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Apple: Three Intriguing Numbers

No Monday Note last week: I was in The Country of Sin, enjoying pleasures such as TGV trips across a landscape of old villages, Romanesque churches, Rhône vineyards — and a couple of nuclear power plants. All this without our friendly TSA.

Back in the Valley, Apple just released their latest quarterly numbers. They weren’t as good as expected, a fact that launched a broadside of comments ranging from shameless pageview whoring (I’m looking at you, Henry) to calm but worried (see Richard Gaywood’s analysis).

As I’ll attempt to explain below, Apple’s latest quarterly performance is unusual. But, stepping back a bit, the company’s numbers are nonetheless phenomenal.

Net sales, growing 23%, are more than three times larger than Amazon’s — and Apple’s net income is more than 1,000 times larger, $8.8B vs. a tiny $7M for the Seattle giant, whose shares went up after disclosing its earnings release anyway.

Turning to Google, Apple sales of $35B are more than three times Google’s $11.3B (including Motorola, for the first time), with net income numbers in a similar ratio at $8.8B and $2.8B respectively.

Ending comparisons with Microsoft, its revenue grew 4% to $18B, about half of Apple’s and, for the first time, the company posted a net loss of $492M, due to the huge $6.2B aQuantive write off, a one time event. Excluding that number, Microsoft net income would have been about $5.5B, two thirds of Apple’s. iPhone revenue at $16B for the quarter, approaches Microsoft’s number for the entire company, iPad, at $9B is about half.

For in-depth coverage of Apple’s Q3 FY 2012, you can turn to Philip Ellmer-DeWitt’s Apple 2.0 or Horace Dediu’s Asymco — possibly the best source of fine-grained industry analysis. I can also recommend Daring Fireball for John Gruber’s lapidary comments and carefully chosen links, and Brian Hall’s Smartphone Wars — vigorous commentary and insights, occasionally couched in NSFW language. Of course, you can always wade through Apple’s 10-Q SEC filing, if you have the time and inclination. Of particular interest is Section 2 MD&A, Management Discussion and Analysis, starting on page 21.

Out of this torrent of information and argument, I suggest we look at three numbers.

First, the 3% “Miss”, Wall Street’s term for failing to hit the revenue bull’s eye. I’m not referring to the guessing games played by Wall Street analysts, both the pros and the so-called amateurs. In the past, the amateurs have done a consistently better job of forecasting revenue, gross margin, profit, unit volumes, but this time, the pros won. Although almost everyone substantially overestimated Apple’s numbers, the pros weren’t nearly as optimistic as the amateurs.”

Instead of measuring Apple’s performance against the predictions of the traders and observers, we can recall what the company itself told us to expect. About a month into each quarter, management provides an official but non-committal estimate of the quarter’s revenue. This guidance is a delicate dance: You want to be cautious, you want to sandbag a little, but not so much that your numbers aren’t taken seriously. Unavoidably, a lot of second-guessing ensues.

Apple has consistently beaten its own guidance, by 19% on average over the past three years, and as much as 35% in Q1 2010. But in this past quarter, Apple “achieved” a historic low: Actual revenue came in at only 3% above the guidance number. Richard Gaywood provides a helpful graphic in his TUAW piece:

Apple management offered explanations during the conference call following the earnings release: The economy in Europe isn’t doing so well, “rumors” about the iPhone 5 have slowed sales of iPhone 4s… These might very well be the causes of the lackluster performance, but one has to wonder: Weren’t these issues known two months ago when the guidance number was announced? Apple is praised for its superbly managed supply chain, its global distribution network, its attention to detail. How is it possible that it didn’t see that the European economy was already cooling? How could management not have heard the steady murmur about an upcoming iPhone?

Put another way: What did you know and when did you know it? And, if you didn’t know, why didn’t you?

There is a possible alternative explanation: Samsung is making more substantial inroads than expected, as their impressive quarterly numbers just released would attest: 50.5M smartphones shipped, almost twice as many as Apple’s 26M.

Sharp-eyed readers may protest the comparison: Samsung reports the number of devices “shipped” while Apple reports units “sold”. But even if we allow for unsold inventory, Samsung’s performance is impressive.  (And, as circumstantial evidence, I noticed an unusually heavy amount of advertising for the Galaxy S III during my recent overseas trip.)

Samsung’s strong showing will almost certainly continue — so how will Apple react? A new product? Price moves? Both? In the conference call, Tim Cook assured his audience that Apple won’t create a “price umbrella” for competitors, that it won’t insist on premium price tags and thus leave small-margin money on the table.

Which leads us to the second number: Gross Margin guidance for the current quarter, ending September 30th, is 38.5%, down from 42.8% for the quarter that just ended. In consultant-speak, that’s an evaporation of 430 basis points (hundredths of percent) in just one quarter — and we’re already one month into it with no visible change in the product lineup other than the full availability of newer MacBooks (Air, Pro, Retina), and no evidence of heavy-handed discounting.

During the conference call, a Morgan Stanley analyst noted that Apple hadn’t shown Gross Margin numbers below 40% for the past two years. Would Apple care to comment?

We expect most of this decline to be primarily driven by a fall transition and to a much lesser extent, the impact of the stronger U.S. dollar.

The entire Gross Margin drop of about $34B of sales (the latest guidance) amounts to $1.5B, a sum that will shift in less than two months, and probably less than one as any momentous announcement is unlikely before Labor Day (the first Monday of September for our overseas readers). This could portend a strong price move in the “fall transition”. To put the $1.5B shift in perspective, imagine Apple dropping its “usual” Gross Margin by $100 per device (new or existing); this means 15M lower-margins devices in the three weeks of September after Labor Day. Or perhaps Apple’s CFO is sandbagging the guidance once again.

The third curious number is the most perplexing: While the entire company grew by 23% compared to the same quarter last year, Apple Store revenue grew by only 17% — and this in spite of adding 47 stores over the year, for a total of 372. Why would Apple’s much vaunted retail channel grow more slowly than the company? The weak Euro economy can’t be the explanation, there are relatively less Apple Stores there. The same can be said for “rumors” of newer devices, they impact all channels and not just company stores.

We’ll see if this last quarter was simply a manifestation of a natural “granularity” of its business (as opposed to the unnatural smoothing of quarter after quarter numbers favored by Wall Street), or if the company is entering a new chapter of the smartphone wars and, if this is the case, how it will change tactics.

JLG@mondaynote.com

Business Model Dances

Apple will licence the iOS. An unexpected disturbance is apparent in Apple’s vaunted Supply Chain. It’s not what’s there, but what isn’t: In the past, each new iPhone was preceded by an increase in orders for displays, batteries, memory, cases, etc. But now, as we approach the September/October launch of the new iPhone 5, the manufacturing pipeline is only modestly full.

Concerned by the underflow, I put in a call to a friend at DigiTimes. Is this just a test run that portends a delayed release? According to my friend’s usual sources: No, the launch hasn’t been pushed back. The parts aren’t on order because Apple intends to produce the new iPhone in much smaller numbers offered through online sales only, plus a small subset of the Apple Stores worldwide (no more than 44 stores, says the rumor). But there will, nonetheless, be much rejoicing at the launch, because…

…Apple will announce a broad iOS licensing program.

This is great news for “rational” business people: Apple has finally come to its senses. I imagine the explosion in the media:

Apple sees the light at the end of the tunnel, and it’s the Android locomotive with Samsung at the controls.

or…

Years ago, I told Apple’s CEO: ‘Mr. Jobs, break down that wall’. Thank Heaven, Tim Cook is a reasonable man: the Walled Garden is now open to all.

But I couldn’t help but ask: Why launch a new iPhone at all, why not leave the field fully open to Apple’s new partners? My friend was ahead of me; he had already asked the same question. The answer: Apple must set the proper hardware standards for the iOS platform while leaving room for its OEMs. The iPhone 5 isn’t an ordinary iPhone, its a design point.

As I put down the phone, I spin out the rest of this story:

In order to compete with Android, which is free but for the occasional payoff to the Redmond Patent Troll, the iOS license is forced to essentially zero, as well. Before its epiphany, Apple made about $400 per iPhone. Now enlightened, Apple’s margin for each design point iPhone is around $50 per unit, and the company makes nothing on the huge number of iOS clones sold by Samsung, HTC, Huawei and ZTE, RIM and Nokia (just kidding about these last two).

Within weeks (days?), the big Wall Street funds that own most of AAPL dump their shares and the most valuable high-tech company in history loses 90% of its market cap.

Let’s stop the fiction here and consider the very real peril in switching business models. Once you choose a path, you stick to it for the rest of your life, whether brutish and short, or long and prosperous.

In the mid-nineties, Apple tried to correct the errors of its un-licensing ways and almost paid with its life as Power Computing and Motorola siphoned gross margin money out of Apple’s P&L. When Jobs reverse-acquired Apple, one of the first things he did was stanch the bleeding by canceling the Mac OS licenses. It was met with noisy disapproval –  for a while.

With this in mind, let’s look at two other companies that are trying to finesse difficult business model moves: Microsoft and Google.

Microsoft announces its Surface tablets…pardon…Tablet PCs, and quickly finds itself between two business models: Are they offering a vertically integrated device, a la Xbox; or are they licensing a software platform, as in Windows/Office? As remarked upon by Horace Dediu and others, one day Ballmer says:

“We are working real hard on the Surface. That’s the focus. That’s our core.”

and the next, with equal strength of conviction:

“Surface is just a design point.”

Ballmer isn’t delusional, he knows he can’t dump his OEM vassals and become a vertically integrated tablet maker overnight, setting up manufacturing, distribution, and support for 100 million or more units a year. Also, PC+ wars of words aside, he sees that these annoying “media tablets” are gaining on Windows PCs.

The solution: Announce Tablet PCs that he hopes will spur HP, Dell, and Lenovo to imitate and even outdo Microsoft own Surface devices. In a perfectly Nixonian explanation, Ballmer promises that after years of forcing PC clone makers into a race to the bottom by constantly eating into their margins — and then condemning them for their shoddy products — the new, open Microsoft won’t cheat its business partners, they won’t withhold some of that “openness” for exclusive use by Microsoft’s own devices.

As with the presidential precursor, this could be a very shrewd move…and ultimately doomed.

If it works, Microsoft will have succeeded in “reimagining” Windows.

If it doesn’t work, Ballmer will have a “neither-nor” business model on his hands: He’ll have chased away partners without gaining the time and talent to create a Microsoft tablet business the size of Google’s and Apple’s. Perhaps, in Brian Hall’s words: “Someone should tell Microsoft that PC+ is about as likely as Minicomputer+“.

So far, traditional Windows OEMs have been quiet, with the (perhaps transitory) exception of HP which announced that it won’t make a Windows RT tablet. (That’s the ARM-based variant, as opposed to the more conventional Intel-based one.)

All subject to change, as we know from Ballmer’s constant zigs and zags.

With Google we see what could be the beginning of several contortions. Just like Microsoft, Google seems to have become impatient with their own subjects: “No one seems to be able to do a proper tablet…we’ll have to do it ourselves.” (We know what “proper” means, here: It’s a grudging recognition of the great degree of complexity that belies the iPad’s benign surface.)

So now we have Google’s 7″ Nexus tablet, the first such device to receive the highest of honors — A Tablet To Rival the iPad — bestowed by reviewers from the NYT, the WSJ, Ars Technica, and others.

(I’m getting mine. Here’s my order number: 15731260465432498277.1587861291707893. Thirty-six digits. They must be kidding, right? Or they’re making room for a lot of orders from exoplanets. Not enough for a Googol, though.)

Is Google’s “vertical” move into designing, manufacturing, selling, and supporting its own tablets the same as Microsoft’s? Probably not. In the past, they tried with phones made by HTC, but the experiment didn’t last. Because Amazon was able to pick Android’s lock and create the Android-based yet non-Android Kindle Fire, Google’s current move could be much more serious.

And it could carry serious risks, as well: The gentle folks at Samsung are not going to take this with a smile and a quick genuflection. If they’re not cowed by Apple, they certainly aren’t going to let Google eat into their tablet business. As for phones, there’s Google’s $12.5B subsidiary, Motorola Mobility, another irritant for Samsung and other Android smartphone makers.

Like Microsoft, Google now faces the toxic waste of its own licensing formula: A good, enthusiastically-adopted platform that launches a race to the bottom. With few exceptions, the low margins and the haste to produce model after model have starved engineering teams of the budgets and time they need to to come up with “proper” products. Google becomes unhappy, decides to “do something about it” — and thus pushes itself closer to a business model change in which it competes with its own partners.

For the first Nexus tablet, Google can sell it at cost (or close to it), just like Amazon. But Google doesn’t have Amazon’s ecosystem, its vast store of physical products and digital content that the Kindle Fire helps sell. Sooner or later, this could force Google to make tablets “for their own sake”, as a money-making business unit.

Or they could stick with the current Android strategy: An OEM platform that runs zillions of devices, all with the same goal: Expose the consumer to Google services, to the radiation of its advertising business, all the time, everywhere, on any device.

Or , like Microsoft, end up in a neither here nor there crack of the business model space.

This is going to be interesting.

JLG@mondaynote.com

iPad Mini: Wishful Thinking?

Or another killer product? Or, on the pessimistic side, a loser defensive move showing Apple’s fear of competitors such as Amazon, with its Kindle Fire, and Google’s 7″ Nexus tablet?

Recent leaks from purported sources inside Apple’s traditional suppliers have ignited a new frenzy of speculation. And not just from the usual blogging suspects — often better informed and more insightful than the official kommentariat. BusinessWeek and the Wall Street Journal both stuck their august necks out: The so-called iPad Mini will be launched this coming September.

On this matter, my own biases are on the record.

In an August 2009 Note titled “Apple’s Jesus Tablet: What For?“, I went as far as measuring the pocket on men’s pockets. As a result, I posited a 10″ (diagonal) tablet might not provide the same desirable ubiquity as a 7″ one that men could carry in a coat or jacket pocket, and women in a purse.
(Apple once came to a similar conclusion: the original Newton project started by Steve Sakoman in 1987 was a letter-size tablet. After he and I left, the screen size was cut in half and the actual Newton came out as a pocketable product.)
Five months later, on January 27th, 2010, Steve Jobs stood up and changed the personal computing world for the third time with the 9.7″ (diagonal screen size) iPad. The take-no-prisoners price ($499 for the entry model) was a big surprise. Another one, much less obvious, was Dear Leader’s unusually tentative positioning statement: ‘We’ll see how the iPad finds its place between the iPhone and a MacBook’. (I’m paraphrasing a bit but the tone was there.)
The iPad surprised many, Apple included and, at the beginning, was often misunderstood. I recall my initial disappointment at not being able to perform the same tasks as on my laptop. A huge number of normal humans of all ages thought differently. As we know now, the iPad grew even faster than the iPhone. Notwithstanding Microsoft’s clinging to its ossified PC-centric rhetoric, this turned out to be the true beginning of the Post-PC era.

This excited competitors around the world: You’ll find here a list of 76 tablets announced at CES. By the end of 2011, few had accomplished anything. One exception was Amazon’s Kindle Fire, its Xmas season numbers were rumored to reach more than 4M units, even 6M by some rumored estimates. This rekindled, sorry, rumors of a smaller iPad.
In October 2010, Jobs famously dismissed the idea: “7-inch tablets should come with sandpaper so users can file down their fingers.” None of the journalists present at the time had the presence of mind to ask him about the iPhone screen…
Tim Cook, Steve’s disciple put it well at the D10 conference last June when he affectionately (and accurately) called Jobs a great flip-flopper, citing examples of products features his then boss ended up endorsing after repeatedly nixing them.
In an April 2012 Monday Note, I discussed the possible end of Apple’s One Size Fits All for  iPhones and, in particular, iPads. There, I linked to an A. T. Faust III post lucidly explaining how the original 1024 x 768 resolution could easily scale down to a 7.85″ tablet and achieve a nice 163 ppi (pixels per inch) resolution, the same as pre-Retina iPhones. This leads one to believe there is abundant (and inexpensive) manufacturing capacity for such pre-Retina displays.

A few questions.

First, developers. As we saw with iOS apps for iPhone and iPad, size matters, apps don’t scale. That hasn’t dampened the enthusiasm of developers for investing in app versions that take advantage of each device unique characteristics, as opposed to committing the cardinal sin of “It’s like the other one, only smaller/bigger”.
So, if developers believe a 7″ iPad would sell in large numbers, they’ll happily fire up Xcode, adapt their existing app, or write a new one. As for the belief in large unit volume for a 7″ device, the initial reception accorded to Google’s Nexus tablet shows there is potentially a lot of life in a smaller iPad.

(I ordered a Nexus tablet and will dutifully report. Last April, I bought a Samsung Note phablet and promised a report. Here it is: I’ll sell you mine for $50. A respectable product, I could definitely live with it. But, IMO, too big for a phone, too small for a tablet.)

Second, Apple was on offense. Now, competition succeeded in putting it on the defensive. While initial Kindle Fire sales were rumored to be huge, the same “sources”, checking on display supplier suppliers, now claim sales of Amazon’s tablet dropped precipitously after the Holidays. Amazon keeps mum, but is also rumored to prepare a slew of not one but several tablets for this year’s Xmas quarter.
As for the Nexus tablet, it isn’t shipping yet.
Instead of a defensive move, I think a 7″ iPad might be another take-no-prisoners move:

From the very beginning of the iPad and its surprising low $499 entry price, it’s been clear that Apple wants to conquer the tablet market and maintain an iPod-like share for the iPad. Now that Apple has become The Man, the company might have to adopt the Not A Single Crack In The Wall strategy used by the previous occupant of the hightech throne.

If this cannibalizes 10″ iPad sales, no problem, better do it yourself than let Google, Amazon or Samsung do it.

Lastly, the price/cost question. As you’ll see on this video, Todd Schoenberger, a Wall Street haruspex visibly off his meds, contends an iPad Mini is a terrible move for Apple, it would be a break with its single product version focus. Like, for the example, the one and only Macintosh, the one and only iPod. Also, he continues, an iPad Mini wouldn’t allow Apple achieve the 37% gross margin it gets from the bigger sibling.
No. If we’re to believe iSuppli, a saner authority on cost matters, the latest 32 GB 4G iPad carries a Bill Of Materials of about $364, for a retail price of $729. Even with a bit of manufacturing overhead, we’re far from 37% today. And, tomorrow, a smaller iPad, with a smaller display, a smaller battery, a correspondingly smaller processor would nicely scale down in cost from the “new” iPad and its expensive display/battery/processor combo.
To where? I won’t speculate, but Apple has shown an ability to be very cost competitive when using previous generation parts and processes. See today’s iPhone 3GS and iPhone 4 prices for an example.

I have no inside knowledge and quite a few inclinations: I’d love a pocketable iPad as much as I like small computers such as the defunct Toshiba Libretto and the lively 11″ MacBook Air.

If Apple comes up with a smaller iPad later this year, I think it’ll be a killer product.

–JLG@mondaynote.com

What’s next for RIM?

A sad coincidence provides a stark contrast between the fortunes of two high tech companies, titans present and past. Last week, on (almost) the same day that the iPhone celebrated its fifth birthday, RIM issued very bad quarterly numbers: Down 43% year-to-year to $2.8B; a $518M net loss compared to a $695M profit in the same quarter last year.

A short five years ago, the BlackBerry was sine qua non in the smartphone world. Today, the future looks gloomy: RIM admits that they expect “the next several quarters to be very challenging”; they announce “a global workforce reduction of approximately 5,000 employees”; and, last but not least, they tell us that the new BB10 OS, initially promised for the end of the year, will be delayed until Q1 2013.

The downward trend has been evident for some time. It led to the replacement of RIM’s historic co-CEOs, Messrs. Lazaridis and Balsillie, with former co-COO Thorsten Heins – and it leads us to ask a series of questions about RIM’s survival.

Will BB10, RIM’s answer to iOS and Android — the company’s “number one priority” — ever ship? And, if it does, will it matter?

Probably not…and probably not.

To start with, BB10 isn’t a next-generation OS, it’s not a version N+1. It’s a whole new infrastructure based on QNX. Certainly, QNX is robust, venerable, and respected — but over its nearly 30 years, it has evolved into the premier OS for real-time applications embedded in consumer electronics, medical devices, and automobiles, not smartphones. From the QNX website:

QNX software is the preferred choice for life-critical systems such as air traffic control systems, surgical equipment, and nuclear power plants. And its cool multimedia features have QNX software turning up in everything from in-dash radios and infotainment systems to the latest casino gaming terminals.

When RIM acquired QNX from Harman International in 2010, the OS came with a handful of sophisticated but narrow, focused tool kits and libraries. Tool kits that let developers build “high-value consumer-grade solutions that range from simple media players to multiple-node systems with intra-vehicle multimedia sharing.” Algorithms that “improve the clarity, quality, and accuracy of voice communications for the most challenging acoustic environments … from conference rooms to automobiles.”

Admirable, certainly, but can they do Angry Birds?

What QNX lacks is a general-purpose application framework for developers. This is the most important (and fattest) part of the smartphone operating system. To app developers, the app framework manifests itself as APIs (Application Programming Interfaces). There are more than 1,000 APIs in Android and iOS. Building such a framework is a complex, time consuming task. A vital one, too: No app framework means no developers, no apps, no sale in the smartphone era.

RIM’s CEO saw that the company’s engineers needed more time, bowed to reality, and announced that BB10 would be delayed until “Q1 2013”.

In normal times, delaying an OS release by a few months is almost routine, part of an always arduous development process. But these times aren’t normal: In the smartphone wars, nine months is a very long time. And we suspect there will be further delays: How many of the company’s software engineers will lash themselves to the mast as RIM continues to lose money, market share, partners, credibility? How many of their best techies have already fled to companies where their work will have a chance to matter, to be enjoyed by fellow app developers and by legions of paying customers?

But let’s assume BB10 finally ships (and that it doesn’t suffer from too many early release bugs). Will it matter? By Q1 2013, Android and iOS will be even more entrenched; BB10 — and whatever new hardware RIM can manage to produce while it sinks and lays people off — will have to be strikingly superior to reverse the company’s slide into insignificance. RIM will have to build a real ecosystem (app store, media, companion devices, payment system) that can compete with what Apple and Google deploy…to say nothing of what Samsung appears to be building.

We could stop here. If BB10 doesn’t matter, that’s the end of the road for RIM. Investors seemed to agree. The day after the quarterly earnings release, RIM shares lost 19% of their value. Subtracting RIM’s $2.2B in cash from its latest $3.8B market cap, the company is left with a (putative) enterprise value of $1.6B. Since its high in June 2008 — a mere four years — RIM has lost about 95% of its value.

Which raises another question: Under the circumstances, why are investors now buying RIM shares? (78M shares last Friday, more than 4X the average daily volume.) Are they philanthropists and necrophiliacs…or astute traders? What prospective endgame justifies the uptick?

There are two theories.

First, RIM will be cut up and sold in pieces: A BB10 licensing business, a BBM (BlackBerry Messenger) operation, an entry-level hardware unit. On closer examination, however, this doesn’t make much sense.

– CEO Heins says RIM licensing will be “fully open”, by which he probably means even more open than Android. Right. Who needs a fledgling OS — without an ecosystem?

– BlackBerry Messenger is/was well-loved, and for good reason, but it doesn’t make sense on its own. Which smartphone platform would it run on? Android, iOS, Windows Phone? Or Tizen for high-end feature phones?

– As to the hardware unit, Huawei, ZTE, and others already produce low-cost BlackBerry killers sold in developing countries and, soon, everywhere. They don’t need RIM’s imprimatur, particularly if BBM and BB10 are no longer part of the brand.

Which leads us to the second theory: RIM sold as a whole to a muscular player such as one of the Chinese companies already mentioned. This could present a different sort of problem: BlackBerries are still popular with many government agencies around the world and Huawei, for one, isn’t. As for other wholecloth buyers: Samsung is busy with four platforms already (Bada, Tizen, Windows Phone, Android). Microsoft has its own story with Nokia. Who else?

Speaking of Ballmer & Co., yet another line of thought is that RIM will ditch BB10 and jump on the Windows Phone platform. Easier said than done, we saw what happened when Nokia osborned its Symbian and MeeGo devices. The move would need to be done in secret and quickly. (Allegedly, Nokia got its first Windows Phone devices from Compal, an experienced Taiwanese supplier; that might be a place to look for a quick transition.) Running BBM on top of Windows Phone 8 would please customers. Microsoft’s ecosystem would also help.

Would Microsoft want to see RIM join the Windows Phone party? Probably…but RIM’s CEO nixed that move. Moreover, Heins nixed all such moves, including joining the Android camp: He wants RIM to stay on its own platform.

Can Heins stick to his guns? We’ll see what he has to say after his brand new (effective July 1st) General Counsel, Steve Zipperstein, takes him aside and whispers in his ear about shareholder lawsuits. For almost 10 years, RIM’s new legal eagle worked for the US Department of Justice as a federal prosecutor…

RIM’s $2.2B in cash, no debt, gives it a bit of maneuvering room: It’s a lot easier to sell your company, or parts of it, when there is money in the bank. Further, the 55 days (of average sales) in channel inventory isn’t completely bad news, some of it could be flushed — at a loss — to generate additional cash and more “runway”. But for how long?

JLG@mondaynote.com

Microsoft: Apostasy Or Head Fake?

My appetite whetted by three days of rumors, I went online last Monday and watched Microsoft introduce its Surface tablets. After the previous false starts — the moribund Tablet PC and the still-born Courier — Microsoft finally took matters into its own hands. Ballmer & Co. could no longer wait for OEMs to create vehicles worthy of Windows 8’s “reimagined” beauty and function, not while the A-team ran away with the tablet market.

It was a terrific performance that hit all the right notes:

• World-class industrial design by Microsoft’s guru, Panos Panay.
• An ARM-based consumer tablet running Windows RT, and an x86 enterprise version on Windows 8, both with the innovative Metro UI.
A “digital ink” stylus for handwriting and drawing, faithful to Gates’ famous dictum: “I’ve been predicting a tablet with a stylus for many years, I will eventually turn out to be right or be dead.
• Creative, thoughtful touches: the integrated kick-stand, a novel smart cover with an integrated keyboard, the magnetic stylus that sticks to the side of the device.
• MicroSD, USB 2.0, and Micro HD video connectors.
• 10.6” displays: ClearType HD for the ARM-based tablet, ClearType Full HD for the x86 device.
• Both tablets are slim and light: 9.3 mm/676 grams for the consumer model, 13.5 mm/903 grams for enterprise. (That’s .37”/1.5 lbs, .53”/2 lbs, imperial.)

47 minutes later, Microsoft has jumped to the head of the tablet race. Yesterday’s laggard is now the Big Dog. Thrilling. I want one — probably the lighter Windows RT model.

The live demo wasn’t fumble-free, as a number of critics have pointlessly pointed out. Yes, Windows Chef Steven Sinofsky had to swap out a busted tablet, but this (probably) means nothing, it happens all the time, trust me — I gave my first computer demo 44 years ago and have fumbled through a few more since then.

I smile when I imagine Ballmer on the phone to Tim Cook, letting Apple’s CEO know that a complimentary toaster/fridge – the “convergence” of his nightmares – is on its way to Cupertino’s One Infinite Loop. (Perhaps I should explain: In a recent D10 Conference interview, Cook dismissed the notion of a hybrid tablet + laptop with a quip: “You can converge a toaster and a refrigerator, but those aren’t going to be pleasing to the user.”)

Fantasy phone call aside, this is an historic event. Microsoft decides to make its own hardware and, straight out of the gate, unveils two attractive products that combine the best features of tablets and laptops, both supported by the huge Windows ecosystem.

Unsurprisingly, the momentous happening unleashed an orgiastic excess of premature evaluation. Reactions were fast and predictably polarized. It was, in the repurposed words of one witty blogger: Choo, choo, all aboard the Pundit Express to PageHitsVille! (He was referring to a different event, but I can’t resist repeating the epigram.)

After a few hours, a pattern started to emerge:

- Reviewers who weren’t in attendance, unencumbered by direct experience, were more inclined to view the new products through pre-existing biases and to issue clear-cut predictions.

- The privileged few who were invited to the press event in Los Angeles were more nuanced in their analyses, but with a recurring complaint: They didn’t have an opportunity to use the product for themselves, they were hurried along in small groups to look at non-functioning machines. A couple examples:

I was only permitted to touch the device while the machine was powered off. Microsoft representatives were happy to show off the device, but they didn’t let me actually use the new tablet (Slate’s Farhad Manjoo).
As for performance, we’ll be honest: tech press were treated to about two minutes at each of several stations, some of which demoed design, and not so much the power that lies inside that thin frame.

Unfortunately, we didn’t get to see a working demo of the keyboards. As in, we weren’t permitted to type sample sentences and feel what it’s like to hammer out characters on a flat keyboard, or on keys that have just 1.5mm of travel (Endgadget’s Dana Wollman).

With these observations in mind, I took another look at the video and realized how many other important details were omitted from the well-oiled presentation: Price, delivery dates, battery life, wireless connectivity, display resolution (could we have an unequivocal definition of the ClearType HD and ClearType Full HD?).

The missing data, the evasions, the lack of hands-on examination, even the circumstantial evidence of a stage struck device…it all smacks of products that aren’t ready — or even almost ready — for customers’ mitts and credit cards.

This leaves us with a list of questions.

First: Why now? Microsoft’s agitprop specialists aren’t new to the game. They know what happens when you show up with less than fully-baked devices and refuse to answer simple, important questions. Why not announce on, say, October 15th – the beginning of the Holiday shopping season — when they would have a better chance of running a FUD (Fear Uncertainty and Doubt) campaign against the opposition? Why the rush?

Maybe it’s the expectation that Google will announce its own Android tablet at Google I/O later this week…but I find the argument unconvincing. Microsoft would have been better off letting Google speak first so they could analyze the product and come up with a sharply targeted counter, especially if Google ships much sooner than Microsoft.

Second, the Apostasy question. For decades, the Redmond company has preached the Righteous Way of its OEM ecosystem, the wide range of hardware configurations and prices for its Windows platform. Now Microsoft pulls a 180º, they design and contract/manufacture Surface tablets by themselves, with distribution through the Microsoft Stores and online. That’s a whole different religion.

Why?

Is it because, as one supporter put it, “greedy” OEMs have become “obstacles of innovation”, that “the software giant has bled too much for OEMs far too long”? That’s one way to look at it. (Another reading of history sees that under the Windows thumb, Microsoft’s vassals have had little choice but to engage in a price war, in a race to the bottom. For PC makers, this undercut the margins they needed to design and manufacture the “innovative” products that their overlord now chides them for not having in their arsenals.)

There must be a more sensible explanation, and our friend Horace Dediu doesn’t disappoint. In his Who will be Microsoft’s Tim Cook? Dediu comes up with an eye-opening analysis that focuses on the “business model inversion” that has taken place in the last two years.

For decades, software generated much higher margins than hardware. Microsoft was admired for its extremely high margins, while Apple was criticized for stubbornly sticking to hardware and its lower profitability — to say nothing of lower volumes as a marginal PC player. But now, as Dediu points out, Apple is the company with both the higher revenue and operating margin [emphasis mine]:

If we simply divide revenues by PCs sold we get about $55 Windows revenues per PC and $68 of Office revenues per PC sold [1]. The total income for Microsoft per PC sold is therefore about $123. If we divide operating income by PCs as well we get $35 per Windows license and $43 per Office license. That’s a total of $78 of operating profit per PC.
Now let’s think about a post-PC future exemplified by the iPad. Apple sells the iPad with a nearly 33% margin but at a higher average price than Microsoft’s software bundle. Apple gives away the software (and apps are very cheap) but it still gains $195 in operating profit per iPad sold.
Fine, you say, but Microsoft make up for it in volume. Well, that’s a problem. The tablet volumes are expanding very quickly and are on track to overtake traditional PCs while traditional PCs are likely to be disrupted and decline.
So Microsoft faces a dilemma. Their business model of expensive software on cheap hardware is not sustainable. The future is nearly free software integrated into moderately priced hardware.

Which leads Horace to his killer conclusion:

For Microsoft to maintain their profitability, they have to find a way of obtaining $80 of profit per device. Under the current structure, device makers will not pay $55 per Windows license per device and users will not spend $68 per Office bundle per tablet. Price competition with Android tablets which have no software licensing costs and with iPad which has very cheap software means that a $300 tablet with a $68 software bill will not be competitive or profitable.
However, if Microsoft can sell a $400 (on average) device bundled with its software, and is able to get 20% margins then Microsoft is back to its $80 profit per device sold. This, I believe, is a large part of the practical motivation behind the Surface product.
The challenge for Microsoft therefore becomes to build hundreds of millions of these devices. Every year. Sounds like they need a Tim Cook to run it.

It’s difficult to argue with Horace’s logic, but there’s another way to look at Microsoft’s new posture: It’s just that, a posture, a way to wake up PC OEMs and force them to react. “If you do the right thing and come up with the world-class product Windows 8 deserves, we’ll back off and let you enjoy the just deserts of your efforts.” It’s a devious thought, but it could be more realistic than the notion that Microsoft will produce something in the order of 100 million Surface tablets in 2013 in order to keep their dog in the fight. (For reference, the lead PC maker, HP, currently ships about 16M devices per quarter.)

I’m also curious about Microsoft’s rigid insistence on calling these devices PCs. See their official site announcing a “New Family of PCs for Windows”:

Try as they might, Microsoft won’t be able to convince folks to refer to the Surface as anything other than a “tablet”. The Redmond team seems fixated on a best-of-both-worlds product: Everything a PC does plus the best features of a tablet. This is what John Gruber calls being caught Between a Rock and a Hardware Place. (Gruber’s post, which quotes Dediu’s, is itself quoted and felicitously expanded upon by Philip Elmer-DeWitt.)

Peter Yared offers his help with a witty clarification:

In the end, I can’t see how Microsoft can suddenly morph into a tablet, er, PC maker capable of pumping hundreds of millions of devices per year. The fuller Surface story is yet to unfold.

JLG@mondaynote.com

The Nokia Torture

How would you like to be a Nokia employee? Last week the bosses came up with more bad news: In order to cut 3B€ (about $3.8B) in expenses by the end of 2013, another 10,000 employees will be shown the door — this after earlier cutting payroll by 4,000 people. The news came couched in corporate doublespeak: Nokia sharpens strategy and provides updates to its targets and outlook, with a shamefully misleading first subtitle:

Company announces targeted investments in key growth areas, operational changes and significantly increased cost reduction target

Followed by a second one, finally hinting at the bad news:

Company lowers Devices & Services outlook for the second quarter 2012

In the opaque 2900-word release, management concedes business is worse than expected, with no immediate hope of improvement:

During the second quarter 2012, competitive industry dynamics are negatively affecting the Smart Devices business unit to a somewhat greater extent than previously expected. Furthermore, while visibility remains limited, Nokia expects competitive industry dynamics to continue to negatively impact Devices & Services in the third quarter 2012. Nokia now expects its non-IFRS Devices & Services operating margin in the second quarter 2012 to be below the first quarter 2012 level of negative 3.0%. This compares to the previous outlook of similar to or below the first quarter level of negative 3.0%.

In English: ‘Our smartphone business sucks, it lost money last quarter, it will lose even more money for the current quarter ending in June, probably in the 5% operating loss range, and we’ll experience similar bleeding for the foreseeable future.’

Bond-rating agencies took note and promptly downgraded Nokia’s debt to junk status, another worrisome development. Reading Nokia’s Q1 2012 numbers, we see Net Cash at 4.8B€ (approx. $6B), 24% less than a year ago, 13% less than the immediately preceding quarter. With accelerating losses, the cash drain is likely to do the same. This puts Nokia in a dangerous squeeze: It could have to borrow money at unfavorable rates, or be prevented from doing so, or be forced into liquidation.

This is how: We know Nokia has already borrowed money, about 4.9B€ (approx. $6.3B), but we don’t know what the small print on those bonds say. Creditors often put conditions (covenants) giving them the option to demand immediate repayment if the debtor’s business deteriorates too much.

Nokia’s management is worried, it shows in little signs such as the length of precautions taken in what is known as Forward-Looking Statements. These consist in lawyerly language telling us everything we have heard or read could be nullified by a number of changes in the weather, the price of pork bellies or crop failures. The practice, as often, stared with the best of intentions: Management should be free to share their views of the future without being held too strictly to their description of inherently fragile circumstances.

In February 2011, Nokia’s cautious language about 255 words. Last week, attorneys in charge of covering the backs of Nokia execs needed more than 1,400 words, listing precautions from A to K, and from 1 to 39.

Put simply, this betrays is a growing fear of lawsuits.

In the meantime, Nokia’s CEO, Stephen Elop, is “opening the second envelope”, that is firing members of his exec team, including one who imprudently followed him from Microsoft. Next time, it’ll be his turn — and too late to save the company.

Many blame Elop, but what about the Board of Directors? In 2010, when the fact Nokia was on the way down became too obscenely obvious for the Board to ignore, they fired the CEO, OPK (Olli-Pekka Kallasvuo), an accountant cum lawyer, and doubled down by hiring Elop, a Microsoft exec with zero smartphone experience and a record of job-hopping. The new CEO soon said one very true thing, ‘This is a battle of ecosystems’ and did a terrible one: He osborned Nokia’s existing Symbian-based products as he committed to a distant collaboration with Microsoft and its unproven Windows Phone system software. What did the Board do? Directors approved the move. Willfully or stupidly, it doesn’t matter, they supported Elop’s imprudent move.

Nokia, once the emperor of mobile phones, shipping more than 100 million devices per quarter, is now in a tailspin, probably irrecoverable, taking its employees into the ground.

And there is Nokia’s chosen partner, Microsoft. What will Nokia’s failure do to its future? Ballmer knows Microsoft can’t be relegated to a inconsequential role in the smartphone wars. Will this lead to Microsoft going “vertical”, that is buying Nokia’s smartphone business and become an vertically player, as it already is in its Xbox business?

JLG@mondaynote.com

Mobile Advertising:
The $20B Opportunity Mirage

There are a lot of questions left to be answered about Facebook’s IPO fiasco, but one thing we know is this: As consumers shift their use of Facebook from PCs to smartphones, investors worry about lower mobile advertising revenues. Is this a temporary situation that will be remedied when usage patterns settle, or do investors have a right to be concerned? Must the advertising industry learn to adapt to a permanently leaner income stream from smartphones?

Let’s start by taking another look at Mary Meeker’s latest Internet Trends presentation from last week’s All Things Digital conference. On slide 17, she projects a $20B opportunity for Mobile Advertising in the US:

When Meeker uses the word “opportunity”, she means “unfulfilled potential”: Mobile Ad Spend in the US alone should be $20B larger than it is. For reference, Google’s latest quarterly revenue was about $10B worldwide.

$20B is a big number, and it got me thinking. How is it possible that the industry’s richest and most sophisticated players are unable to grab such a big pile of money? They have the brains and the computers, they’re aware of the situation…Is there a deeper problem?

A too-easy answer is the market’s age: Mobile advertising is still in its infancy. But that’s an indefensible excuse: The first iPhones shipped in late June 2007, the Smartphone 2.0 era is now five years old. Both Android and iOS are prosperous platforms with bulging App Stores, they sell tens of millions of devices every month, close to half a billion this calendar year. Brand managers, advertising agencies, search engines, social networks, a myriad of vibrant startups keep trying, but mobile advertising barely moves the needle.

We get closer to the heart of the matter when we look at a common thought pattern, an age-old and dangerously misleading algorithm:

The [new thing] is like the [old thing] only [smaller | bigger]

We’ve seen this formula, and its abuse, before. Decades ago, incumbents had to finally admit that minicomputers weren’t simply small mainframes. Manufacturers, vendors, software makers had to adapt to the constraints and benefits of a new, different environment. A semi-generation later, we saw it again: Microcomputers weren’t diminutive minicomputers but truly personal machines that consumers could lift with their arms, minds, and credit cards.

The “Tech-savvy We” should know better by now; We should have learned, but the temptation — and the lazy easiness — of the “X=Y but for the form factor” algorithm continues to derail even Our most “different thinkers”. When the iPad was introduced, a former Apple Director described the offering thus: “It’s just a big iPod Touch” (which proves nothing more than that Steve Jobs didn’t burden his Board of Directors with loads of information).

At the D8 conference in 2010, in front of an iPad-toting audience, a bellowing CEO dismissed Apple’s tablet as just a PC, minus the keyboard and mouse. (And I’ll share the shame: On April 3rd 2010, I looked at my new iPad through PC goggles and lamented the Mac features that were “missing” from my new tablet.)

Now we have advertising on smartphones, and we’ve fallen into a comfortable, predictable rut: “It’s just like Web advertising on the PC, shrunk to fit.” We see the same methods, the same designs, the same business models, wedged onto a smaller screen.

PC advertising has successfully navigated different screen sizes. On a large screen you might see something like this:

Plenty of space for both advertising and content. Even on a smaller screen, the ads are unobtrusive:

But on a smartphone, this is the advertising that’s supposed to entice us:

…and this is the NY Times, one of the better mobile apps.

Mobile ads aren’t merely smaller, they have less expressive power, they don’t seduce…and they’re annoying.

Of course, there’s more to the smartphone misunderstanding than the fairly obvious screen size problem. There’s also a matter of how we use our computing devices.

When we sit down in front of a laptop or desktop screen, our attention is (somewhat) focused and our time is (reasonably) committed. We know where we are and what we’re doing.

With smartphones, we’re on the move, we’re surrounded by people, activities, real-world attractions and diversions. As yet another Mary Meeker presentation suggests, time spent on mobile devices is fragmented:

We’re not paying (a loaded word) the same type of attention as we do on a PC.

Business Insider features an InMobi report on mobile ads, with the following comment [emphasis mine]:

Those ads were served across 6 billion mobile devices. That’s less than $1 per device, per year—a tiny sum. That tells you how far mobile advertising has to go, and how massive it will become in the next five years.

The dollar-per-device statement is a fact, the assumption of “massive” growth is wishful thinking.

When I hear that there’s a mother lode of advertising revenue in location-based ads that are pushed to my mobile phone as I stroll down Main Street (with my permission…I hope), ads that offer succulent deals in the stores and restaurants I’m about to pass, I wonder: Do we want barkers on our devices? Is this the game changer for mobile advertising, yet another kind of spam? LBA may be a hot topic among marketers but the public is dubious, as this MobileMarketer article soberly explains:

The reality is that this scares consumers, rather than excites them. Mobile marketers need to realize that what gets them and their peers fired up does not necessarily move consumers in the same way.

And this…

According to [Rip Gerber, CEO of Locaid Technologies, San Francisco], marketers create their own privacy obstacles when they forget relationship, relevance and preferences in favor of short-sighted metrics.

If the industry hasn’t cracked the mobile advertising code after five years of energetic and skillful work it’s because there is no code to crack. Together, the small screen, the different attention modes, the growing concerns about privacy create an insurmountable obstacle.

The “$20B Opportunity” is a mirage.

JLG@mondaynote.com

Monday Note Exclusive: The Walmart Garden Smartphone

Last week was the 10th anniversary of the Wall Street Journal’s All Things Digital Conference, D10 for short. For the past three years it’s been held at the Terranea Resort in Rancho Palos Verdes, South of Los Angeles.
If I leave in the wee hours and take an North and East detour around the Evil 405, it’s a “short” 6-hour drive from Palo Alto. This is a welcome opportunity to avoid airport hassles, to bring all my toys, to listen to Glenn Gould and to catch up on phone calls. For a long I5 Central Valley stretch, I also get to work on my Spanish, the only language spoken on local FM stations. The fare varies widely: plagent Mexican love songs; garrulous commercials spoken at ultra-high speed with the rolling rrrrs that bring up smiles and childhood memories; the obligatory preachers and the occasional public interest program — the latter with a distinctly more educated Castellano enunciation.

I like the conference formula: Interviews of ‘‘heads of state’’, high-tech and media CEOs, by Walt Mossberg and Kara Swisher, two highly regarded tech journalists. No talking heads, no mind-numbing PowerPoint presentations — we gave at the office. I once complained to Uncle Walt his questions looked a little soft, without much of an attempt to follow-up on obvious evasions or outright fabrications. ‘Think again’, Walt said, ‘you used the word obvious; don’t think you’re the only BS expert in the audience, I let everyone draw their own conclusion.’ He’s right, I recall moments when a telco executive made such impudent statements audience members looked at each other wondering wether the guest was lying or incompetent.

The D10 site is supplemented by iPhone and Android apps, all giving access to videos, transcripts and commentary. High-quality, mostly, but the abundance can be overwhelming. If you’re short on time, look for the following:

Ed Catmull, the Pixar co-founder. For me, his interview was the highlight of the conference. Quietly brilliant and wise. A short video here.
Larry Ellison, founded Oracle in 1977 and still running it. He never disappoints, mercilessly ridiculing SAP and HP and the former CEO of both. Larry is a dangerous adversary, wittier and more knowledgeable than most CEOs.
Mary Meeker broke the No PowerPoint rule, she took us through a 125-slide deck.
I’m a fan of hers and often refer to her legendary Sate of The Industry presentations, but she could have done an even more effective job by concentrating on one or two slides, by commenting on their origin and significance. See for example this one:

It summarizes Facebook’s biggest problem, what she diplomatically calls a $20B opportunity: mobile ads fail to produce any kind of significant revenue, and we’re not sure why.
Ari Emmanuel, the assoholic Hollywood super-agent was equal to his reputation, he shouted down The Verge’s Joshua Topolsky for having the nerve to question his view of Google’s role in filtering content. For all the entertainment value, the verbal violence and bad faith were uncalled for and do nothing to improve the agent’s clients image. Topolsky’s measured reply is here.
Tim Cook, long-time Steve Jobs’ second-in-command and now Apple CEO. He gave a quiet, competent performance, masterfully deflecting questions about future products and reminding us imitating Steve Jobs definitely isn’t the way forward.

But we shouldn’t lose sight of the real formula for this gathering: Great interviews and demos on stage + even greater schmoozing in the hallways.

There, I got really lucky.

In the line for the coffee urns, I overheard two Walmart execs animatedly pitching their upcoming smartphone to the CEO of an app development company — in Spanish. They must have felt safe in the belief the catering staff might understand the language, but definitely not the topic. Using a simple, striking one-liner…

“Walmart wants to become the Walmart of smartphones.”

… they told the gent he could help their company achieve this goal and, in the process, profit immensely.

Later that evening, I introduced myself to the developer — in his native language. After a couple of drinks and cross-cultural pleasantries, I asked about his interest in Walmart’s smartphone. He was relaxed and practical: ‘They have a big business (and big problems) in Mexico, I can help them get good apps for their launch there later this year, but you know their reputation, they squeeze their suppliers, I’ll want money upfront…’
I nodded and asked what he liked most about the product: the design, the platform, the business model? Little by little, I learned Walmart’s smartphone program came from Walmart Labs, a Silicon Valley outpost of the Arkansas giant. The project was born out of frustration with Google’s conversion of Google’s free Product Search to Google Shopping’s pay-to-play model where inclusion in search results (as opposed to ads on the side) now requires a payment. There is also a reaction to Amazon’s rumored smartphone, a complement to its Kindle Fire. Actually, my drinking companion said, Walmart’s smartphone takes more than a leaf off Amazon’s playbook: like the Kindle Fire, it relies on an Android fork, that is grabbing the Open Source code and retargeting to its own business purpose — without the onus of included Google apps that come with the sanctioned Android version. The hardware is from HTC, with a NFC chip for fast and easy contact-less checkouts; the software platform is designed to help product discovery and content sales and, like Amazon, Walmart will launch its own App Store in the US, Canada and Mexico.
To sell its “Walmart Garden” smartphone, the company will use its more than 5,000 North-American stores and set itself up as an MVNO, reselling Sprint in the US, Rogers in Canada and Telmex in Mexico. The Walmart smartphones will come with both conventional (also called post-paid) contracts and pre-paid plans for customers will lower credit scores.
I couldn’t get an idea of projected prices or sales volumes, but the developer said evangelizing Walmart execs were dangling a future installed base numbering in the tens of millions, may be 100 million after a few years.

This is fiction.

Mostly but not all: Walmart Labs do exist, but the rest is invented. I’m sure Walmart watches Google’s every move and worries about the Search giant becoming an unavoidable — and therefore increasingly expensive — toll gate. But designing, selling and supporting one’s smartphone is no easy task, even for a competent giant like Walmart.
Put another way, does it make sense for every major corporation to develop its own branded smartphone as a way to keep their customer relationship “pure”, protected from search engine and social network predators?

Smartphones aren’t merely handsets with bigger screens and more functions, they’re app phones, they’re part of an ecosystem. They’re a separate, highly specialized, often risky trade, not just another line of business easily added to a large corporation’s portfolio.

Which bring us to the recurring Facebook phone rumors. Some are so asinine I’ll just quote without a link:

Facebook has quietly assembled all the important bits of a mobile phone [emphasis mine]. It just released its new camera application that uploads directly to Facebook, its own messenger service, and it’s reported that Facebook is courting mobile web browser developer Opera.

Right. Kick any trash can around the Valley and all the unimportant bits, hardware, operating system, retail distribution, service and support crawl out. Unsurprisingly, the general reaction to the latest Facebook phone rumor, summarized here, has been overwhelmingly negative. It’s one thing for Apple to defy conventional wisdom (infelicitously spewed by Palm’s Ed Colligan), they had never made a telephone before, but Jobs & Co. had validated experience in the entire hardware food chain, from design to retail stores. It’s another for Facebook to learn and quickly become competitive in a trade now dominated by giant slayers of Apple and Google stature.

I greatly admire Zuckerberg, I think he’s a cagey strategist playing the long ball, and I don’t believe he’s this naive. He might worry about Google becoming too much of a toll gate for his company’s good, but building a Facebook smartphone in order to contain the Android invasion isn’t the right answer. Google has enough adversaries, some with business models that differ enough from Facebook’s, to offer a choice of viable allies. Stay tuned, as Apple’s CEO said at D10.

JLG@mondaynote.com

Decoding Share Prices: Amazon, Apple and Facebook

There are many religions when it comes to calculating the “right” price for the shares of a publicly traded company. At a basic level, buying a share is an act of faith in the company’s future earnings. The strength of this belief manifests itself in the company’s P/E (Price/Earnings) ratio. The stronger the faith, the higher the P/E, an expectation of increased profit.

Sometimes, an extreme P/E number beggars belief, it invites a deeper look into the thoughts and emotions that drive prices.

One such example is Amazon. On the Nasdaq stock market, AMZN trades at more than 174 times its most recent earnings. By comparison, Google’s P/E hovers around 17, Apple and Walmart are a mere 14, Microsoft is a measly 11.

This is so spectacular that many think it doesn’t make sense, especially when looking at Amazon’s falling profit margin (from this Seeking Alpha post):

Why do traders bid AMZN so high in the face of a declining .5% profit margin?

In his May 5th PandoDaily piece, “Nobody Seems to Understand What Jeff Bezos is Doing. Does He?”, Farhad Manjoo questions Jeff Bezos’s strategy and Amazon’s taste for obfuscating statements:

“Amazon is not merely “willing” to be misunderstood, it often tries to actively sow widespread misunderstanding. This works [to] its advantage; if competitors don’t know what Amazon is up to, if they can’t even figure out where and how it aims to make money, they’ll have a harder time beating it.”

…and he concludes:

“Is Bezos crazy like a fox? Or is he just plain crazy? We have no idea.”

He’s not alone: Year after year, critics have challenged Bezos’ business acumen, criticizing his grandiose views and worrying about the company’s bottom line. But the top line, revenue, keeps rising. See this chart from a Seeking Alpha article by Richard Bloch:

The answer to Farhad’s question, the cold logic behind the seemingly irrational share price is clear: Amazon sacrifices profits in order to gain size and, in the process, kill competitors.

That’s step one.

Step two: After having cleared the field, Amazon will take advantage of what is delicately called “pricing power”. As the Last Man Standing, they will raise prices at will and regain profitability. This isn’t Amazon’s only game. The breadth of their offering, their superior customer service and awesome logistics, make life difficult for poorly managed competitors such as Best Buy, or the undead Circuit City, to name but a few companies whose weaknesses where exposed by Amazon’s superbly efficient machine.

But traders recognize the wink and the nod behind today’s numbers, they are willing to pay a high price for a share of Amazon’s future dominant position.

Apple’s share price sits at the other end of the P/E spectrum. Revenue and profits grow rapidly: + 58% profit year-to-year, + 94% net income. “Normal” companies in their league are supposed to fall to the Law of Large Numbers: High percentage growth becomes well-nigh impossible when a company achieves Apple’s gigantic size. A $100B business needs to dig up $25B in new business to grow 25%. $25B is roughly half the size of Dell. When Apple’s revenue grows 58%, that’s more than one Dell on top of last year’s business.

Apple is the nonpareil of fast-growing, prosperous companies. They’re in a young market: smartphones and tablets. They can easily break the Law. With only 8% of the mobile phone market, the iPhone enjoys considerable headroom. And the iPad’s +151% year/year unit growth shows even greater potential.

So why isn’t Wall Street buying? Why do they think Apple has so much less room to grow than Amazon?

First, a big difference: Apple’s founder is no longer with us while Bezos is very much in command. This is no criticism of Tim Cook, Apple’s new CEO. A long-time Jobs lieutenant, the architect of Apple’s supremely effective Supply Chain, a soberly determined man, well liked, respected and healthily feared inside the company, Tim Cook is eminently credible. But traders are cautious; they want to see if the Cook regime will be as innovative, as uncompromisingly focused on style and substance as before.

Second, the much talked-about iPhone subsidy “problem”. The accepted notion is that Apple has strong-armed carriers into paying “excessive” subsidies for the iPhone, some say as much as $200 more than carriers pay other handset makers. (See “Carriers Whine: We Wuz Robbed!” of March 11, 2012.) Carriers rattle their sabers, they let everyone know they’re looking forward to the day when they will no longer be fleeced by the Cupertino boys.

The numbers are impressive. Take about 150 million iPhones this calendar year (37M units in the last quarter of 2011); assume that 80% of these iPhones are subsidized by carriers…that’s $24B in subsidies. For people who are betting on Apple’s future profits, these are big numbers that could go either way: Straight to Apple’s bottom line as they do today, or back to the carriers’ coffers “where they belong”. For Apple, with today’s P/E of 14, a swing of $24B in profits would result in a change of $336B in market cap. (Today Wall Street pegs AAPL at $525B.)

I’m not saying such a shift is likely, or that it would happen in one fell swoop. I use this admittedly caricatural computation to make a point: Carrier subsidies have a huge impact on Apple’s bottom line, and the perceived uncertainty over their future gives traders pause.

I’ll now take the opposite tack with this Horace Dediu tweet:

In my venture investing experience, it sometimes happens that the top salesperson makes more money than the CEO. In most instances the exec is happy to see big revenue come in and doesn’t begrudge the correspondingly large commissions. But, in the rare case of the CEO turning purple because a lowly peddler makes more money than him (it’s a male problem), we take the gent aside and gently let him know what will happen to him if he does it again.

Carriers sound like the bad CEO complaining about excessive sales commissions racked up by their star revenue maker. Carriers are contractually obligated to keep iPhone figures confidential so we can’t make a direct ARPU comparison — but we have anonymous leaks and research-for-hire firms, they’re curiously silent on the question of actual ARPU by handset. In the absence of a clear case made to the contrary, we’ll have to assume that the iPhone is the carriers’ top revenue generator, and that the subsidies will continue.

This said, if Apple comes out with a mediocre iPhone, or if Samsung produces a distinctly more attractive handset, the salesman’s commission will disappear, Apple’s revenue per iPhone (about $650 in Q1 2012) will drop precipitously, and so will profits.

That’s the scenario that makes traders cautious: Large amounts of profit are at risk, tied to carrier subsidies. They wonder if Apple’s lofty premium is sustainable and, as a result, they assign AAPL a lower P/E.

But “caution” may be too weak a word. In a May 7th 2012 Asymco post, Horace Dediu plots Apple’s share price as a function of cash:

This is troubling. It implies that cash is the only determinant of Apple’s share price.

Put another way, and recalling that share prices are supposed to reflect earnings expectations, it appears Wall Street puts little faith in the future of Apple’s earnings [emphasis mine]:

“Given this disconnect from the income statement, the pricing by balance sheet multiple seems to be a symptom of something deeper. Reasons vary with the seasons, but the company is not perceived to have sustainable growth.

Fascinating. The collective wisdom of Wall Street is that one of the most successful high-tech companies of all times, with three healthy product lines, strong management, generally happy customers and employees is not perceived to have sustainable growth.

We’ll see.

(In the interest of full disclosure, I’ll repeat something I’ve stated here before: I don’t own publicly-traded stocks, Google, Microsoft, Apple or any other. I consider the stock market a dangerous place where, across the table, I see people with bigger brains, bigger computers, and bigger wallets than mine. I can’t win. The casino always does…unless you don’t trade but, instead, invest–that is buy shares and keep them for years, the way Warren Buffet does.)

And Facebook?

I’ll wait for the dust of this botched IPO to settle before I try to figure out what Facebook’s share price reflects. I agree with Ronal Barusch in his WSJ blog piece: I’m not convinced that Facebook or its bankers will suffer irreparable damage.

Still, rumors and accusations are flying. Following Nasdaq’s disastrous handling of Facebook’s opening trades, we hear that the New York Stock Exchange is discreetly suggesting that the company move to a more sophisticated trading platform. This is a great opportunity for Facebook to change its FB stock trading symbol and adopt one that more accurately reflects its opinion of Wall Street.

I have a suggestion: FU.

JLG@mondaynote.com

California’s Financial and Cultural Deficits

I think I found a cure for both. First, the symptoms. Financially, California is close to being bankrupt, it spends more than it makes and runs a huge $361B debt, as illustrated by the online, live Debt Clock:

Unemployment is high; infrastructure is neglected; the pride of California, its UC Colleges, must raise tuition beyond the reach of the very people it was supposed to lift into higher education; California’s State Parks, another treasure, are neglected and being closed.

Fortunately, there’s a solution — and it’s right in our neighborhood. We’ve seen the wealth created by a flurry of recent Valley IPOs, and we’ve watched the rise in share price of more established companies. From Apple to Zynga, Facebook, and LinkedIn, we have a fresh crop of McBillionaires ready to help.

So, here’s what we’re going to do.

First, let’s all agree: $100K in monthly compensation is plenty. Beyond that, a 75% tax rate will help replenish the Golden State’s coffers.

Second, millionaires and billionaires won’t suffer much from a small yearly tax on their assets: 0.25% from $1.5M to $5M, half a penny on every asset dollar from $5M and up. Simplifying a bit, if you have $10M in assets you’ll pay about $50K in asset taxes every year, $100M yields $500K, $1B (think Facebook IPO) brings in $5M, and so on. A pittance for the great feeling of helping one’s fellow Californians.

Then there’s culture. Californians are perceived as a bunch of materialists obsessed with bling, cars, tans, IPOs, wineries, private jets, and various types of cosmetic augmentation and reduction. Outsiders deride our materialism, they call us nekulturny, they joke that the difference between yogurt and California is that yogurt has a living culture.

We can change all this by adding a simple clause to our asset tax code: Works of art are non-taxable. This would result in an explosion of art purchases and patronage. Sculptures, paintings, installations would grace every home and office of substance; artists from all over the world would flock to California, a Villa Medici for the 21st century.

Finally, we have to take care of our abused high-tech workers. Regard the poor Facebook programmers who had to spend yet another night in front of their computers before the IPO. Management profiteers attempt to ennoble this abuse by calling it a hackathon and parading the participants before the media, but we’re not buying it.

Let’s put an end to these destructive and demoralizing practices. Instead of a single 70-hour work week, we’ll create two jobs, hire two employees, each working 35 hours per week. And to promote a serene atmosphere, let’s agree that companies with 50 employees or more will have a “worker council” to oversee decisions such as staffing changes, compensation levels, group activities, layoffs, and the like.

Of course, as with any bold reform, some unintended, counter-productive side-effects may need to be considered.

Let’s start with the asset tax scenario. You work at a successful Valley company, you make good money and decide to help younger entrepreneurs by recycling your gains into their creations. You invest $1M in a startup and get 20% of its shares. As expected, you have to pay the asset tax on that investment, every year. The company attracts new investors at a higher valuation. Great, your initial $1M is now worth, say, $10M…on paper. You will now pay 10 times as much asset tax as before, $50K every year. Unfortunately, after years of valiant struggle, the company shuts down. You lose your investment — and the cumulated asset tax. You would have been better off buying art instead. Less angst, more civic pride (although, admittedly, less investment and innovation, fewer jobs).

You’ve long figured out I’m not serious. A 75% tax bracket, an asset tax, a 35-hour work week and worker councils — such naive measures would create a massive flight of money and talent out of California and into neighboring states that would be delighted to benefit from our boneheaded reforms.

And you’ve also figured out that the measures I’ve outlined, in a slightly oversimplified form, are or will shortly be in force in France. The asset tax is almost 30 years old and its current rate is likely to increase; the 75% income tax bracket is an election campaign promise and, believe it or not, the works-of-art exception is real.

This has resulted in a number of unfortunate countermeasures: High-tech execs pull up stakes and head to London or Brussels; European headquarters move out of Paris and Lyon or are created elsewhere. All because, to paraphrase François de Closets, French demagogues see no difference between Steve Jobs’ fortune and traders’ loot.

The 35-hour work week experiment failed to stanch French unemployment.  The code that complicates the management of companies employing 50 or more people, as Frédéric noted two weeks ago, has resulted in an abnormally high number of companies with 49 workers or less.

From the outside, this is puzzling: Instead of attracting talent and capital, France creates a combination of fact and perception working against the very interests it purports to protect. In addition to the flight of taxable assets, this will accelerate the Brain Drain French officials often rail against. In the US—and particularly in California—we welcome French entrepreneurs, engineers, business people—and money. Do French politicians understand the real world, or will they continue to closet themselves in the French Exception’s virtual reality?

JLG@mondaynote.com