away, an issue free upgrades won't change.

Disclosure: I am long MSFT. 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. My son is long AAPL in an UGMA account.