Yesterday, May 19, marked the 15th anniversary of the first Apple (NASDAQ:AAPL) retail stores, opened in Virginia and California. At the time, as is so often the case with an Apple initiative, the stores were pre-declared to be a failure. What the pundits didn't get about the Stores is what they still don't get about Apple. The tide of commodity PC hardware that was supposed to engulf Apple is now receding in a multi-year decline. We live in a post-commodity era, in which quality and value, rather than mere low cost, are the deciding factors for most consumers.
When Apple announced its stores in 2001, there were three basic models of retailing: the supermarket, the department store, and the mall boutique. One could find all three models applied to selling consumer electronics and computers. That Apple chose the mall boutique model completely mystified observers at the time.
Didn't Apple understand that computers were being commoditized? An article Commentary: Sorry Steve, Here's Why Apple Stores Won't Work reflects the prevailing view at the time. The article pointed to the experience of Gateway in its retail stores as proof that Apple would fail:
"Apple's problem is it still believes the way to grow is serving caviar in a world that seems pretty content with cheese and crackers," gripes former Chief Financial Officer Joseph Graziano.
Rather than unveil a Velveeta Mac, Jobs thinks he can do a better job than experienced retailers at moving the beluga. Problem is, the numbers don't add up. Given the decision to set up shop in high-rent districts in Manhattan, Boston, Chicago and Jobs' hometown of Palo Alto, Calif., the leases for Apple's stores could cost $1.2 million a year each, says David A. Goldstein, president of researcher Channel Marketing Corp. Since PC retailing gross margins are normally 10% or less, Apple would have to sell $12 million a year per store to pay for the space. Gateway does about $8 million annually at each of its Country Stores. Then there's the cost of construction, hiring experienced staff. "I give them two years before they're turning out the lights on a very painful and expensive mistake," says Goldstein.
Apparently, the numbers did add up, and opening the Stores is now widely acknowledged to have been a brilliant move on the part of Steve Jobs. In the last fiscal year that Apple reported revenue separately for its retail operations, 2014, the Retail segment had revenue of $21.46 billion.
Goldstein's analysis failed because he failed to account for the transition of the economies of the developed nations to what I call the post-commodity era. As the wealth and disposable income of consumers increased in the late 20th century, they became more discriminating. Middle class consumers especially were no longer content with the lowest cost options for many of the goods they purchased.
This can be seen in automobiles, the quality of which improved tremendously in the late 20th and early 21st centuries. If you look at cars built in the early 70s, compared to today, the build quality and reliability are deplorable. Cars today are also more expensive, in real terms, but arguably a better value. The reason that higher quality, yet more expensive cars have become the norm is because that's what won in the marketplace.
Apple's bet on its stores was essentially a bet that the same process was occurring in personal computers and electronics. It was a bet that higher quality and value would win over consumers. Value is necessarily subjective, but Apple has made a reasonably good case for the value of its products with consumers.
In addition to having more disposable income, consumers have gravitated to higher quality products over time as a result of experience and learning. A fundamental role of the Apple Stores was intended by Jobs to be educational, to educate consumers about the Mac, about its advantages, and about computers in general.
Most importantly, there was fundamental attention paid to the user experience of the store, just as it was for the user experience of the products. This was part and parcel to the boutique retail model, but Jobs consciously took it much further. Gone was the traditional cash register. Products were not locked away in plastic packaging, but made accessible for customer use. The genius bar was created to make technical support as frictionless as possible.
The Post Commodity Future
Tomorrow, Apple will open its new flagship store in San Francisco. The store bears the imprint of Angela Ahrendts, but still retains all the essential elements that made Apple retail successful. Over time, the scale of the Stores has gotten bigger, as Apple's product lines and mass appeal have expanded. They're almost supermarket sized, but they don't feel like supermarkets, they still feel like Apple Stores.
There's still the accessibility to products, the clean modern design and the spacious openness. Apple has always been about humanizing technology, and Ahrendts seems to want to take that further. Past Apple stores had a modern feel, but were also a little sterile. Under Ahrendts, the Genius Bar has been replaced with a Genius Grove of live trees, an area where customers can interact with Creative Pros in a collaborative setting.
Source: Business Insider
The commitment to the Stores amounts to a reaffirmation of Apple's post commodity approach to its products. High quality and value (as Apple defines value) are the uppermost objectives, rather than market share and racing its commodity competition to the bottom.
In fact, Apple doesn't really have any commodity competition, nor is commoditization a threat to Apple in any way. Yet, the PC commoditization model, which hearkens back to the late 80s, is something that analysts and investors still seem to find appealing. For instance, SA contributor Ian Bezek recently wrote:
First off, Apple is a tech company. Admittedly, much less of a tech company than they used to be since they haven't introduced relevant new products in years, but still tech nonetheless... Apple has nothing except its momentary advantage in smartphones. There's nothing durable to support the business beyond the next few years; when smartphones fade to sub-$100 commodity products - as all portable formerly hot tech gizmos do - then what?
Apple shook the smartphone industry to its foundations when it introduced its first 64-bit SOC in late 2013, forcing its competitors into yearlong efforts to catch up. Apple's SOC innovation paved the way for the success of the iPhone 6/6 Plus in 2014.
Apple's competition is not coming from commodity makers. The brands that couldn't compete on quality in smartphones, such as Motorola and Nokia, fell by the wayside. The competition for Apple is coming from the companies that have embraced the post commodity reality. Companies such as Samsung (OTC:SSNLF), Huawei and Xiaomi (BATS:XI) compete on the basis of quality and value.
This is really the challenge for Apple. It's not enough to deliver a higher quality product than at the commodity level. It has to create other important discriminators, as well as new products. Offering new unique technologies and innovations are going to be key to competitiveness going forward. Apple won't be able to win on quality alone.
I know I've just given the Apple bears a big hole to charge through. They will claim Apple has ceased to be innovative, therefore is doomed. As always, the bears, like Mr. Bezek, ignore Apple's innovations or discount them. In fact, Apple has never won on quality or design alone. Innovation has been part and parcel to Apple's business model from the beginning.
Investing in Innovation
Apple's reliance on innovation understandably makes some investors nervous. Where will the innovation come from? What will it be? Should Apple be so dependent on the "next big thing?"
Having come from a background in technology development, these are questions that don't bother me at all. I believe that most Apple analysts, and probably most tech business analysts, simply don't understand how technology development works. They look at companies like Apple and think that it's charismatic CEOs like Jobs who spark the innovations. That's not really true.
Real technology development is not so glamorous. It's performed by highly skilled but usually non-charismatic scientists and engineers who will probably never get any public attention. Their work is driven by a passionate curiosity about the subject areas they specialize in. Often, they care little about whether their research will translate into successful products.
The role of Jobs was to recognize the products latent in the research of those scientists and engineers working at Apple. This was his true genius and contribution. Those scientists and engineers are still doing research at Apple. In fact, their ranks have greatly expanded with the growth of Apple's R&D budget. In its most recent quarter, Apple's R&D budget was $2.5 billion, triple what it was in the same quarter of 2012.
The Apple bears will of course claim that just spending a lot of money doesn't guarantee innovation. Well, actually, it does. That money is spent employing the engineers and scientists who are the real engines of innovation.
Apple doesn't have Steve Jobs to provide his product insight, but that just means Apple will have to experiment more, trying out innovations to see what works. The Apple Watch is a case in point.
Daniel Eran Dilger's take on the Watch is that it's the iPod of the Future. If that were the case, I would say that Apple should give up now. Apple Watch is Apple's preemptive disruption of its own iPhone business. The Watch is not the iPod of the future, it's the iPhone of the future.
The ability and willingness to be self disruptive has been the hallmark of Apple from its earliest days. It means that Apple is still capable of translating all that research into meaningfully creative, innovative and disruptive products.
Apple's dependence on innovation is not a weakness, but its greatest strength. I remain long Apple and recommend it for investors with a 3-5 year investment horizon.
Disclosure: I am/we are long AAPL.
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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