How Apple Almost Pulled It Off

| About: Apple Inc. (AAPL)

Much has been said and written about the fall in Apple's (NASDAQ:AAPL) shares from above $700 to the $400s level where they are now. Many people are stunned how this company, which generates extraordinary amounts of revenues, profits, margins, cash flow and sits on a mountain of cash can be so cheap, with the shares falling so precipitously.

Just consider the revenue growth:

Or profit growth

Or free cash flow growth:

And compare these impressive developments with the market valuation, which has moved downwards (apart from the dip in the aftermath of the financial crisis in 2008-9).

This is a curious contrast. Indeed, at present metrics, Apple can only be called cheap, especially if one realizes that its main products (the iPhone and the iPad) are emblematic products at the center of some of the biggest growth markets in technology.

However, one has to realize that share prices are looking into the future. One could conceive them as a market consensus on where the company is heading. Even that seems unduly pessimistic, considering the growth track record the company has been able to generate, and it very well might be.

Just unleashing some simple economics can explain much of this apparent paradox. More concretely, there are two economic perspectives that are highly applicable:

  • The innovators curse
  • The economics of business strategy

Innovators curse
Often, companies that produced the original innovation, creating new markets, is not the company which will benefit the most or has the strongest position in that market. It's distressing, but it is often better, in economic terms, to be a follower (imitator) than an innovator.

Innovation is not only very expensive, more importantly, it's also a high risk strategy. Way more innovations fail to catch on at all, or generate only very mediocre returns when they do. Before embarking on innovation, especially the quantum leaps forward like the iPhones and iPads which are whole new products, rather than improvements on existing ones, the company has little hard evidence whether these will be a success. And failure is expensive.

A strategy where a company waits which innovation is successful and then trying to reverse engineer it to imitate it and create something similar avoids betting on the wrong innovation. The imitator company still has to invest significantly in R&D, as "re-creating" the product requires extensive technical knowledge and know-how.

Imitators are also faced with another problem, intellectual property protection. You know these patent wars between Apple, Google (NASDAQ:GOOG) and Samsung (OTC:SSNLF). The simple fact is, in capitalist markets, there are strong tendencies towards commoditization. Whenever a market or profit enjoys above normal returns, incentives are created for others to enter these markets.

But there are other market forces at work, to which we'll now turn.

The economics of business strategy
One doesn't have to go to the latest business strategy literature, a simple re-reading of 1980s Michael Porter already largely explains why Apple is bound to run into trouble. Michael Porter explained that there are five forces which impact how profitable a market is:

  • The threat of new entrants
  • The threat of substitutes
  • Industry rivalry
  • The power of suppliers
  • The power of customers

Now, the first two, we've basically covered already. The crucial concept here is how large the entry barriers are. We believe these are substantial, but certainly not prohibitively high. Take the iconic iPhone. It single handedly created a whole new device, the concept of a smartphone, with a third party applications ecosystem.

For new entrants, the crucial element here was the operating system. They could not use Apple's (needless to say), but there was an alternative, Android. It certainly wasn't as good as Apple's in the early days (perhaps it still isn't, depending on who you speak with), but it was free.

The hardware consists largely of components that are freely available on the market, like processors, memory, gyroscopes, screens, batteries, signal chips and the like. All available from multiple vendors.

Now, despite that, Apple could have pulled it off. In fact they were unlucky that they didn't, as they did just about everything right. For instance, they didn't make the mistake which they made with the MacIntosh in the 1980s, by keeping all in-house, but encouraged third party providers to write application.

Three things are crucial here: scale, speed and integration. Scale, as the user wants ample choice in applications. Speed, as to create a first-mover advantage, and integration, to give the user a seamless experience. Apple all got that just about right. Combined with the famous Apple design, they seemed to have a near unbeatable product.

It is somewhat curious if we go back to the 1980s, to the Mac versus Windows clash, which Apple lost. Then, as now, with the early iPhone versus the early Android phones, Apple's product seemed way ahead. In the 1980s, the crucial mistake was not licensing the operating system.

A few years ago, with market adoption of smartphones that much faster, compared to computers in the 1980s, they didn't have to. They seemed to have enough of a head start to create a crucial first mover advantage, in which the best applications would flock to Apple because they offered the largest installed base, reinforcing its market dominance.

No network effects in a world of inter-operability
However, Apple's undoing is the fact that unlike PC software in the 1980s, smartphone applications are largely interoperable. That is, they can be easily recreated for another software platform, so the platform they work on matters a great deal less. What made Windows so dominant from the 1980s onwards was that much of its software wasn't interoperable and much was downright complicated to use, creating strong network effects.

Businesses wanted Windows, not because it was the best operating system (it almost certainly wasn't), but because it came with crucial applications which were difficult to learn (like Windows itself, we could add). This created two strong network effects which cemented Windows:

  • Crucial applications unique to windows with non-interoperable standards
  • Significant learning effects, producing high switching cost

Once a business used Word for Windows, to make things a bit less abstract, they had little incentive to use something else as they invested a significant amount of time mastering it, and the file formats weren't very well translated to other platforms (the latter problem has eased significantly over time).

That is, Windows had strong network effects. The platform became more useful the more users were using it, which reinforced its advantage in a positive feedback loop. None of this applies to any of the iPhone (or iPad) applications, apart perhaps from iTunes. There are no learning effects (a 2 year old can operate the iPad, from a business strategy point one could argue that these products are way too easy) and apps are mostly interoperable (you'll find the same, or similar apps on Android).

Yet, Apple almost pulled it off
Still there are some lock-in effects of customers via data in the cloud. It's still a hassle, especially for iPhone users to switch data to an Android phone, so there are still switching costs.

That is, time was crucial. If Apple could quickly get a large user base, these switching cost might cement its leading position and become insurmountable (as far as anything in technology is insurmountable). In fact, Apple did have another advantage, in the form of a positive feedback loop.

The bigger their platform, the more attractive it becomes to write applications for it, reinforcing the advantage. However, it's fairly easy to write the same, or similar applications for another platform, so many application writers simply considered that as an extra revenue stream or a necessary service to their clients.

Still, if Apple would have enjoyed its dominant position for a little longer, who knows, they just might have pulled it of creating such positive feedback mechanisms that their position would have become difficult to assail. Their undoing was that the main competitor, Android, is both a free and open standard.

This is making it popular for those that want to add their own software (the skins from phone makers and telecom companies for instance), and opening up a host of hardware companies offering way more variety, saturating the market and trying new concepts, like the phablet.

Resource based view
Newer business strategy approaches, like the resource based view of the company (RBV) that emerged in the 1990s, focus on what makes companies unique, rather than focus on industry characteristics, as even within the same industry or markets, profits can vary wildly between individual companies. These are either resources (something a company has) or capabilities (something a company can do).

Looked at it that way, one can certainly argue that Apple's unique capabilities revolve around innovation and design. We've already noted above that many innovative products, even ones as iconic as the iPhone, get imitated one way or another. That either leaves Apple to do it all again, and come up with yet another iconic, category defining product (iWatch? Apple TV?), or get its competitive advantage mostly from its design acumen and the creation of the best user experience.

While the iPhone and the iPad mini especially are certainly design winners according to most, is that enough to keep on commanding premium prices and a large market share while the combined competition produces many more iterations in a kind of mass trial and error experiment, some of which, sooner or later, are going to be a match for Apple's design?

And in the meantime, relentless commoditization is marching on with Chinese producers entering en-masse, producing smartphones and tablets for the masses in developing countries, eating away at Apple from below.

Apple nearly became the dominant company with a difficult to assail market position in smartphones, as well as tablets. However, its first mover advantage wasn't decisive enough and the interoperability of many applications and the lack of serious learning effects conspired to keep switching costs relatively low, which kept positive feedback mechanisms in check.

The fact that its main rival, Android, is both free, and open standards, enabled it to overcome its initial disadvantages and establish a large user base that has surpassed that of Apple in the smartphone market and might very well surpass Apple in the tablet market as well.

In this light, the fall in Apple's share price reflects these developments, even if one can argue that these markets are still growing fast, and Apple's shares are unusually cheap almost by any measure. While no longer the dominant player in smartphones, and perhaps losing that position in tablets as well fairly soon, we wouldn't count Apple out.

Even seen from a "mature market" or "cash cow" perspective (we're still years away from that in smartphones and tablets, but investors are getting restless with Apple's large cash hoard and cash flow generation), the shares are cheap.

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.

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