Category Archives: Thoughts

Amazon vs. Apple: the Gathering Storm

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Two weeks ago the Wall Street Journal confirmed earlier reports that Amazon plans to launch a tablet this fall. It’s rumored that it will have a 9-inch screen and run an Android operating system.

On the surface this looks like a terrible idea. Since the launch of Apple’s iPad last year, tech titans including Samsung, HP, Motorola, and Research in Motion have all fast-followed with their own tablets, but the outcomes have been uniformly disappointing – John Gruber at Daring Fireball estimated that, even including Nook Color e-readers, the iPad’s share of the category is in the ~95% range. As Marco Arment put it, “[t]here really isn’t much of a tablet market. There’s an iPad market.” It’s widely agreed that Apple has the best tablet OS, form factor, and specs, plus the most apps and the strongest brand. It’s believed that Apple also has a cost advantage (due to early investments in suppliers’ production facilities), enabling entry level iPad pricing that none of the other major players have been able to beat.

So trying to enter this market as the 14th or so player doesn’t sound like a smart move for Amazon. Unlike the aforementioned hardware makers, it could easily sit this game out. Or could it?

Crazy Like a Fox

Amazon is a retailer that, despite its ever-growing “A to Z” product offering, still makes 40% of its revenue – and even more of its profit – by selling software and content, like books, movies, music, and games. This media, not physical goods, is still Amazon’s selling focus. Don’t believe me? Check out the department list at the left side of its home page – right now it reads:

  • Unlimited Instant Videos
  • MP3s & Cloud Player
  • Amazon Cloud Drive
  • Kindle
  • Appstore for Android
  • Digital Games & Software
  • Audible Audiobooks
  • Books
  • Movies, Music & Games
  • Electronics & Computers <- Finally, ten items down, the actual physical stuff!
  • Home, Garden & Tools
  • Grocery, Health & Beauty
  • Toys, Kids & Baby
  • Clothing, Shoes & Jewelry
  • Sports & Outdoors
  • Automotive & Industrial

It’s often been said that Apple makes money selling devices, and uses its software and content (e.g., iTunes) to drive those sales. Amazon does the reverse. Being the content-retailer of choice is so important to them that they designed and marketed an intuitive e-reader, the Kindle, just to ensure they’d own the e-book space. (A side note: crucial to Amazon’s success here was the realization that, in the digital media retailing world, “purchasing” and “consuming” activities would converge in a single device.) Even with a beautiful piece of hardware, Amazon was clearly tempted to view it as a mere complement for their true aim (selling digital media) in a razor-and-blade strategy. Which is exactly what Amazon’s been doing: rapidly dropping Kindle prices to get devices in the hands of as many users as possible (the ad-supported version is now only $114 and, in a sense, the Kindle app in every mobile store is essentially a free version of the device). This strategy shares elements with the idea of commoditizing your complements – in both cases, a cheaper complement (e-reader) helps you sell your money-maker (e-books).

In the meantime, of course, Apple has launched its own iBooks app and store on its iOS devices, a credible second-runner to Kindle. In theory, Apple doesn’t need to have its own content stores on its devices – if customers decide they like using the Kindle app for e-books (or, say, the Netflix app for movies), that would still help Apple sell iPads and iPhones. But Apple knows that providing its own proprietary, well designed content stores and formats will increase user stickiness and earn them a nice pile of cash on the side. So Amazon built a device to help them sell e-books and Apple built an e-bookstore to help them sell devices.

In an alternate universe, a fragile peace could have emerged between Apple and Amazon, with each holding a knife against the other (a strategic phenomenon known as spheres of influence). But unfortunately for Amazon, the Kindle was only a minor threat to Apple’s ability to use e-reading to sell devices, while Apple’s “knife” was and is much bigger. Apple recently announced it has sold 222 million iOS devices, all of which have iTunes (movies and songs), the App Store (software and games), and now the iBookstore. In other words, the sheer speed of Apple’s success in selling devices has made its threat a reality: it’s already become a dominant software and content retailer.

This position has emboldened Apple to muscle Amazon around a bit. This week, Apple began enforcing an earlier threat to take a 30% cut of every publisher sale made through an iOS app (like Kindle), as well as disallowing in-app buttons that took readers out of the App Store to make a duty-free purchase. Unable to cope with such a burden, Amazon – as well as Barnes & Noble, Borders, Google, and purveyors of other types of content like Rhapsody – removed the stores from their apps on Monday.

While users can still use Apple’s mobile browser Safari to access the Kindle store and download content, this is obviously a huge blow to Amazon’s ability to retail content. Controversy aside, Apple clearly knew that most digital retailers would choose to close up shop rather than pay such huge fees. A lot of pundits have missed this point – Apple isn’t trying to make money by taxing iOS users’ purchases in other companies’ stores. It’s trying to be the only good store in town (a la iTunes), and it’s doing it by crippling Amazon’s ability to have a store on the turf Apple owns. Amazon and the other companies aren’t revolting, they’re getting run out of town.

This is why Amazon can’t sit the tablet game out. To sum up, they’re basically looking at four facts that, combined, spell big trouble for them:

  1. Selling digital content and software is extremely important to Amazon.
  2. People want to buy (and consume) digital media on highly functional mobile devices (i.e., smartphones and tablets).
  3. Apple reigns supreme in those product categories.
  4. Apple’s aggressively preventing Amazon from selling digital media on Apple devices.

The only link in that chain that Amazon feels it can attack with any chance of success is #3.

And in This Corner…

The good news for Amazon is that, because it’s aiming to put devices in people’s hands primarily to enable selling them content and software, it doesn’t have to adopt the same “me-too” strategy that’s so dismally failed the other hardware manufacturers. One big key to success is a low price: a Retrovo study indicated that this was a huge selling point to potential tablet customers, and that a price in the $250-400 range could garner significant share relative to iPads at $500-830.

Is a price that low even possible? That depends on two things – first, Amazon would have to keep costs to a bare minimum. There’s plenty of signs that’s exactly what it’s doing – from outsourcing manufacturing to a large, experienced Asian producer (possibly Samsung), to using a simpler, smaller touchscreen, to forgoing cameras. It could also save money by using lower-cost processors and chips and having less flash memory storage. But another part of keeping the price down is relinquishing device profitability. Unlike the huge margins sought by Apple, Amazon can adopt the razor-and-blade strategy (possibly even accepting a loss on each tablet sale) and try to make it up on subsequent revenue from the digital media users buy on the device. Through a combination of these two tactics, I bet Amazon could price a tablet below $300.

The second big key to success, however, is the right user experience and capabilities. Some, such as MG Siegler, doubt whether customers would even want a stripped-down tablet from Amazon. But I believe it has an opportunity here to capitalize on its strengths and create the ideal content discovery and consumption device, rather than the ultra-flexible machine Apple’s designed. Imagine a tablet perfectly designed to find, buy, and consume books, newspapers and magazines (via the Kindle app), audiobooks (via Audible), music (via a rebranded Amazon MP3 and Cloud Player), movies and shows (via Amazon Instant), games, and other software (via the Appstore for Android). Running the Android Honeycomb OS, the tablet could tightly integrate these features in a simple interface with Amazon’s Cloud Drive for storage and syncing, Amazon’s excellent loyalty program Prime (with perhaps a free year’s membership), and an improved recommendation engine for discovery. General tablet functionality like web browsing, email, and social media would be key secondary features, while more advanced apps and capabilities – perhaps including 3G service – might be absent altogether. In many ways it might resemble a better-packaged Nook Color.

Could Amazon pull this off? Despite not yet having a tablet, Amazon’s brand is strong enough that a majority of potential tablet customers would consider buying it based on name alone. If Amazon nailed the pricing and user experience described above and added some brilliant marketing, I think it could be the first non-iPad tablet to sell in the multi-millions. That’s not the whole battle, though – Amazon would still have to convert enough digital media purchases to make it all worthwhile. Here’s where Amazon’s strengths in retail, pricing, and loyalty could really pay off. Amazon also just signed up 100 newspapers and magazines to deliver full-color issues to subscribers in the Kindle app, a sign that content creators still have faith in Amazon’s experience in selling and delivering digital media.

Ready for War

Any way you slice it, Amazon is making a huge bet by entering the tablet market. I don’t think anyone realizes how high the stakes are for them, and thus for Apple too. On the one hand, Amazon’s success with the Kindle, combined with CEO Jeff Bezos’ strategic direction (and the inevitable feeling of having one’s back against the wall) bodes well for an Amazon tablet. On the other hand, selling an Amazon tablet means convincing consumers not to buy the most successful consumer product ever. The last thing I would tell a company that spends half its energy battling Walmart would be that it should start spending the other half going toe-to-toe with Apple.

But Amazon is gritting its teeth and marching onto the field. The clouds have gathered. Get ready for a rumble.

Gloating, Part 1

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I’m not an investment analyst and don’t usually recommend stocks, but a month ago it seemed pretty obvious that Apple was being severely undervalued by the equity markets. So I posted a short article saying its price was absurd and that it was a clear “buy.”

What’s happened since then? Shares of Apple (AAPL) closed today at $386.90, up ~23% from the June 20th close of $315.32. In other words, in one month Apple created over $60 billion of shareholder value (measured by change in market cap). Not too shabby.

Their earnings report yesterday (which blew away the analyst consensus by 33%) had a lot of interesting data on their rocketing sales by product and region, but the most important thing about their share price growth over the past month is that there hasn’t been any single major driver, like a huge product announcement (its recent patent wins were about as close as it came). Instead, Apple’s just been consistently executing on a great strategy.

Of course, a month is nothing in this game – we’ll check back again in 6, 12, and 24. But remember that performance is a lagging indicator of a successful strategy, which is why smart amateurs that understand Apple tend to out-predict the Wall Street pros. A good example is John Gruber of Daring Fireball, who picked up on a strategic shift when Apple announced the iPad a year and a half ago:

There was a meta-message in today’s Apple event, not about the iPad in particular, but rather about Apple as a whole … [T]his is Apple’s way of asserting that they’re taking over the penthouse suite as the strongest and best company in the whole ones-and-zeroes racket.

Some people have asked me why I write so much about Apple. This is a company that was almost dead 15 years ago, but is now in the running to becoming the most valuable company in the world. Strategy and innovation is how they did it.

Why Apple Had to Choose

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Fifteen years ago, in perhaps the most important article on business strategy ever written, Michael Porter wrote that “the essence of strategy is choosing what not to do.” He drew a critical distinction: many decisions lead to unambiguous improvement, but real strategy – the key to lasting competitive advantage – requires trade-offs: choosing to focus on doing A well, even if that requires you to sacrifice B. Porter’s idea is neither complex nor new, but it’s still hard-learned.

Apple recently released a completely redesigned version of its advanced video-editing software, Final Cut Pro X. Amateur movie-makers such as the New York Times’ David Pogue praised its ease of use, but the reaction among professional video editors was scathing. Missing features and other changes were slammed. With regard to the negative feedback he got following his review, Pogue said he’d “never encountered anything quite like this.” The pro crowd was so incensed with what was termed Apple’s “failure,” “worst launch,” and “biggest mistake in years” that speculation quickly turned to what Apple could have been thinking. Some suspected that it intentionally stripped away critical features to “dumb down” its product and appeal to the much larger amateur editing market – a theory that only angered the pros further. Pogue himself emphatically argued that Apple didn’t intentionally turn its back on the professional market – instead, Apple just “blew it.”

Pogue is wrong. As Sachin Agarwal (founder of Posterous and a former Final Cut Pro product designer at Apple) put it, they knew the Final Cut Pro X redesign would be controversial. He described the rationale for their decision bluntly: “Apple doesn’t care about the pro space.” Nor does it compete on features – it “doesn’t play that game.” Instead, Apple took a professional-grade product down-market by making it simpler, cheaper, and more intuitive – and to do this, they changed and eliminated functionality.

What’s funny is that this has always been Apple’s strategy. While IBM made faster and more powerful PCs for the technical elite in the 1980s, the Macintosh had less RAM but introduced a mouse and graphical interface that any user could understand. More recently, many critics thought the iPad would be dead on arrival because of the features it lacked, but a few, such as John Gruber, understood that Apple was making a conscious trade-off – ignoring the feature-seekers and tinkerers in order to create the world’s most intuitive computer, cheap and capable enough for the mass market.

Did Apple have to choose? If it tried to design software or devices for both laymen and the elite technical segment, it would be forced to make a thousand subtle sacrifices to pull off the straddle – on features, UI, price, marketing, etc. In the end, it might still have made great products, but not as good as those it has now.

The risks of failing to choose are all too apparent when you consider some of the biggest disasters in the high-tech industry recently. There are eerie parallels between last week’s anonymous Research in Motion open letter to the CEOs (“instead of chasing feature parity … [t]here is a serious need to consolidate our focus…. Strategy is often in the things you decide not to do”) and Yahoo’s infamous 2006 leaked “peanut butter” memo (“We want to do everything and be everything – to everyone…. The result: a thin layer of investment spread across everything we do and thus we focus on nothing in particular…. We need to boldly and definitively declare what we are and what we are not”).

Contrast these with Steve Jobs’ philosophy on strategy, repeated endlessly over the years: “People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully … We’re always thinking about new markets we could enter, but it’s only by saying no that you can concentrate on the things that are really important.”

RIM’s share value is down ~33% over the last month. Yahoo’s is down ~60% over the last five years. By contrast, since Jobs returned to Apple, its share value is up almost 10,000%.

Michael Porter might say that the Final Cut Pro X debacle is exactly why Apple is the most successful company in the world.

It’s the Brand, Stupid

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There’s a lot of discussion going on about whether – and why – consumers will choose to buy tablets (mostly running Android) other than the iPad, and, to a lesser extent, smartphones (mostly running Android) other than the iPhone. As usual, pundits and analysts predict that Apple’s dominance must inevitably erode, while John Gruber (@daringfireball) and a few others argue that they’re wrong. Gruber calls the debate “perhaps, the most polarizing topic of punditry in tech today.”

The pundits’ argument is based on sensible Econ and Strategy 101: Apple is making a killing now, but that’s because it was first out of the gate with these products, and without some kind of protective moat, all good things must pass, right? Apple doesn’t seem to have an insurmountable barrier or killer app (like iTunes with the iPod). Therefore, the fast followers will catch up on Apple’s hardware capabilities and apps, and price-compete their way to share. The only question is how long it will take.

One big counterargument, of course, is that Apple has core competencies that not only got it out of the gates first, but enable it to run faster too – particularly in innovation and design. By the time Samsung caught up to the iPad, the iPad 2 was already around the next corner.

In the tablet market, Gruber, John Paczkowski and others make a second argument too – that catching up to Apple isn’t good enough. To really win, a competitor like Samsung, RIM, or Dell has to provide a good answer to the question “why should somebody buy this instead of an iPad?” But this only hints at the much bigger moat Apple’s built around itself: its brand.

Many techies see a brand as an elaborate marketing ploy companies use to appeal to the emotional part of consumers’ minds, and a lagging indicator of success. In other words, you can fool consumers for a while, but your brand will stay strong only if the products are; either way, a brand doesn’t itself create lasting success.

This misapprehends what a brand really is: a promise in the mind of consumers. Unlike, say, five years ago, today most of the extremely high value of Apple’s brand doesn’t come from its ads, its fanboys, or even its retail stores. It comes from average consumers’ experiences.

Imagine a non-techie thinking about buying a new smartphone or a portable computer. Even if she’s never been in an Apple store, there’s a decent chance she got an iPod Nano as a present at one point. More importantly, she almost certainly knows many people who have bought an iMac, iPod, iPhone, MacBook, or iPad over the past decade, in various versions and combinations.

What impression of Apple has this given her? Almost certainly, it’s been overwhelmingly positive, because Apple hasn’t launched a crummy new product in a long time – and that includes both new-category (iPad 1) and next-gen (iPhone 3GS) devices. And here’s the key – when it comes to sales, it’s OK to have a bunch of misses, so long as you have a few big hits. But with a brand, misses hurt. People hate wasting money, and they know they’re taking a risk when they buy a major new piece of technology, same as when they go to a pricey new restaurant. If people talk about how a product kind of sucks, that won’t just hurt sales of that product – it hurts sales of the next one too. The opposite is also true.

Four or five years ago, even if you heard great things about Apple products, it was still acceptable to brush them off – sure, the iPod was cool, but I’m not sure about this new phone. But now, in consumers’ minds, Apple has been batting pretty close to a thousand for a decade. And that’s its best asset – the fact that you can’t sneeze without hitting five people who’ll tell you they love their iPad, will never switch from their iPhone, or that their Macbook “just works” – and zero who say otherwise. In other words, it’s the brand. We’ve been surrounded by great Apple experiences for so long now, we’ve been trained what to expect – if Apple announced it was coming out with a washer/dryer, we’d laugh, but we’d also immediately form some positive expectations about how it would look and function.

That’s why it’s getting harder to defend buying anything but an Apple product: simply because you can be confident you’ll like it. Tech mavens might always be willing to adopt the “best” product, but most consumers are more wary. If Samsung, RIM, Dell, or anyone else today announced a tablet that had 13 good reasons why everyone should buy it instead of an iPad, tomorrow most people would still buy iPads, because the one reason that really matters to the average Joe is risk. Technology is complicated and often disappointing, but Apple’s brand credibly promises people that they’ll love the next thing they buy that has a little bitten apple on it. Other tech brands can’t do that without sounding like the Boy Who Cried Wolf. And one great product won’t close the credibility gap – they’ll need a decade of great products, with almost no misses. The kind of trust Apple’s built up creates incredible momentum. That’s why the “tablet market” is Apple’s to lose.

Apple’s Absurdly Low P/E Ratio

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Fortune has a short post by @philiped today that calculates Apple’s PEG ratio (price / earnings / earnings growth, a favorite measure of Peter Lynch) to be below 1.0, and far below companies such as Dell, Amazon, and Cisco, implying that it’s undervalued (same for Google and IBM).

In other words, Apple’s profit growth is explosive, but as I write this, its P/E is still in the mid-teens (currently 15.0). Google’s is 18.8. The S&P 500 overall is 22.6. Amazon’s is 81.3.

This means either the market is expecting Apple’s growth to slow dramatically, or it believes Apple’s future earnings to be highly risky – or both. Whatever the case, Apple’s stock is down 10% in the past four months.

This is absurd. Would anyone in his right mind actually bet against Apple’s earnings growth right now, given the sales it’s posting for iPads, iPhones, and iMacs? If this is a Steve Jobs story, it’s hugely overblown.

Prediction: Apple will continue to outperform the S&P and tech peers like Amazon over the next 6, 12, and 24 months. I’m putting reminders to check back into my calendar.

Buy now.