It is quickly becoming clear that vertical integration is the way to go in the new era of compute devices. As smartphones and tablets make further headway as the compute devices of choice for the mainstream, there will be intense competition to design, build, and market them.
Apple (NASDAQ:AAPL) is the largest success story to date in these bold new segments of computing. It designs its own devices along with the operating system and the system-on-chip, which allows it to have extremely favorable gross margins over its peers, directly resulting in its the acquisition of the lion's share of the profits in the smartphone and tablet spaces thus far. This business model is a proven winner, so it naturally invites competition.
Enter Microsoft - A Cash Rich Winner
Microsoft (NASDAQ:MSFT), developer of the popular "Windows" and "Windows Phone" operating system lines, is in a position to directly compete with Apple in the smartphone and tablet spaces. The company has already shown an intent to do so in tablets with its "Surface" line of products, but it has not yet publicly announced plans to do so in the smartphone space.
The only missing piece of the puzzle for Microsoft to be able to become a direct competitor to Apple would be in-house system-on-chip design expertise. While numerous third parties exist to supply system-on-chip solutions, Microsoft will likely be looking for ways to develop a competitive advantage as well as maintain a favorable gross margin profile against competing iOS and Google (NASDAQ:GOOG) Android products. In this case, a long term strategic investment in a semiconductor designer would be helpful.
Apple acquired P.A. Semi for $278M in cash - a steal considering that it was able to leverage this development team's expertise across a number of generations of iPhone and iPad products, which have generated billions in cash-flow for Apple and its investors. The in-house team has also proven itself to be useful for more than just a gross-margin advantage: the Apple "A6" system-on-chip, which is the first Apple chip to feature a custom-designed CPU core, has proven to be more efficient than any other smartphone system-on-chip available, essentially bringing ARM (NASDAQ:ARMH) Cortex A15-class performance to market before anybody else.
So, if Microsoft were to pursue a similar strategy, it would want its own in house team. Now, it could do this in two ways: building an in-house team or outright buying a company to do it - which method is not really relevant at this point as Microsoft, with $62B in cash, has enough money to finance either option.
Windows RT And ARM - The Real Reason For This Move?
I have often questioned the reason that Microsoft had for bothering to go through the hassle of porting Windows to the ARM instruction set. Intel's (NASDAQ:INTC) "Clover Trail" processors have proven to be quite formidable in both performance and power consumption for the cheaper/lower end of the tablet market against the top ARM-based designs, and the higher end "Core i5" processors are vastly superior in terms of performance than any other solution available in the right thermal envelope. So, why bother with Windows RT for ARM?
Well, the nice thing about ARM is that anybody can pay some money to get an instruction set license (and even more for the right to use ARM's core designs), and then go ahead and design a customized system-on-chip solution based on this IP. This would enable Microsoft to go ahead and develop its own ARM-based solution (just as Apple has) and deploy it in its own custom-built devices that carry higher gross margins because the middle-man of an SoC developer had been cut out (although Microsoft would still need to pay to get such a design fabricated at Taiwan Semiconductor (NYSE:TSM) or GlobalFoundries).
The Risks To This
It's not all gravy, however. The development costs of a custom system-on-chip are significant (it took Apple ~$500M and 4 years to do it), and the company would need to ensure that it would be shipping devices in sufficient quantities in order for the gross margin expansion to more than offset those costs. This means that Microsoft would need to, as Apple did, have several generations of healthy, high volume, and growing sales of its own devices before taking on such a risk.
Further, as Microsoft does not own its own fabrication plants, it would then compete for space at the leading edge foundries such as Taiwan Semiconductor or to a lesser degree, Global Foundries. Apple is fortunate enough to have an exclusive deal with Samsung to ensure supply, but at the major foundries, Microsoft would need to compete with established, fabless semiconductor firms for the limited manufacturing space.
Finally, the system-on-chip is actually a fairly small part of the bill-of-materials for a tablet or a smartphone. According to Anandtech, a typical SoC sells for about $15-30. Given that Microsoft's "Surface" tablets will likely sell for north of $500, it would seem to me that marginally cutting costs on the chip would not be worth the risks of moving into the semiconductor design business. The key focus to improving margins would need to be in areas such as the procurement of flash memory, displays, metals/plastics for the chasis, and so on.
There's one more huge risk that is inherent to the strategy of even going into the device building business at all: the OEMs.
Competing With The OEMs - A Potentially Fatal Mistake
The key ingredient to Microsoft's success has been the ubiquity of its Windows operating system. Apple makes a mint selling its iPhone, iPad, and MacBook Pro at incredibly high margins. In the smartphone space, Apple is able to due to brand recognition and the willingness of carriers to subsidize these devices to get away with its gross margin profile. With MacBooks, Apple wins because it caters to the very high end, high margin market. On the tablet side of things, Apple is primarily winning because competitors in the Windows and Android space have not yet reacted by releasing high end, competitive tablets (although this will change).
It is not clear how sustainable Apple's margins are in these areas, and it is even less clear how well Microsoft could build a strong enough brand identity/fan base in order to ever hope to make as much selling devices as Apple has. The traditional business model has also worked: sell the high margin software to the OEMs and let them do all the fighting to get the products sold to the consumer.
By competing with the OEMs, Microsoft would certainly have a gross margin advantage in that it would not need to pay for the operating system. However, by alienating all of these PC OEMs looking to build Microsoft-based tablets, it would be significantly strengthening the position of Andoid tablets. The OEMs would be quick to flock to this new ecosystem, then by sheer scale and force, Android would become the overwhelmingly dominant platform in the tablet space (as it is in the smartphone space).
By having Android own the tablet space - and potentially the future of computing - Microsoft would be setting itself up to become a niche player going forward. While Apple's "magic" allows it to be a very profitable lone-wolf, it is unlikely that Microsoft would succeed here. Of course, Microsoft would likely still own the desktop and notebook PC markets, but as these are not a particularly strong growth segment, Microsoft would be hamstringing itself.
It will be interesting to see how the "Surface" performs and, more importantly, how well Windows RT does compared to Windows 8. Further, it will be key to watch Windows tablet market share relative to iOS and Android. In any case, while I believe Microsoft will, at times, do "Apple-like" hardware moves, I don't believe that the company will aggressively pursue it outside of these smaller scale demonstrations. Microsoft's excellent financial health has been a product of its healthy gross margins, reaped primarily by selling software and letting others worry about hardware.
I think this is a sound strategy, and with continued emphasis on improving the Windows 8/RT ecosystem, Microsoft will gain share in tablets and gain back share in the PC space. That's where the growth and the money is. Apple is a very successful, marketing driven anomaly, and I hope Microsoft's management realizes this.
Disclosure: I am long AAPL, MSFT, INT. 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.
Additional disclosure: I may trade out of my AAPL position at any time.