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In my last technology post, I wrote that we are moving to an Internet-centric world where your computing device or operating system are less important because your data will live and breathe in the Internet cloud. Google (GOOG), in particular, is preparing for this world because it has a dominant role in the Internet through search. But everyone is moving to an Internet-centric service and content delivery strategy.

The telecom providers understand that their networks make them gatekeepers who can extract rents from content providers. Having paid handsomely to build these networks, they are fighting to not become dumb pipes and resisting net neutrality in order to keep that gatekeeper role. This is one reason Google is trying to build its own network and circumvent the telcos. Eventually, I think the land-based telcos will lose and the battle will move to one between mobile operating systems like Apple’s (AAPL) iOS and Android. Although mobile phone operators may still be able to extract rents for a while longer than the fixed-line telcos.

The PC OS landscape

In the past, the operating system has been important in computing because it allowed the same software to be run on different computing devices, permitting users of those devices to transfer data easily as they were using the same software. But, the OS also benefitted as the more installed users one OS had, the more developers created software for the operating system. These network effects made achieving critical mass a defining factor. Going forward, network effects will also be important in monetizing OS-proprietary e-Commerce platforms like iTunes and Google’s new iTunes competitor.

One reason Apple was near bankruptcy before Steve Jobs re-appeared on the scene is because Apple’s Macintosh’s installed base had shrunk. I used a Macintosh from the mid-1980s but was forced to switch to a PC when I bought a laptop in the mid-1990s that I used both at home and for work. As the PC gained sway, millions of users like me were forced to give up the Mac. And, of course, that meant software developers gravitated to the PC platform and the Mac became a niche product.

The Move to the Internet-centric Model

As Internet bandwidth increased, more and more of what had to be done locally or over a local area network on a PC in the past could now be done over the Internet. Platform-independence increased and the PC became a dumb terminal as the content lived in the Internet, one reason Microsoft (MSFT) tied IE to its operating systems. I like to think of iTunes as one of the most profitable demonstrations of content’s move to the Internet.

The first wave of Internet companies were either pure play Internet companies like Yahoo (YHOO) or e-Commerce companies like Amazon.com (AMZN). Amazon transacted in physical product virtually. Yahoo! published free content which it monetized largely through advertising. iTunes was the most successful early example of a company which combined the two: a service which could monetize digital content using an e-Commerce strategy.

Before iTunes, we all bought music at the record store. And to the degree we used it on a computer, we inserted the CD or we burned it to mp3 files. The point is that our original purchase was a physical product. But, with iTunes, we could buy virtual content on the Internet.

Remember, none of this would have been possible without the increase in Internet bandwidth. iTunes doesn’t work in volume on a dial-up modem. Moreover, as bandwidth increased, an enormous array of PC-based content started to live in the Internet. Of course, initially all of this content was still locked into the PC model since the PC was the only device through which we could get the music, files or what have you. But that changed as mobile processing speeds increased.

The Mobile OS landscape

From the Morgan Stanley presentation I showed you in the last post, you know that mobile is the fastest growing part of the Internet. We see huge early stage growth. Legitimately, there are only a few mobile OS platforms to choose from right now: Nokia (NOK)/Symbian, Palm (PALM), Windows Mobile, RIM (RIMM)/Blackberry, Apple iOS and Android.

And until recently all of these operating systems were used mainly with a Smartphone form factor. However, mobile computing is really about using the Internet to take your content with you to whereever you go regardless of what kind of device you use, PC, phone, set-top box, GPS, mp3 player or handheld video. What people want is to be able to access their music, photos, videos, email, websites, etc and have the same intuitive stress-free user experience regardless of device or location.

This is a tall order and it requires that the OS be ported across a range of form factors, meaning that you had better have some serious economies of scale if you want a lot of software that people use to access their data to be developed for your platform. Bottom line: not all of these platforms are going to make it. Some will cease to exist while others will merge. I believe Apple will be one of the survivors given the installed base of their iPhone/iPod OS while the Android OS is emerging as a main rival.

Apple’s Strategy and Android’s Threat

Apple is less a technology company run by engineers and more a consumer products company which is oriented toward usability and user experience. Apple’s iPhone/iPod/iPad is a premium product which has very good high end market share. So think of Apple as the BMW of the computing world where the goal is to make a higher-end product that is cool to look at and to use but simple to operate.

The strategy seems to be to create a consistent mobile device interface across a wide range of form factors which share an operating system for software development.

Apple’s profitability in Mobile/Apps/Music/Video is predicated on:

  1. Network effects from having large market share
  2. The tie-in of the OS with the hardware and iTunes
  3. The higher profit margins of premium positioning

Android is a threat primarily because it attacks all of these at once.

First, Android has encroached on Apple’s smart phone territory by opening up its OS to other hardware manufacturers. Apple has closed this off, meaning it is the only manufacturer against a plethora of others. Remember, it is the installed base of the operating system that creates network effects for software development and users. As in the PC market, it is irrelevant who the manufacturers are from a software perspective.

As a result, we see Moto (MOT) and HTC with great Android handsets (although the EVO seems to be a dud). Even Samsung (OTC:SSNLF), Garmin (GRMN) and Dell (DELL) are in the mix and many others are coming. This means that Android’s installed base is creeping up and that’s significant for platform development. Look at the Twitter app, the upcoming Skype (EBAY) App, The Adobe (ADBE) Acrobat App. All of these are now being developed or released on Android because of its burgeoning installed base. The Twitter App was released on Android before the iPhone, a first for a major App.

I have argued Apple’s going it alone on hardware and allowing Android to be installed on every other manufacturer's devices is a repeat of the Mac-PC wars in that "one company cannot compete against 100s." The result has been a growing installed base for Android to the point that the Android OS had more installs than the iPhone in Q1. This reduces switching costs away from the iPhone. It means a re-allocation of software development and an erosion of top line growth from Hardware and Apps. Can the new eye-candy iPhone change this? Maybe. Some see the iPhone 4 as a bit of a letdown. We’ll find out in due course.

Second, Apple came to prominence again because of its tie-in between iTunes and the iPod. If you wanted to use iTunes, you could only use an iPod. If you wanted to use an iPod you had to use iTunes. So as the iPod took off, this had a built-in network effect which gave Apple a lock on two complementary but different markets, online music and digital music players.

What Apple did afterwards was extend this lock into the mobile space by creating the same closed system tie between the iPhone and iTunes. Again, the forced tie increased iTunes’ installed base while furthering its network effects. That’s why Apple broke the Palm’s attempt at syncing with iTunes. Android – and their cloud music announcement – is going to break that tie because the large installed base of Android will siphon people off of both iTunes and the iPod/iPhone platform and cause Apple to lose both hardware and software revenue. Already, a music software program named doubleTwist allows people to sync their Android, Blackberry, PSP or Palm with iTunes making a switch that much easier.

Third, Apple has very good margins due to its premium pricing. That’s why I liken it to BMW. However, I suspect Apple will soon be faced with a choice of whether to go downmarket to protect share and network effects and suffer margin erosion or to allow Android to erode Apple’s market share. The iPad fills a premium niche that was partially filled by the iPhone/iPod as a mobile computing device. So maybe it can more than offset the margin erosion. Still, it’s a worry. And Apple is getting into online Ads as a way of competing with Google on its own turf. Perhaps this will be a distraction for Google. More likely, their tactics will invite the regulators to review competition rules. Ultimately, however, Google has used Microsoft’s strategy of letting the hardware manufacturers do its dirty work. They will be the ones flooding the market with Android product and this is going to be tough to fight against.

And of course, there’s the AT&T network exclusivity which means that the iPhone is not just limited to one hardware manufacturer, it is also limited to one network in the US while Android is now installed on every other network in the premium price space. Let’s hope that the rumoured Verizon link up actually happens. With Android phones also filling a less premium priced space, I guarantee you there will be margin pressure. Does that make Apple a short? Barron’s says no but the pressure is definitely on. If the iPhone 4 does well, Apple’s share will continue apace because market darlings don’t fall unless there are negative surprises. And even if we get a negative surprise, I imagine we need to see a few before it really pressures the shares.

Source: The Coming Apple iOS – Android Wars